Tuesday, January 04, 2011

The Insurance Crisis You Didn't Hear About

Everyone remembers AIG, and how it was too big to fail, since its insurance propped up everything from major construction projects to risky mortgages.
But the insurance industry as a whole was grossly destabilized by the banking crisis. Any risk upsets insurers, and there was plenty to go around.
Including one particularly noxious little instrument: The death bet, or life settlement industry, to use the polite term.
Intended as an estate planning tool, the death bet works as follows. I'm rich. Filthy rich. So I take out a life insurance policy in the millions. It's probably more than I need, but I've got an inflated sense of self-worth.
Oops. Now I need cash. Quick cash. I turn around and sell that policy to an investor pool who agrees to make the premium payments in exchange for an annuity payment to me based on the benefit, plus assignment of that benefit to the pool. (NB This is not the only purpose these policies serve, but it's a good example of how ugly this can be)
The new owners then sit back and begin to cheer every single sniffle I get. The faster I die, the more profitable the policy is.
In the scramble of the subprime mortgage market, insurers, much like Captain Renault in Casablanca were shocked! SHOCKED! to find out that many of the highly profitable transactions were mere gambles on the lives of policyholders!

Since the bust in the market, insurers have portrayed themselves as the victims. They have filed hundreds of lawsuits over the past two years seeking to cancel policies they say weren't intended as estate-planning tools, as buyers purported, but were instead meant to enrich investors speculating on old people's lives. The industry also asked regulators to stop investors from wagering with their products.

Now, some investors are striking back. They are asserting that insurers' own agents and managers encouraged investor-driven sales to boost their compensation, and that the industry cried foul only when faced with big payouts on the policies and bond-market declines that made some policies less profitable than expected.

The investors want the insurers to be forced to honor the contracts, or to refund all of the premiums they have paid. Some are seeking punitive damages. The claims appear in filings in state and federal courts nationwide.

The irony is, of course, that this market was already in a tizzy not because of the financial shenanigans of the bond markets (bonds and annuities are usually the underlying instruments behind life insurance policies and included mortgage-backed securities) but because, well, people are living longer.

See, actuarial tables may be the last bastion of inefficiency in financial markets, because they rely on information after the fact: when a person dies, that's how long you know he or she has lived. The average age of people dying is compared to the numbers of people still living who are that age and that's one way life expectancies are calculated, or at least that's the basis for the calculations.

Radical changes...an epidemic or natural disaster...can appear nearly instantaneously. Subtle changes take months if not years to come to the fore. And there's the problem because these same rich people can afford the best medical care and thus confound the statistics which can adjust for income but have a much harder time adjusting for accumulated wealth. Remember, they've likely retired when they sell these policies so annual income is reduced significantly, but wealth continues to accrue.

So how does this affect you? Well, estimates of the current market for these instruments remains over $10 billion new policies every year. Not much, but if insurers are forced to recapture premiums and refund them to investors, the size of the market could make the AIG bust look like a run on a Bedford Falls building and loan.

And then, if no bailout is forthcoming, your insurance premiums-- car, life, and home-- will skyrocket.