Betting on Death: The Banks’ Dangerous Gamble

In the United States, investment banks buy life insurance policies at a premium from private individuals who want to get out of financial trouble. Once the person has died, these institutions collect money from the insurance company. This cynical practice attracts numerous investors.

Goethe’s Dr. Faust sold his soul to the devil in exchange for eternal youth. What are we supposed to think of people who plan to get rich by betting on the death of their fellow human beings? To whom have they sold their souls? These questions aren’t purely theoretical. Thanks to the latest form of financial innovation, you can now invest in life insurance policies that policyholders wish to drop.

As it happens, it is legal in the United States to sell your own life insurance policy back to the insurer who initially issued the policy, which is logical, or to an investment bank. Who are the policyholders who would be interested? Usually, people of a certain age are involved. Since their children are grown, life insurance is no longer really necessary, and they may very well prefer to get a sum of money that they can use for other purposes.

If the recent financial crisis has left them in financial distress, the money they make can allow them to pay off debts or get proper care.

Which financial institutions are active in this area? Certain investment banks that were supposed to be “too big to fail.” They buy up the policies, bundle and securitize them, while also diversifying them. Then they offer them to investors. Diversifying risks means, for example, to pool together life insurance policies belonging to cancer patients with those belonging to AIDS patients. As the reader will understand, the risk being diversified is the risk of a death that comes too late. In fact, if the insured would be so inconsiderate as to live longer than expected, the investors would not collect the amount specified in the contract until a too-distant maturity date.

Let’s look at an example. Mrs. Smith, age 60, lives in Chicago. She raised her three children on her own. When they were young, she took out a life insurance policy that would have allowed them to collect $500,000 and, through a trustee, to help pay for their education, if by some misfortune she had died prematurely. Now that she has lost her job because of the economic crisis, she plans to sell back her policy so that she can have enough money to take care of her needs. This possibility is much more attractive because her children are now independent adults. The insurance company offers her $120,000 to buy back her policy, while an investment bank offers $300,000. The bank has made its bid after obtaining the results of Mrs. Smith’s required medical exam. The exam showed that she had a fairly high risk of cancer. And in fact, her unemployment has led her to consume more tobacco. For Mrs. Smith, the choice seems easy. She will opt to sell her policy to the bank, which is offering a larger sum of money. This will allow the investors involved to collect $500,000 on her death.

It should be noted that if this system is put in place on a large scale (life insurance policies in the United States have a total face value of roughly $26 billion), as is currently being discussed, either the insurance companies involved will end up in a difficult situation, or premiums will rise to the point that life insurance will be prohibitively expensive for many. These people will no longer be able to buy insurance and will live in fear that a fatal accident will put their young childrens’ education in jeopardy.

In fact, in calculating their premiums, insurance companies factor in the high probability that many policyholders will sell back their policies when they reach a certain age. This reduces their costs, since it is quite possible that they will not have to pay the face value of the policy ($500,000 in the preceding example) on the date of the client’s death. If the policyholders sell their contracts to banks, then the insurance companies will have to pay out the face value at the time of the client’s death, which will have the contrary effect of increasing their costs. They will then be prompted to raise their premiums, which could make them lose clients who will no longer be able to afford this type of protection.

Recent research at New York University estimates the insurers’ potential losses at $1.3 billion per year. This type of secondary market was developed at the end of the 1980s and began with life insurance policies that belonged to young people suffering from AIDS and who had less than two years to live. During the 1990s, this market was extended to policies belonging to people over 65 years old who have a limited life expectancy.

The amount offered by the bank is a function of the following factors: the policyholder’s current age, his health status and his financial situation. This means that someone will be more attractive as a client when he gets older, his health declines, and his financial situation becomes more fragile.

The most important variable in this calculation is the mortality factor. The sooner the client dies, the greater the profit for the investor. Therefore, the greatest risk is an inaccurate systematic estimation of life span.

Moreover, this kind of securitization completely distorts the nature of life insurance policies, since it turns them into wagers on the deaths of the individuals involved. It could also have an impact on public health. It is disquieting to think that cancer or AIDS research, or health insurance reform in the United States, could be seen as a danger to powerful financial groups because of the risk they represent in terms of increased life expectancy. Recall that the United States, the number one economic power, is only number 27 worldwide in life expectancy.

Some “experts” try to be reassuring. The systemic risk is probably very limited, they explain, because of the process of securitization, the diversification of illnesses and age groups. Chief among them is Joshua Coval, a professor of Finance at Harvard Business School who was quoted in Jenny Anderson’s Sept. 5, 2009 New York Times article, “Wall Street Pursues Profit in Bundles of Life Insurance.” [Read Here]

The only serious risk would be the possibility of a policyholder dying too late!

If the introduction of new financial products leads us to define risk in this way, it means that the new products clearly play a harmful role in the economy. In fact, growth comes from economic agents that consume and invest. Growth can be stimulated by financial innovation only if such innovation is regulated. It is impossible to imagine that financial products that allow investors to bet on the lives of vulnerable human beings, or on business failures, like Credit Default Swaps, can be compatible with durable economic growth on the one hand, and be faithful to the basic principles of capitalism on the other. To keep the Faustian dream from turning into a nightmare, it’s time for the public to take over the debate, and for these products to be banned.

The authors are affiliated with the Swiss Banking Institute of the University of Zurich.