Wall Street Magic Has Moved To Bundling Life Insurance Settlements

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Wall Street played a huge role in creating the economic mess we are in through the securitization of sub prime mortgages and through other ill advised financial products. Now, the NY Times reports that the banks have turned their attention to buying up life insurance settlements and then applying some of the same principles to them that were used on the sub prime mortgages.

Here’s the basic gist. Life insurance policies often have a cash surrender value if you want to cancel the policy. But normally this is not a significant amount of money. So what does an elderly or very sick person do if they have a large life insurance policy but need money now? They “sell” their policy to someone who pays money to then keep the policy in force until the person dies.

The idea is that you pay less for the policy and the premiums than you will receive when the elderly or sick person dies.

Until recently, this has been a relatively small market but the big banks that were part of the source of the sub prime problems, and many of whom received a couple of our tax dollars, are planning on making this the “next big thing” in the financial markets.

Here’s how it will work:

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.

The earlier the policyholder dies, the bigger the return – though if people live longer than expected, investors could get poor returns or even lose money.

Either way, Wall Street would profit by pocketing sizable fees for creating the bonds, reselling them and subsequently trading them.

The concern rests in what will happen when investors do not fully understand these risks and the whole market goes down. Will we step up and keep the banks afloat with our tax money again? Or do we let them sink?

Another concern is whether this will raise insurance premiums:

Indeed, what is good for Wall Street could be bad for the insurance industry, and perhaps for customers, too. That is because policyholders often let their life insurance lapse before they die, for a variety of reasons – their children grow up and no longer need the financial protection, or the premiums become too expensive. When that happens, the insurer does not have to make a payout.

But if a policy is purchased and packaged into a security, investors will keep paying the premiums that might have been abandoned; as a result, more policies will stay in force, ensuring more payouts over time and less money for the insurance companies.

“When they set their premiums they were basing them on assumptions that were wrong,” said Neil A. Doherty, a professor at Wharton who has studied life settlements.

Indeed, Mr. Doherty says that in reaction to widespread securitization, insurers most likely would have to raise the premiums on new life policies.

Of course this may be a fantastic new financial product that is good for everyone. It may give elderly and others the opportunity to get the treatment they need or to enjoy their last years rather than their kids getting a big payout on a life insurance policy. It may create more liquidity in the marketplace and help restore the economy.

One thing is for sure – the same characters who were responsible for the good and the bad in the mortgage markets will be bringing their magic to this new area and we all need to be aware of this new trend and how it will affect us.

We’ll keep an eye on this and keep you posted….

Update on 9-8-09 — John Wirzbicki of CT Blue has an interesting take on this development. Read his blog post here.

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