After enduring the collapse of the mortgage market, Wall Street has found its next big moneymaker, and doing your part to help financial firms earn profits is simple: All you have to do is die.
Creating tradable asset-backed securities from illiquid investment assets played a big role in helping the mortgage market become as large as it did. It also created huge amounts of revenue for major Wall Street firms that underwrote those securities, including Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS), and the now-defunct Lehman Brothers. But with the mortgage market in tatters, some now believe that a new product referred to as "life settlements" may bring a new wave of asset-backed securities into the market.
Why life insurance is the next big thing
To understand these new securities, you first need to understand the asset that's backing them. In a nutshell, life settlements connect ordinary people who own life insurance policies that they no longer want with investors who see value in purchasing those policies.
Here's how it works. Say you have a life insurance policy that was designed to provide for your family if you passed away. Now your kids are all grown, though, and you'd just as soon stop paying annual premiums. You can always simply choose to cancel the policy. Depending on what type of policy you own, you may be entitled to get the policy's cash surrender value back from the insurance company.
However, what you get is often far less than the true economic value of your policy. Even a term policy that has no cash surrender value may have economic value, depending on its eventual payout and your life expectancy. As a simple (though unrealistic) example, say you knew for certain that you would die next month. If you owned a $100,000 life insurance policy and just had to make a single $100 premium payment to maintain it, then it would clearly be worth it to keep the policy in force rather than canceling it.
Making a deal
That's where the life settlement comes in. An outside investor may offer to buy your policy for more than its cash surrender value. In exchange, that investor gets all the rights to future payouts from the policy. So in the example above, an investor might pay you $90,000 for your $100,000 policy. That works out well for both of you: you get $90,000 to spend while you're still alive, and the investor makes a $9,900 profit (after paying the $100 premium) in a single month.
Of course, in reality, there's a lot more uncertainty involved. If you live a long time, an investor will have to pay more in premiums to keep the policy in force, and it'll take a long time for that investor to get paid off.
As intriguing as they sound, life settlements are a relatively small business right now. Small companies like Life Partners Holdings (NASDAQ:LPHI) and a host of privately held businesses currently help facilitate them. But right now, the major obstacle is bringing investors and policyholders together; like a mortgage, each transaction has unique characteristics.
Similar to holding securitized mortgages, the appeal of a life-settlement-backed security is that rather than having full exposure to a single policy, you could own small pieces of thousands of different policies. That way, even if some policies end up losers, you'll still make money if enough other policies are profitable. That's why companies like Goldman and Credit Suisse (NYSE:CS) are closely examining the potential for life-settlement-backed securities.
Winners and losers
In this case, what's good for securities underwriters may be bad for life insurance companies. Major insurers like MetLife (NYSE:MET), Prudential Financial (NYSE:PRU), and Manulife Financial (NYSE:MFC) have already faced substantial losses in their investment portfolios resulting in part from the market's sell-off as well as exposure to financial derivatives that have performed badly. They'd obviously prefer to see policyholders surrender policies cheaply, rather than having to pay the full policy value to third-party investors on the death of the original policyholder. If the life-settlement market matures, insurers may have to raise rates to compensate for fewer canceled policies.
At least in the short term, though, a more liquid life-settlement market could help policyholders. Although the complexity of actuarial projections makes it possible that life-settlement companies could take advantage of unsophisticated policyholders, it's still likely that policyholders would get more from a life settlement than they would otherwise. In tough economic times, those proceeds could make a big difference to struggling seniors.
As Wall Street gets back on its feet, there are other signs the economy is recovering. Matt Koppenheffer has all the details right here.
