Sunday, September 6, 2009

Life Insurance Backed Securities (LIBS)?

Today's New York Times has a fascinating article on a new kind of structured product that is hitting the market, which is backed by life insurance policies that the holder has cashed out of.

First, let me briefly try to explain what a structured product is. (If you know this already, please skip ahead.) Simplest example: Mortgage Backed Security (MBS). So a bank makes a bunch of mortgages. The mortgage holders hopefully make regular payments, and, if not, the bank loses some money, depending on how much they can sell the foreclosed house for, and the administrative and legal costs of doing that.

Now, in an MBS, the bank sells the mortgages to a special corporation set up for for this purpose, which funds the transaction by selling debt and equity to investors. These investors' dividends and coupons are funded by the payments from the mortgage holders. If the mortgage holders default, then there is a hierarchy based on the seniority of the investors' debt and equity as to who loses money first (and has been getting a higher coupon because in exchange for holding this risk appropriate).

The MBS marketed failed for fundamentally three reasons:

1) Lenders and brokers weren't going to be holding onto the mortgages, and so had minimal incentives to lend to credit worthy customers
2) Investors that bought the higher rated debt backed by these mortgages had no really understanding of the fundamentals of these mortgages or the sophistication of the structure
3) A massive drop in the housing market would would (and did) wipe out investors who thought they were well protected

Okay, now, to the issue at hand. I'm old and need cash and want to cash out my life insurance policy. Instead of borrowing against it, I decide to sell it a bank, in exchange for a lump sum. The bank them pays my premiums, and, upon my death, gets my payout.

So, now we have the makings of a structured product. An investor puts up a bunch of money, which goes to both to the lump sum of the policy-holder, and to cover the ongoing premiums, and then gets a regular coupon from the ongoing, staggered deaths of the policyholders in the pool.

Here's the ways that this is different from an MBS:

1) It's fundamentally a secondary market product from the consumer's perspective. He or she has to want to sell their policy to create the market. In a MBS, he or she simply has to want to buy a house (and then the bank sells off the mortgage). It's a subtle difference, but it means that this requires two consumer touch points (purchase of policy and cash out of policy, whereas an MBS only required one).

2) Ideally, the underlying collateral of this product should not be cyclical (meaning correlated to the business cycle), unlike housing, which makes it very attractive to investors.

3) The idea of real tail event analogous to the housing market crash would be some kind of fountain of youth discovery, which is not so likely. So, ideally, while life expectencies should slowly rise, life insurance prices should adjust.

Now, here are the three problems from the MBS case that this new product will still have:

1) It still has volume based incentives over performance based incentives. The banks structuring this deal have absolutely no incentive to find the policyholders who have lower remaining life expentencies. They simply want to get as many policies as possible and then get the product out the door, skimming off their fee as always.

2) It's still fiendishly hard to model. Now, the good news is that the insurance industry is much better at this than the mortgage industry, since with life insurance it's a question of "when" you'll die, whereas with a mortgage it's a question of "if" you'll default.

3) That said, investors (e.g. pension funds) are still going to buy this product because it has a high rating from the rating agencies (i.e. AAA), without really doing the due diligence into the risks and their correlation with the rest of its portfolio. This kind superficial strategy did them in last time, and not enough may have learned their lesson.

So, will we see what happens with this product. Should be very exciting to watch, especially as the baby boomers retire.

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