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Marketplace Scratch Pad

They’ll bet your life

Scott Jagow Sep 8, 2009

Here’s an argument for why bailing out Wall Street might’ve been a horrible idea — the bankers have little incentive to be careful. They’re already cooking up the next exotic, dangerous way to make piles of money, and that could be to gamble on when the sick and elderly will die.

Marketplace’s Amy Scott reported on the infancy of the idea a couple years ago. But now, the New York Times says this financial “innovation” is starting to take hold on Wall Street. Emphasis mine:

The bankers plan to buy “life settlements,” life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to “securitize” these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

Sound familiar? Oh, it gets better:

“We’re hoping to get a herd stampeding after the first offering,” said one investment banker not authorized to speak to the news media.

In the aftermath of the financial meltdown, exotic investments dreamed up by Wall Street got much of the blame. It was not just subprime mortgage securities but an array of products — credit-default swaps, structured investment vehicles, collateralized debt obligations — that proved far riskier than anticipated.

The debacle gave financial wizardry a bad name generally, but not on Wall Street. Even as Washington debates increased financial regulation, bankers are scurrying to concoct new products.

But before we lump this idea in with previous schemes, let’s take a closer look at it:

Defenders of life settlements argue that creating a market to allow the ill or elderly to sell their policies for cash is a public service. Insurance companies, they note, offer only a “cash surrender value,” typically at a small fraction of the death benefit, when a policyholder wants to cash out, even after paying large premiums for many years.

Enter life settlement companies. Depending on various factors, they will pay 20 to 200 percent more than the surrender value an insurer would pay.

So, this is a public service for people who want to cash out their policies while they’re alive. What’s to stop someone from taking out a policy for the sole purpose of selling it back to the broker? More:

Not all policyholders would be interested in selling their policies, of course. And investors are not interested in healthy people’s policies because they would have to pay those premiums for too long, reducing profits on the investment.

But even if a small fraction of policy holders do sell them, some in the industry predict the market could reach $500 billion. That would help Wall Street offset the loss of revenue from the collapse of the United States residential mortgage securities market…

The players are already lining up to get into life insurance bundling…

Goldman Sachs has developed a tradable index of life settlements, enabling investors to bet on whether people will live longer than expected or die sooner than planned. The index is similar to tradable stock market indices that allow investors to bet on the overall direction of the market without buying stocks.

The Times also talked to a ratings agency called DBRS, which is trying to come up with a “safe” formula for bundling life policies without the risks of previous securitization:

The solution? A bond made up of life settlements would ideally have policies from people with a range of diseases — leukemia, lung cancer, heart disease, breast cancer, diabetes, Alzheimer’s. That is because if too many people with leukemia are in the securitization portfolio, and a cure is developed, the value of the bond would plummet…

If a cure is developed, investors lose a ton of money.

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