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Life Settlements can be quite a gamble

Source: Asia Insurance Review | Sep 2017

Life & Health

Mr Ronald Klein of The Geneva Association gives an update on the Life Settlement industry, where investors are pitted against policyholders who may have an advantage of knowing about their health via cheaper genetic tests today. Anti-selection might as such be rampant and (re)insurers should be aware of this growing risky venture. 
 
 
It is mid-September and once again the entire non-life reinsurance industry is descending upon Monte Carlo to meet and greet at Le Rendezvous. 
 
   I often wondered why the reinsurance industry chooses cities known for gambling as the home for conferences – the non-life industry in Monte Carlo and the life industry in Las Vegas for ReFocus each March. Are reinsurers notorious for gambling? It would be interesting to perform a survey of those in attendance at Le Rendezvous to see what percentage of the attendees actually spend time gambling in Monte Carlo. My guess would be that it is a very small percentage.
 
   Since I will be attending Le Rendezvous this year, that percentage is likely to increase as I have been known to hit the tables from time to time. Oh, not for large amounts, but a little action is always fun. My favourite casino game is Craps. What I like most about the game of Craps is that it is a “team sport”. There is one person, the “shooter”, who rolls the dice for the entire table. When the roll is good, everyone wins. When the roll is bad, everyone loses. 
 
Strong alignment of interest 
This reminds me a lot of the life reinsurance industry. There is a strong alignment of interest. The policyholder wants to live, the insurer wants the policyholder to live and the reinsurer wants the policyholder to live. 
 
   So, it seems to me that the life insurance industry and the game of Craps have a lot in common. For those of you not familiar with this game of chance, I will offer a short tutorial.
 
Game of Craps
Craps is played on a large table with a pair of standard dice. Each new game begins with a “come-out roll”. It is easy to tell when there is a come-out roll by first locating a hockey-puck-sized disk on the table. One side of this disk is black and reads OFF and the other side is white and reads ON. When the disk reads OFF, it is a come-out roll.
 
   The customary bet is called a “Pass Line” bet and it pays even money on a win. On a come-out roll, a 7 or 11 wins and a 2, 3 or 12 loses. If one of these numbers is thrown, the house either pays or takes the Pass Line bet and there is another come-out roll by the same shooter.
 
   If the shooter throws a 4, 5, 6, 8, 9 or 10 on the come-out roll, that number becomes the “point”. Now the game gets really simple. The shooter has to repeat the point before he or she throws a 7. If the shooter repeats the point, the Pass Line pays even money and then there is a new come-out roll with the same shooter. If the shooter throws a 7 (“craps out”), the Pass Line bet is lost and there is a come-out roll with a new shooter. This is the only time that a shooter must relinquish the dice.
 
   Yes, it is that easy. There are many other bets that can be made in the game of Craps and these “side bets” are a cause of confusion to many people. However, if you would like to understand the basic game, simply walk over to a Craps table and concentrate on the Pass Line. 
 
   While side bets do not typically concern me, there is one bet that I really do not like. It is called “Don’t Pass” and it is basically the opposite of the Pass Line bet – on a come-out roll, 7 or 11 you lose, 2 or 3 you win, and you win if a 7 is rolled before the point (a 12 on the come-out roll is a push for Don’t Pass bettors). The reason that I dislike “don’t bettors” is that they are betting against the shooter. Suddenly, there is no alignment of interest.
 
Misalignment of interests
To me, this is somewhat analogous to the Life Settlements industry, where a company purchases blocks of life insurance policies from the actual policyholders or from intermediaries. 
 
   While the life reinsurance industry is great because of a strong alignment of interest, the Life Settlements market changes this dynamic. Purchasers of Life Settlements want the policyholder to die as soon as possible.
 
   While the selling of an in-force life insurance policy dates back to 1911 in the US, this practice was popularised in the 1980s during the AIDS epidemic and was called Viaticals, from the Latin word viaticum, meaning provision. 
 
   Companies purchased policies from AIDS victims. The policyholder would then get money to purchase expensive medical treatment in hopes of prolonging his or her life. This practice raised many questions – was it ethical to transact business with a terminally ill patient? Should a policyholder have the right to cash in a policy prior to death and spend the money meant for his or her loved ones? Should the cash settlement be taxed since it is prior to death or be tax-free as a death benefit is?
 
   By law, Viaticals were only available if the patient had 24 months or shorter to live at the time of the transaction. The Viatical business began to wane as medications dramatically extended the life of AIDS patients. Prolonged life of existing Viatical holders hurt the returns of investors as payouts were delayed and premiums had to be paid to keep the policy active. 
 
Life Settlement industry
From it, however, blossomed a new industry with fewer restrictions – the Life Settlement industry. Why restrict the purchase of policies to AIDS victims when any ailment, including old age, would do?
 
   Investors hired teams of medical underwriters and medical doctors to review medical information from policyholders looking to settle their policies. It seems to me that properly predicting the remaining life expectancy of individuals is a bit difficult. Whether advanced in years or terminally ill, being off just a few years can dramatically affect investor returns. 
 
   In addition, a person who settles a policy may actually live longer than expected simply by receiving the lump-sum payment for his or her policy. It seems that money has a way of extending life expectancies.
 
Information asymmetries 
What actually concerns me the most about this business is the spectacular increase in availability and the shocking decrease in cost of direct-to-consumer genetic tests. 
 
   A person considering settling his or her policy could order a genetic test for US$99 and then make a well-informed decision with data not available to Life Settlement investors. Soon, whole genome sequencing will be available direct-to-consumer for less than US$1,000, which will give the policyholder a dramatic advantage over investors.
 
   Is it possible that a whole new industry arises where agents offer free genetic tests to policyholders, help those with very positive results settle their policies and then use the proceeds to purchase annuities? Think about how anti-selective this would be to the industry, but how lucrative it can be for agents and genetic testing companies. Talk about misaligned interests!
 
Risky diversification
There have been many non-life insurers and reinsurers that have invested in Life Settlements as a way to 
diversify. 
 
   Estimating when a relatively small group of people will die is difficult for anyone – medical doctor, life underwriter or actuary. But I often wondered why non-life companies would invest in Life Settlements. Depending upon third parties, who are paid fees and not taking risk, is very dangerous in any transaction. My old boss and mentor used to call this “outsourcing decision-making”, which he vowed never to do.
 
   But now, with genetic testing becoming available, Life Settlements are becoming a dangerous investment for any company. Investing in something where your interests are not aligned with the entity that has the most data is a risk no matter what the product is. However, when there is a need in the market, someone will provide the product. 
 
   In short, the Life Settlement market is a real gamble that you may not want to crap out on. My father used to say that he did not like to gamble because he took enough risks in business. I do not expect to see many employees of companies that invest in Life Settlements at the Craps tables in Monte Carlo. They are taking enough risks in business. A 
 
Mr Ronald Klein is Director Global Ageing at The Geneva Association.
 
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