Life insurance securities

Written by Andrew Szabo
Thursday, 10 September 2009 00:00

A recent article in The New York Times noted that Wall Street is back in the business of creating complex bonds that slice and dice pools of underlying hard to value assets. One area that is heating up is securitization of life insurance policies. (See “Back to Business — Wall Street Pursues Profit in Bundles of Life Insurance,” Nytimes.com, Sept. 5). Obviously, after the recent subprime lending and commercial real estate securities fiascos, government regulators will be more alert to the potential risks.

We have discussed in past articles the development of a secondary market in life insurance policies. This market started to bloom during the onset of the AIDS crisis in the late 1980s, as victims began to seek to sell their policies to investors while still alive. What’s more, spurred by various commercial sponsors, some people began to seek financing to take out life insurance policies with the idea possibly to sell these policies after two years, when the so-called “contestability period” ends in most states. The life insurance industry vociferously opposes such “speculative” uses of life insurance. One reason cited by industry spokesmen is that “gaming” of the life insurance market by such speculative uses will tend to increase the cost of life insurance for bona fide uses.

There are now billions of dollars of life insurance policies, many of them originated using leverage, which are looking for a home. The credit crunch has inhibited resale of the policies. For the lenders, many of whom are hedge funds, this is an urgent matter, as the burden of financing further premiums is great. If premiums are not paid, the policies may lapse, the collateral backing the loans will lose its value and the lenders could face a financial crisis.

It is likely that large amounts of such marooned life insurance policies will come to market this year in the form of collateralized life insurance trusts. These securities will seek to match investor preferences for different maturities — short, intermediate and long — by offering a series of tranches of securities, prioritized by the timing of their cash flows.

There are many novel and difficult questions posed by such life insurance securities. First, who will provide the capital needed to keep policies in force? This call on capital is different from most fixed income securities and is perhaps most similar to the risk in private equity funds. Investment banks are batting about different solutions, including reinsurance, contingent claims, letters of credit, sinking funds, zero coupon tranches and other devices. A second problem is estimating mortality risk. The longevity of Americans has increased in every decade since the United States life insurance industry began collecting such data in the second half of the 19th Century. This long-term, one-way trend is again different from mortgage prepayment risk, which rises and falls with interest rates. A third problem is the law of “insurable interest,” which can create a doubt about the enforceability of some life insurance assets originated for or resold to investors, depending on state statutes and case law.

Andy Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment adviser. Questions, call 531-2877 or e-mail This e-mail address is being protected from spambots. You need JavaScript enabled to view it . Previous columns may be found at Blog.GreenwichFinancial.com.