Death Bonds

One evening at the dinner table, my father told me that he would probably die before my mother. He was much older than her, and he explained how he no longer needed to pay premiums on his life insurance now that all of us kids had grown up and made lives of our own. He and my mother would be comfortable for the rest of their retirement without this policy. He said that the insurance companies would refund some of his money, but those bastards completely rip you off. If you’ve paid ten grand in premiums, they’ll give you back two.

He offered me a chance to purchase his life insurance. I would pay him a few thousand, the same as what the insurance companies were offering, and take over ownership of the policy although it was still tied to his death. I would continue to pay premiums, but I would be the one to receive the big payout in the end once he died. This way, all the money he poured in over the years would stay in the family.

I’m sure that analyzing the numbers would have made the decision much harder for me, but I have one important rule when it comes to investing or gambling: if everything inside you says it’s a bad idea, don’t do it. Besides, I don’t think there’s very much on this earth that can destroy him anyway. He’s filled himself with smoke since he was ten. Up until recently, fried chicken was a weekly tradition. His father and siblings abandoned him or stole from him. He's had over 20 different jobs, careers and business failures under his belt. And now, to top it all off, he’s embraced death. There’s no freaking way I would bet against him.

My father is an insurance broker. He had been introduced to this idea a few years back at an annual conference he reluctantly attends. What he discovered was that there are investors out there willing to accept the proposition that I couldn’t. They were buying insurance policies from people who no longer needed them. But why?

To fully understand, let’s go over some more details about life insurance. Most people are like my father. They take out life insurance so that while the kids are growing up, should anything happen, the family is taken care of. But once the kids grow up and move on, paying those premiums becomes harder to justify. There’s no need for the big payout anymore. In fact, insurance companies count on people to accept the “cash surrender value,” to end the contract. They refund you a fraction of what you’ve paid in premiums over the years – you surrender the rest. That’s your only option if you want to stop paying the monthly bill.

But a new option has emerged in the last few years. With outside investors willing to pay a premium to take control of these unwanted insurance policies, people like my father can get a lot more cash back than what the insurance companies traditionally offer in surrender values.

It’s a great investment for the outside investors too. Because cash surrender values are so absurdly low, the investors are still able to scoop up the policies at a discount. They focus on cherry picking policies from older, unhealthy people. Once the investor takes over, part of sustaining the investment is to continue paying the premiums, and waiting for the jackpot. The earlier people die, the greater the profit. The beauty of investing in insurance policies is it has nothing to do with the economy. Markets can go up or down, but you can always count on people dying.

So who’s buying all these policies? Enter: Death Bonds. Numerically sculpted like the Grim Reaper, this is a financial instrument composed of unwanted life insurance policies. Institutional money managers, like hedge funds, are letting insurance brokers everywhere know that they are interested in buying insurance policies from people who need the cash. As they aggregate these policies, they securitize them. Securitizing is just a fancy word for taking similar financial instruments (like several insurance policies), and lumping them together to make an industrial sized financial instrument (like a bond that is based on several individual insurance policies).

Now that we have all the pieces, here’s the recipe for a Death Bond:

• Picking the fruit is essential. Lucrative insurance policies tend to come from people who are older and have paid into these policies most of their lives. Their recent health history shows a lot of risk. Of course, the big payout at the end is crucial too. Buy as many of these policies as you can;
• Add up the total death benefits of all of these policies once everyone is ultimately dead (assume $1 Billion);
• Securitize these individual policies to make a much simpler, larger, and more attractive financial product for institutional investors: the Death Bond;
• Find investors that collectively will give you $1 Billion in exchange for your Death Bond;
• They effectively invest $1 Billion in your bond. The investment will pay them interest each year, and 15 years from now, the Bond will return their $1 Billion principal;
• The issuer of the Death Bonds receives $1 Billion in cash up front. They take this money and continue paying the premiums in order to keep the underlying insurance policies alive. They can invest the rest in low to moderate risk investments for the next 10-15 years. Part of this cash would be used to pay a coupon to investors each year, so they receive about 5% per annum on their $1 Billion dollar investment in the Death Bonds;
• By the time these bonds have matured, most of the underlying insurance policies should have paid the death benefit. There is plenty of cash available to pay the investors their principal back when the bond expires. Also, the Death Bond issuer has been investing the excess cash during this time which they can draw from as well, just in case people outlive their calculated life. Once they have paid back the investors in full, the remaining cash is gravy.
  

It sounds like a win-win situation, right? Individuals that need the money get more cash for their policies because of this emerging market. Creators and issuers of Death Bonds are able to make a profit on these policies by securitizing them, making them attractive to other institutional investors. Finally, those institutional investors make a moderate and safe return during a time of extreme volatility. But in finance, someone has to lose. In this case, that would be the insurance companies.

The Death Bond market is growing. They are especially attractive right now because they provide a decent rate of return that isn’t correlated with the markets. As the policies change hands, from individuals to institutions, more of the policies will be carried out until maturity (death). This means insurance companies will have to make additional lump sum payments that they may not have accounted for in their reserves.

Insurance companies calculate reserves based on the probability of death, but remember, historical data reflects that a great number of people traditionally accept the cash surrender value – there was no other alternative before. With the emergence of Death Bonds, these policies are kept alive until the death benefit is collected. Insurers must respond by facilitating this drastic change in their cash outflow. The faster the Death Bond market grows, the harder it will be for insurance companies to recalculate what a sufficient reserve is.

By forcing insurers to pay out these death benefits, rapid growth in the Death Bond market will pose liquidity problems to life insurance companies. This is primarily an American phenomenon, but we can already name life insurers (AIG) that are barely staying afloat, kept alive by periodic government cash injections. Should the Death Bond market explode, this could push struggling insurance companies to the brink of extinction.

But I don’t want to end this on such a pessimistic note. Let’s assume that everyone involved is doing their homework and only transacting on insurance policies that are backed by healthy insurance companies. Let’s pretend that Wall Street won’t try to lowball people like my father for their insurance policies to enhance their profits. Let’s even go as far as saying that all the issuers of Death Bonds, who by the way have no prior experience with predicting life expectancy, somehow grasp the actuarial task proficiently enough to structure the duration of Death Bonds correctly. This way, everyone involved lives happily ever after – until they die.