In the midst of its ill-considered effort to impose some discipline on the American colonies through legislation, the British Parliament also spent some time pondering the growing insurance industry headquartered in London. The result, in 1774, was the Life Assurance Act.
It was a lot more successful than Britain’s attempts to tame the American colonies — so successful, in fact, that the original law remains in force today. It shaped the growth of what is now a huge international industry: insurance.
The act stated simply that in order to obtain a life insurance policy you had to have an insurable interest. A person has a natural financial interest in his or her own life and in that of spouses and family members. But there is no such interest in regard to neighbors, and certainly not with strangers.
The British Parliament felt obliged to make life insurance contracts without insurable interest illegal because their increasing popularity was transforming the insurance industry from a risk-sharing business to a gambling business. Essentially, investors were betting on the mortality of strangers.
The insurance industry has prospered on the insurable interest principle. But, as always, there are those for whom prospering is not enough. They have a need for easy money.
And so it is that the same wonderful Wall Street guys who brought us the subprime disaster are now offering a new opportunity for investors: the life settlement-backed security.
It works like this: a person assigns his or her life insurance policy to an investor, who then pays the premiums. When the person dies, the insurance benefit is paid to the investor.
This new scheme threads through the law and insurable interest concepts like a spaceship pilot careening through an asteroid belt — except in this case there is no princess to be rescued, only a pot of gold. Since the original life insurance policy was issued to someone with an insurable interest in his own life, it is valid. And if he or she chooses to sell its benefits off to an investor, it is legal — gambling, surely, and more than a little ghoulish, but legal. And the proceeds aren’t subject to federal income tax.
Life settlement-backed securities are the dark side of what was a good thing — the viaticum, or viatical settlement. This is an agreement by which a person can receive his or her insurance death benefits while still alive. They were most commonly used when the policy-holder was seriously or terminally ill and, in fact, first saw widespread use in the United States during the AIDS epidemic of the 1980s, when the proceeds were used to pay for medical treatment.
Much like subprime lending, viatical settlements were initially a sensible response to an economic need. And as long as the people involved had some sort of stake in the outcome and its risks were apparent, this type of settlement made sense.
Much like the subprime situation, viatical settlements became vehicles for questionable, disreputable and predatory marketing techniques, and increasingly involved distant, third-party investors.
The bad reputation that viatical settlements developed attracted the interest of state prosecutors and kept the big banks and investment houses away from the market. The result was that after flourishing during the 1980s, viaticals had pretty much disappeared by the time the dot-com bubble burst.
Now they are coming back — ironically, in the same package-and-sell marketing model that worked so well for subprime mortgages. And illness plays a smaller role. These new viaticals, called life settlements, are more often motivated by a desire for lifestyle support than a need for life support, but they are otherwise the same.
The big difference comes when first-tier Wall Street firms begin buying them, pooling them and using them as collateral to sell bonds — charmingly called “death bonds” — to investors. The success of this scheme will prompt a marketing effort to sell the life-settlement idea to insurance policy holders and, eventually, to convince people to purchase new life insurance policies they can’t afford for the sole purpose of selling them.
The purchase and sale of life settlement-backed securities violates one of my own Life Rules: never put yourself in a position where you are worth more dead than alive. And the more this market expands, the more likely it is to spawn walking targets and a supporting industry whose products and services are always launched with the words, “Remember, it has to look like an accident.”
The life-settlement market will be worse than the subprime mess, even without hit men. For those gambling on death, for example, every medical advance is a financial disaster. How can that perspective be a good thing for America?
James McCusker is a Bothell economist, educator and consultant.
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