The business of betting on death is fighting for its life on Wall Street.
Once considered a promising diversification play and the possible makings of a bubble, trading in so-called life settlements is still scarce and getting scarcer. The Life Insurance Settlement Association said that half of such commerce has disappeared in the past year, roughly $8 billion in transactions.
While many elderly policyholders are still game to sell their insurance claims and there are an estimated $10 trillion in individual policies in the United States up for grabs, investor interest has all but vanished in recent months, as credit dried up and securitization activity flat-lined.
Banks have also grown skittish about the business as the Securities Exchange Commission and the Financial Industry Regulatory Authority both pledged in recent months to take a hard look at such investing.
Economically, the practice makes a great deal of sense. Here's how it works: a company buys a life insurance policy, accepting the ultimate payout in exchange for a lump sum of cash and a commitment to keep covering premiums. The company then sells the policy to a brokerage, which in turn offers the policy as an investment, typically to institutional clients like pension funds. The sooner the insured person dies, the more money the policyholder makes.
"Insurance is a good value for people to hang onto, but if they can't or don't want to or if their wife of 30 years dies and they have a new girlfriend and want to go on a cruise, then it makes some sense," said Doug Head, executive director of the life settlement association.
Like with subprime mortgages, most investors buy bundles of the holdings, assembling a diverse batch of policies by picking coverage of different sizes and of individuals with different afflictions and health risks. A cure for cancer, for example, would be disastrous to a fund holding policies solely on cancer patients, so life investors hedge with a macabre series of selections.
Proponents say that the business makes for a more liquid insurance market and provides cash infusions to people who may no longer want or need a death payout to beneficiaries.
Investors, in turn, get a payoff entirely unswayed by the economy or capital markets.
"People who were sitting on these investments during the crisis were real happy, because they didn't go through the precipitous decline," Head said. "And they didn't lose their hair in the process."
Michael Wong, an investment bank analyst at Chicago-based Morningstar Inc., said that life settlements offer "a statistically known payout and a market large enough for it to matter to investment banks."
Indeed, as Wall Street became interested, the life settlements business grew from a $2 billon industry in 2001 to $16 billion in 2008. An estimated 3,000 finance pros currently work in this business.
Goldman Sachs started buying life insurance policies in 2006 and eventually bought a minority stake in a company that specialized in such transactions. In December 2007, it launched a longevity index called QxX, intended to help life insurance investors measure the risk of covered individuals living longer than expected.
Credit Suisse, which also entered the market in 2006, has 90 workers in New York and London dedicated to life insurance investing. It buys policies directly and sells them to insurance companies, fund managers and pension funds. On average, Credit Suisse pays the insured 10 times more than they might get from an insurance provider to surrender their policies, according to Kurt Gearhart, head of regulatory and execution risk in the firm's Life Finance Group.
However, capital has been scarce in recent months and the increased volume of life insurance settlements drew the attention of regulators.
In July, FINRA issued a warning to firms dealing in life settlements, noting that such transactions are subject to federal securities laws and FINRA rules. It pledged to keep a close eye on the transactions and threatened to reign in huge sales commissions.
In mid-September, SEC Chief Mary Schapiro called for a special task force to investigate the business and look for "regulatory gaps." "As unsettling as this might sound, life settlements are a growing market," Schapiro said. "And, there is a belief that this potentially could become the next big securitized product offered by Wall Street. ...The fact is we need to be out in front on this issue."
Schapiro said that the practice requires seniors to share sensitive private health information and may expose the elderly and seriously ill to abusive or fraudulent sales tactics.
The regulatory pressure appears to have spooked Wall Street. A number of big finance firms, including Credit Suisse, Goldman Sachs and JPMorgan Chase, declined to answer questions for this article.
Meanwhile, the Life Insurance Settlement Association has lost 15% of its members in 2009, about 25 companies with five or six employees each, on average, that either went out of business or didn't have enough cash around to pay dues.
In a House of Representatives hearing in late September, Goldman Sachs Managing Director Steven Strongin said that life settlements don't pose systemic risk to the economy but have "real potential for abuse of consumers."
Russel Dorsett, president of the association said that the number of public life insurance securitizations "can be counted on one hand -- with several fingers left over."
Head, executive director of the association, said that interest from big finance firms will slowly recover, but efficient public securitization of life insurance policies is likely still years away.
"I think we'll get there, but it will take awhile," he said. "We're still feeling our way."
Buttressing Head's hopes, about 100 people from Wall Street firms have registered for the association's annual investor conference in Manhattan Nov. 8; that's twice as many as last year.
Meanwhile, life settlement proponents continue to fight comparisons to the subprime mortgage business. The association predicts that life settlements will never be as widespread as mortgage securitization because many people buy coverage with the intent to keep it.
And death, for better or worse, is easier to forecast than home prices.
-- Read recent testimony on life settlements here
-- Read SEC Chairman Mary Schapiro's recent speech on life settlements here.