U.S. courts make death arbitrage a tougher game

September 26, 2011

By Reynolds Holding
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

A U.S. court has just made death arbitrage a tougher game. Cashing out life insurance can keep a policyholder afloat if he suddenly needs the dough. But an active secondary market tempts some to buy insurance just to sell the policy on. Delaware judges have wisely made such ghoulish bets on life expectancy easier for insurers to kill.

Since the creation of life insurance in the 16th century, speculators have tried to wager on the death of strangers. Britain banned the practice in 1774, and U.S. law required policyholders to have an interest in seeing that the insured person stayed alive.

But the rules in the United States loosened as both policyholders and financiers saw the potential advantage of letting insured people whose circumstances changed cash out their policies. A regulated secondary market sprang up. Taking this to its perhaps logical extreme, people were eventually persuaded to buy policies solely for investors, who set out to beat the insurance companies’ system of figuring when people would probably die. Now, with thousands of such policies coming due, insurers are contesting their validity.

A big hurdle, though, is that the small print of most policies says they cannot be challenged after two years. That keeps insurers from reneging on coverage after holders have paid premiums for years, and some courts have proved reluctant to change that. But last week, Delaware’s Supreme Court came up with a creative solution.

It relied on centuries-old precedents to say policies that were, in reality, investors’ bets on human life were invalid from the beginning. That meant the two-year limitation on challenges was also invalid. But the court also wanted to preserve legitimate payouts. So the judges specified that if the original policyholder paid the initial premiums, the policy was probably valid and could be resold. If, on the other hand, the premiums were paid by someone with no stake in the insured person staying alive, that was evidence of a sham.

The decision puts Delaware at odds with New York, which recently upheld the two-year limitation without exception. But it reaffirms what is fast becoming the law in most U.S. states. That means more uncertainty for secondary-market investors as insurers contest policies. But it’s also a welcome reminder that there are a few things that remain off-limits in financial markets.

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