Death Bonds

Death bonds (aka life settlement-backed securities, longevity derivatives, mortality bonds) are asset-backed securities, a derivative based on the securitization of life insurance policies purchased from the elderly or the terminally ill. These securities were mainly sold in Europe.

Death bonds are a type of asset-backed security that originated from 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.

The way they worked was that the seller, usually older than 70, went to a viatical broker to find buyers for the seller's policy. The broker usually got 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 turned to viatical settlements because they needed the money 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. There is much fraud in this area, and only some 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 were mainly institutional investors, such as pension funds.

Death bonds can exist because of 2 characteristics of life insurance:

1. The beneficiary does not need to have an insurable interest in the insured.
2. 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 is that death bonds have no correlation to other investments. However, the yield depends 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 = the payout amount minus the payment 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 was from overly optimistic (for the investor) projections of the yield based on inaccurate life expectancies. Every premium 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 a long 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 much 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 not pay a claim because the policyholder lied about his health — called 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 must have enough funds to cover the shortfall.

A big 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.