Life Settlements-Backed Securities Draw Scrutiny, Skepticism

Aggressive investment firms and banks believe they’ve uncovered the latest innovation that will refresh investor confidence and bring the markets back to life. Wall Street has set its sights on securitizing a carefully regulated insurance product — life settlements — and already, institutions as large as Goldman Sachs and Credit Suisse are actively examining the potential profitability of packaging life settlements into securities bonds.

But why do investors find so much appeal with the life settlement market?

“I think investors like life settlements as an asset class due to a few reasons,” says Brad Strickland, senior vice president of Melville Capital LLC, a life settlement brokerage. “First of all, they are completely uncorrelated to the more traditionally traded assets like stocks, bonds and real estate; secondly, as death is certain, there is an absolute return on investment. And if life expectancy underwriting is sound, then returns can be quite attractive. Finally, it’s a nice replacement for mortgage-backed securities and other assets that have lost their recent market appeal.”

But even as interest among investment and banking firms flourishes, regulators and industry experts recognize that the practice of securitizing life settlements is complicated and not without its fair share of risk. Indeed, federal regulators are already taking a hard look at life settlements and considering their role in the securities market.  The Securities and Exchange Commission has established a task force to investigate not only the practice of securitizing life settlements, but also to determine how well the people selling their life policies and the investors who buy them understand what they get from such a transaction. The SEC will also look into disclosure practices and standards.

“There are many questions raised by life settlements — from sales practices to privacy rights to the role of securitizations,” SEC Chairman Mary Schapiro told The Wall Street Journal. “And the answers could help determine where more oversight is needed. This is a growing market and we want to be ahead of it.”

Securitized life settlements are compared to the subprime mortgage meltdown because they are similar in foundation and concept. As with mortgage-backed securities, the risks of this securitization plan carry deep implications for consumers, insurers and the markets. For securities-minded firms, the biggest risks are increased life expectancies and potential collapse of the product. Life insurers face the challenge of having to pay more claims than usual, which would likely force them to increase the cost of coverage. And as usual, it leaves the consumer with the most to lose.

Essentially, the plan is for bankers to purchase life settlements and mold them into securities by bundling several hundred or thousands of policies (varying in value from several hundred thousand dollars to about $1 million) into bonds they would sell to investors as something resembling a pension fund. Investors would receive their payouts based on when the original life insurance policyholders die — and the earlier the death, the higher the payout.

Therefore, in order for investors to maximize their earnings, the ideal life settlement bond would not include policies from healthy individuals. Instead, the bond but would be weighted with a variety of policies from numerous sickly people, preferably with as broad a spectrum of disease as possible. They’ll want policies from people suffering from the worst of the worst, like Alzheimer’s, diabetes and cancer. By establishing good disease diversity, investors are less likely to suffer a severe devaluation of their bond if, for instance, a cure for Alzheimer’s were invented.

But it’s highly unlikely that thousands of sick seniors ready to sell their life insurance policies will suddenly appear to form a pool large enough to fund the bond. This fact alone opens the door to unscrupulous agents who may solicit people to buy a life insurance policy with the sole intent of earning their cut by quickly selling the policy on the secondary market. Insurers and regulators also worry that greed may also drive fraudsters to take further advantage of vulnerable seniors by selling them policies — without proper disclosure — they either don’t need or understand.

Securitizing life settlements could be the next regulatory nightmare or even, as some insiders suggest, the next market fuse to blow. With so much risk to go around, it’s time for everyone to brush up on their history — including some of our economy’s most recent.