Life Insurance Bundling is Pyramid Scheme, Should Be Banned

The New York Times is reporting that major Wall Street investment banks are looking for a replacement “exotic” brand of investment for the failed bundled mortgage-backed securities, and that they are planning to launch a brazen market in the resale of already-resold life insurance policies. The scheme carries the risk of bundling and reselling high-risk mortgages, perhaps higher, as longevity of the original policy-holder will determine return-on-investment.

Elderly people strapped for cash can sell their life insurance policies for pennies on the dollar (maybe up to $400,000 on a $1 million policy), and Wall Street wants to buy them, bundle them and sell them to investors. Securitization of a commodity is, in many ways, a sound business practice, especially if you’re the banker doing the selling. But, just as mortgage-backed securities carried a level of risk that made them more like gambling than investing, life-insurance bundling means the security sold is not what it seems.

As the original policy-holder’s life is extended, day after day, the value of the payoff for the insurance policy goes down. More deaths coming sooner means the securitized life insurance policies will pay the bundle-buyers more in profits; longer life means they will see their return go down, or even pass zero into negative territory.

This is because the policy holder has already taken a cut, the investment bank has taken a cut, and what’s left may not be enough to cover the price paid by the investor (which has to be higher in order to make any of this worth the investment banks’ doing). Like mortgage-backed derivatives, life-insurance derivatives deal with a finite pool of money whose value will not increase over time: at some point, one of the gambling investors will find there is not enough money to cover initial investment plus interest.

Unless, that is, there is such zeal among investors to buy into life insurance derivatives that their “investment value” escalates far beyond their initial cash value. This is the nature of a derivative: a finite financial investment value becomes a commodity and the derivatives are the “bets” placed on the the long-term “investment value” (what future investors will pay to get into the game) of the bonds.

But like mortgage-backed derivatives, life insurance derivatives have a fatal flaw in terms of long-term investment value: at the end of the day, someone somewhere will be unable to resell the bonds based on specific policies, because the high investment value will no longer be supported by the cash payout. This is the definition of a pyramid scheme: there is only the money people are putting in, and eventually, when one after another investor takes their payout, there is nothing left for those who stay in the game too long.

Wall Street’s investment banks are trying to blur the line between securitization and pyramid schemes, because if they can (in legal, ethical and commercial terms) they can make a fortune. Life insurance derivatives would not be a pyramid scheme, so goes the argument, because they would be securitized, backed up and buffered, by a complex bundling process within a market of extremely wealthy and reliable firms whose long-term vision allows for the bottom never to fall out.

When the policy in a given bundle into which you bought comes due, and pays too little, your stake in the bundled derivatives is simply shifted forward to the investment value of the as yet extant policies. In other words, everyone buys into one pool; you never have to worry about selling an individual policy that paid out too little.

It sounds like securitization, but in fact, it is not. Securitizing a private company, selling its stocks and bonds, allows investment firms to help marshal broad-market resources, from individual investors and major funds, into the coffers of actual companies that produce value for the market, acquire their own revenue stream and build future value. Investors can track that value, and get in or get out at will.

But the value of the company is securitized through a process that allows for calculated risk and in most cases, doesn’t subject the investor to the possibility that the entire market for stocks of a given kind will just evaporate on any given day or over one week during one summer of confusion. Life insurance derivatives are not that kind of security: they are a bet on the fictional value of an actual financial asset that cannot increase in value and cannot produce a new revenue stream through its own activity.

In this way, life insurance derivatives have the same fatal flaw as mortgage-backed derivatives: they are a gamble based on nothing but other gambles, and with an underlying financial logic that says such an investment should not be considered, over the long-term, over the whole market, wise.

What’s more, there’s the ethical abyss which is betting on the shortening of human lives. For investors to be gambling their money away on a lottery based only on the value of other gambles is bad enough, and very unwise for the market and for investors, but to have a financial stake in the shortening of human lives is fundamentally inexcusable.

In practical terms, investors would never know who the policy-holders are or how long they are likely to live, and there is no way an individual investor could take deliberate action to shorten anyone’s life in order to gain a profit, in theory. But as a matter of legal and moral integrity, there is something fundamentally improper about placing bets that pay off when people die sooner rather than later.

Life insurance derivatives are bundled, securitized fixed-value financial assets that (much like high-risk mortgages) allow investors to buy into a betting pool that is not a genuine long-term investment in the value of a productive commercial entity. They amount to a pyramid scheme whose overall value will be determined solely by the money put in by investors, meaning that no investor can derive a profit without in effect taking that income away from another investor.

They are a pyramid scheme cloaked in the complexities of financial product derivatives, and they should be banned outright. There is no legitimate way that such financial exotics can be sold honorably, through a legitimate marketplace, and pay off the full value of what investors would hope to receive in return for their contribution to the pool.

Such products put investors’ money at risk, but also endanger the entire structure of Wall Street’s investment system. The contemplation of these exotics, in the immediate aftermath of the most severe banking crisis in 80 years, and the attendant record amounts of taxpayer investment required to keep the banking system functioning, shows a reckless disregard for the integrity of the financial system and for the resilience of the market system itself.



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3 Comments on “Life Insurance Bundling is Pyramid Scheme, Should Be Banned
  1. Pingback: New Financial Exotics Tempt Wall Street |

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  3. Can you imagine how Wall Street will intervene in the health-care debate once investors are betting on shorter lives? Any proposal that increases life expectancy, especially among older/sicker people, will be lobbied against. Which would include pretty much any positive change in the health-care system

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