Sunday, December 17, 2006

Supply and Demand: Investing in Death

An article in today's New York Times describes the booming third party trade in life insurance policies (termed SPeculator INduced LIFE insurace, spin-life). Normally, life insurance works as follows, I buy a life insurance policy from an insurance company pay an annual premium until I decide to cancel the policy or die, at which time the insurance company would pay out to my heirs. It seems as though some elderly are cashing out their policies by selling them to third party investors. These investors are willing to pay a lump sum for the right to pay the annual premium and eventually receive the policy payout when the insuree dies. The insuree goes from A) paying an annual premium for a certain payment upon death to B) receiving a certain payment now.

This situation is confusing to me. Normally, I think of insurance as being actuarily unfair to the insuree. That is, on average, the insuree pays in more than he or she takes out. Otherwise, insurance companies wouldn't be profitable (See for instance this article in the LA Times) . Insurees take part in the transaction because they are unwilling to bear the risk. In return for decreasing their risk, they are willing to accept a lower expected payoff. Yet, now think of the situation described in the NYT article. Investors are willing to pay to to become the insuree! Are these third party investors telling us that life insurance is under priced? That, the expected pay out of a life insurance policy is higher than the expected cost? Are they risk seeking?

What are the implications of spin-life? Who benefits? Who loses? Insurance companies will be checking their calculations to make sure they aren't under-pricing their policies. It seems that as expected payouts from the life insurance policies go down due to lack of cancellations, the prices of life insurance are likely to rise. The biggest potential losers, in my view, are the regular consumers of life insurance, who are likely to face higher prices. Is there a need for government intervention? Are there other costs associated with strangers benefiting from the deaths of the elderly? I certainly have little sympathy for the insurance companies who claim they are being
taken advantage of. They are in the business of taking advantage. This time, it seems as though some others are just one step ahead of them.


Shmuel said...

Although the investors are accepting the burden of future payments, they are not "paying to be the insuree" They make a cost-benefit analysis, using a combination of life expectancy reports and requirement of future payment, against the payout. The initial insuree will always be the insuree. They are paying to be the beneficiary.

dick said...

There are two cases where becoming the beneficiary and making the premium payments can be a good idea.

In level term insurance and whole life insurance, in return for overpaying near the beginning of the contract you get to underpay [but not by as much] near the end.

If your health takes a severe turn for the worse you can be underpaying given your then-current health. The canonical example of this is "viatical settlements" for AIDS patients who had gotten life insurance before they got sick in the early 1990s.


John said...

Yeah, it's clearly some kind of irrevocable contract with premiums fixed at the start like whole life insurance here. You don't absolutely need level premiums like in some insurance, you just need insurance whose premiums were fixed at the time of issuance. Once your health takes a turn for the worse, your expected value of the insurance policy should become positive.

(Note also that you've been paying in premiums for as long as the policy has been issued. Over the entire term of the policy, your expected value is negative, but starting for a certain point later, the expected value of the remainder can become positive at some point, particularly with whole life.)

Mary Pat said...

Here's something y'all may not know: some life insurance lines of business are lapse-supported, meaning that the fact that some people stop paying premiums and let the policy lapse means that you've got some policies that pay premiums and never pay a death benefit.

However, if some outside group comes in and pays premiums for people who would otherwise have let premium payments lapse...yes, the contracts are underpriced.

Another way they can be underpriced is if they're underwritten using variables that do not fully capture the mortality risk for the given insuree.

Michael said...

I don't where the insurance companies are being taken advantage of here. If it turns out they were mispricing the policies, they would find this out by doing a current actuarial analysis anyway, and probably already knew.

It's far more likely that speculators are taking advantage of the fact that insurance companies and policyholders are otherwise locked into a plan that doesn't make as much sense for one or the other now as when it was written.

If someone is in very poor health, much poorer than the IC expected them to be at this age when they wrote the policy, the insurance is worth much more to the policyholder. Of course, if the insurance company did it's analysis correctly, there will be other insureds whose policies are worth much *less*. Only those whose policies are worth more will be bought at par or above by speculators.

Other insureds may not have an above par value policy but have found that their circumstances have changed significantly. They may have decided on WL/UL in their 50s when they were fairly well-off to make sure their starving writer daughter would have a nest egg when they died. But then medical costs or poor investment performance has reduced their wealth greatly, and the starving writer wrote a bestseller or got a tenured academic job and doesn't need their money anymore. Now it might make sense to take a lump sum worth 80% of the PV of the contract to have some money now while they can still enjoy it.

I imagine that situations like this occur all the time. Not being able to sell your position to a speculator who prefers it when you no longer do is generally a deadweight loss (for those who would sell at the market price). It doesn't cost the insurance company anything for the insured to sell these.