Commentaries

from Rolfe Winkler:

Merkel on life settlements

Sunday's NYT piece about life settlements -- selling a life insurance policy to a third party, who collects on it when you die -- sparked much conversation in the blogosphere. Felix helpfully points out that there's actually not much news in the story as the market is still minuscule. Still, this is a financial innovation worth discussing in its earlier stages, while there's still time for legislators/regulators to kill it. It really is a terrible idea, one that will benefit no one besides those running Wall Street's securitization machine.

But don't take my word for it. Take David Merkel's. David (FSA, CFA) is an actuary who spent 17 years working in the insurance industry, and five years outside analyzing it. For the last two years, he has been the Chief Economist and Director of Research for Finacorp Securities. He is the founder and writer of the The Aleph Blog, where he discusses financial, economic and insurance topics.

I sent him a quick e-mail asking for his thoughts. His response is worth quoting in full. I've included a few notes to help readers follow along.

I've been critical in the past about life settlements business, but in some ways it is back to the future.  Back in the mid-19th century there were often no cash values for life insurance policies.  If you terminated, you got nothing.  It was possible to sell your policy and get something, but because of the doctrine of insurable interest eventually that market was abolished.

[Reader note: in a nutshell, the doctrine of insurable interest is that you can't insure another person's property, someone else's car, house or life, for example. The moral hazard is obvious, and highly problematic: If you insure property that isn't yours, you have an incentive to destroy that property in order to get paid out on the insurance policy.]

It was abolished because it was gambling, and that it created an incentive for the third party to murder the insured. But Elizur Wright campaigned successfully for cash or nonforfeiture values.

That made life a little better for life insurance consumers, who would get something back on surrender, but not usually as much they could get through a sale to a third party, and not nearly the expected present value of the claim, less the unamortized value of the policy acquisition cost.  Nonetheless, the market stayed stable until the 1990s, until the life settlements business came along.  The doctrine of insurable interest had been weakened by the courts, which I think is bad on public policy grounds.  Third parties should not be allowed to gamble on the lives of others.

Now, the life settlements providers might say, "We aren't gambling.  We have the law of large numbers behind us, and we are able to do advanced analyses of the health of insureds that insurance companies can't legally do.  Besides, we offer some insureds, the sick ones, a better deal than they would receive from the insurance companies were they to surrender.  Why complain?"

If they are acting like insurance companies with the law of large nambers, let them be regulated as insurance companies.  Let their purchase practices be regulated as well.  Yes, they offer better deals to sick insureds, but the insureds are giving away a potentially more valuable future claim....It's a free market, but insureds are not capable of estimating the fair value of a complex insurance claim, and many get cheated.

As to the securitization -- [note: packaging multiple life settlements into securities to be sold to investors] -- that's not a problem.  Securitization is a tool, and ratings are a tool.  Only fools and regulators trust ratings implicitly.  Only the credulous buy certificates of a securitization without significant due diligence.  This is a game for big boys, and if you are not a big boy, don't play.  If you are a big boy, do your due diligence.

Insurance regulations exist because of a philosophy of big companies knowing more than little people.  The same should apply to life settlements and insureds for the same reason.

One last note, if life settlements become widespread, life premiums will rise to reflect the loss of profitabilty, and life reinsurance premiums will rise as well.  There's no free lunch.

Pain in Spain hits cat bonds

Defaults by catastrophe bonds, securities used by insurers to shift the risk of severe losses from natural disasters, have been few and far between.

When deals have run into trouble, it has often been due less hurricanes or earthquakes than some flaw in the way they were structured, such as the four bonds that imploded last year because of their links to Lehman Brothers and dodgy asset-backed debt.

Today Standard & Poor’s downgraded another deal in trouble, Swiss Re’s 252 million euro Crystal Credit transaction. Once again, the problem here is man-made.

This deal is different from most other cat bonds in that it doesn’t reference losses from natural disasters, but is instead tied to the performance of Swiss Re’s credit reinsurance business. Losses on the reinsurance contracts have started to climb as the economy soured. In particular, S&P says, the credit reinsurance business got hit by a “steep increase” in Spanish reinsurance claims.

It’s not the first time these bonds have been downgraded, although things seem to be getting worse. S&P says it’s “most likely” the class C bonds won’t make their principal payments in full at maturity. These were once rated B, and have now fallen to CC. The senior bonds, which were once investment grade, are now B+.

from Margaret Doyle:

Insurers love the FSA

Britain's Financial Services Authority has taken a lot of brickbats. its failure to anticipate the crisis is one of the main reasons that George Osborne, the Conservative finance spokesman, now plans to abolish it, transfer most of its supervisory powers (including for insurance) to the Bank of England leaving a rump responsible for consumer protection.

The FSA is in a weak position to defend itself. Even its newish chairman, Lord (Adair) Turner has admitted that it did not foresee the looming problems at Northern Rock, since nationalised. Worse, the regulator was completely ill-equipped to understand the bigger, systemic problems that were looming. Like most other people in and around the markets, it was lulled into a false sense of security.

However, among the critics, one industry has been steadfast in support of the FSA: insurance. Again and again in my travels around the City, and especially EC3, the corner dominated by Lloyd's of London and various bits of the industry, I have heard nothing but praise for the FSA.

The appreciation is not a recent phenomenon, dating from the arrival of either Hector Sants, who is now taking a tough-guy approach to enforcement, nor that of Turner, a well-known big brain.

Rather, the chief executives and finance directors I spoke to date their admiration for the FSA to 2002-2003. That was the third year of an equity bear market, which was wreaking havoc on insurers' balance sheets and solvency ratios. In order to stabilise matters, insurers were forced to sell stocks. However, this only made matters worse, as the collective selling simply drove the market lower.

What i heard, time and again, was that if the old regulator, the Department of Trade & Industry, had been in charge, they would be been forced to continue selling - up to the point of collapse. "Policyholder protection", or the illusion thereof, dominated common sense.

Fortunately for the EC3 gang, sense prevailed in the person of John Tiner, then a senior executive and later chief executive of the FSA. He relaxed the rules, so that insurers were able to increase the proportion of bonds in their portfolios over time, rather than cashing out in a falling market.