Death bonds (aka life settlement-backed securities, longevity derivatives, mortality bonds) are asset-backed securities, a new derivative based on the securitization of life insurance policies purchased from the elderly or the terminally ill. These new securities are mainly sold in Europe now, but more will be sold in the United States soon. They are not yet rated by any major ratings service, although Moody's and Fitch are said to be rating some big issues soon.
Death bonds are a type of asset-backed security that has its origins in viatical settlements (aka life settlements) in the 1980's and 90's. This was the time when AIDS was rampant and incurable, and many sufferers needed or wanted cash, so they sold their life insurance policies to certain companies or investors that were offering to pay cash for the policy. The company or investor would continue making payments until the insured died. However, as AIDS victims lived longer, viatical settlements were not profitable, and with rampant fraud in the 1990's, they fell into disfavor.
However, viatical settlements are starting to come back in vogue, but the seller is not necessarily terminally ill.
The way it works nowadays is that the seller, usually older than 70, goes to a viatical broker to find buyers for the seller's policy. The broker usually obtains 3 bids for a policy from life settlement providers, who are mostly small firms, and bids may range from about 20% to 80% of the policy's value, depending on how long the insured is expected to live. The buyers take over the payment of premiums—otherwise the seller may stop paying, thereby terminating the policy—and collect when the seller dies.
People turn to viatical settlements because they need the money now or don't want to continue paying premiums, and they receive more money than surrendering the policy to the insurance company for cash.
Brokers generally receive commissions of 5-6% which are paid by seller. Presently there is a lot of fraud in this area, and only 26 states require viatical brokers to get a license.
Most of the buyers are viatical settlement companies, who then resell the policies to hedge funds or investment banks, who then securitizes them into asset-backed securities backed by a pool of about 200 policies. The anticipated buyers of these securities are mainly institutional investors, such as pension funds.
Death bonds can exist because of 2 characteristics of life insurance:
- The beneficiary does not need to have an insurable interest in the insured.
- The life insurance can't be canceled by the insurance company after about 1 or 2 years unless the premium isn't paid.
The main benefit besides the yield, advertised as being 8% to 10% or more, is that death bonds have no correlation to other investments. However, the yield is highly dependent on how long the people live—if long enough, then not only will there be no yield, but some, or all, of the principal may be lost. The yield is equal to the amount of the payout minus the amount paid to the insured minus the premiums that need to be paid, and, of course, the costs of effecting the transaction. Much of the fraud in this area is from overly optimistic (for the investor) projections of the yield based on inaccurate life expectancies. Every premium that is paid reduces the yield.
The disadvantages and risks of investing in death bonds include:
- Gains are taxed as ordinary income.
- Money could be tied up for long periods of time.
- The insured may live much longer than expected. This longevity risk can be reduced by investing in a pool of life settlements.
- There is a large amount of fraud because investors have no way of independently verifying the assertions made by doctors and actuaries about the policyholders.
- Dealing only with licensed providers and brokers may reduce the fraud risk.
- There is litigation risk since insurers may decide to not pay a claim because the policyholder lied about his health—what is referred to as clean sheeting— or that the insured took out the policy for the explicit reason to sell it to a life settlement company, especially if the policyholder sold the policy shortly after applying for it.
- Another risk is dirty sheeting, where the policyholder claims to be in worse condition than in actuality so that his policy will fetch a higher price.
- Sometimes the insured will borrow the money for the insurance policy, but fail to re-pay the loan, so the lender may attach the policy.
- There may be deadbeat risk if some of the investors stop paying the premiums, in which case, the settlement provider will have to have enough funds to cover the shortfall.
There are no ratings yet available by the major rating agencies, though some are expected soon from Moody's and Fitch for some large issues. If some of these securities get an investment-grade rating, then there may be some mutual funds based wholly on life settlements, or some lesser portion, such as the Assured Fund, which is based in the Cayman Islands, where it is not subject to the UK Financial Services Authority, but sells to investors in the United Kingdom. A significant risk for these securities is that the insured may be disqualified for the insurance before death, such as may occur if the insured failed to disclose a pre-existing illness.
The size of the death bond issues for 2007 is expected to top $30 billion, with much larger growth in the near future because of the size of the aging baby-boomer population.