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Ask Mint | Bizarre way to earn money: ‘death bonds’

Ask Mint | Bizarre way to earn money: ‘death bonds’
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First Published: Mon, Nov 24 2008. 01 19 AM IST

Updated: Tue, Nov 25 2008. 12 29 PM IST
People producing real goods and services have long resented the expertise of the financial world in making billions merely by exchanging one piece of paper with another. It is, therefore, not surprising that “death bonds”, a bizarre way of earning money discovered by Wall Street, is looked down upon with utter contempt. However, unmindful of glaring looks, the big boys of the financial markets are now openly talking about opportunities that will appear mind-boggling to ordinary investors.
Johnny: How could anybody even think of making money out of such a ghastly thing as “death bonds”? I am so confused.
Jinny: If the use of the term “death bonds” sounds awful, then let’s use another term: “insurance settlement-backed securities”. Now that sounds more inviting but that is also just another name for death bonds. If you are interested, I can tell you in detail about what goes into making a death bond.
Johnny: Yes, Jinny, please tell me about the life history of death bonds.
Jinny: Securitization has given the financial world many instruments, some of which—such as collateralized debt obligations—have already made a permanent place in our memory. You may not yet have heard much about death bonds but they are also becoming very popular in the US and European markets.
Death bonds are just like any other asset-backed security in which the process of securitization is used to create security instruments generating income out of a pool of assets. Death bond instruments are backed by cash flows generated out of securitization of insurance settlements.
So, before I tell you how death bonds work, it would be better if I tell you a little bit about insurance settlements.
Johnny: I think so, too.
Jinny: Insurance settlements involve the assignment of a life insurance policy by the policyholder to a third party on the basis of a cash consideration. In other words, you sell all economic interest in your life insurance policy to a third party by taking cash from him.
The person acquiring the interest in your life insurance policy pays the remaining premium due on the policy to the insurance company. After your death, the person acquiring the interest in your policy collects the insured amount from the life insurance company. This is how insurance settlement works.
At first sight, it looks very repulsive to think that a group of investors may actually cheer on your death. But before making any judgement, you need to look at the other side.
Illustration: Jayachandran / Mint
Johnny: Tell me about the other side of the picture. What motivates policyholders to enter into insurance settlements?
Jinny: The real motivation is obviously the money which all the parties to insurance settlement transactions make. Every year, many holders of life insurance policies wish to discontinue their policy for some reason or the other.
After a certain number of years, every policyholder has the option of surrendering his policy to the life insurance company, for which he gets a cash surrender value.
Insurance settlement provides an opportunity to the policyholder to encash his policy at a price which is better than the surrender value offered by insurance firms.
Johnny: It seems policyholders simply wish to make the best use of whatever option is available to them. But now tell me, Jinny, how are insurance settlements linked to death bonds?
Jinny: Securitization of insurance settlements leads to the creation of death bonds through many layers of transactions. In the first step, a financial intermediary creates a pool of assets by acquiring interest in different life insurance policies through a series of insurance settlements. In the next step, the pool of assets is divided into fractional interests represented by security instruments and sold to investors.
The security instruments generate a stream of income as the life insurance policies pay off on the death of the insured. The final net gain or loss for death bond investors is equal to the cost of purchasing the insurance policies plus the cost of premiums paid for the remaining term of the life of insured minus the claim amount received from the insurance company on the death of the insured.
Investors of death bonds would, of course, make more profit if people die before their average life expectancy and they are bound to lose if those insured live long. But the real beauty is that to earn their money, investors in death bonds need not look at complex quarterly results and financial ratios. They just need to keep a watch on the average life expectancy of people, which does not fluctuate every day like stock indices.
Although different people live for different lengths of time, the average life expectancy of people remains constant over a period of time.
The size of the death bonds market is growing fast. BusinessWeek magazine, in one of its reports, mentioned that the size of the insurance settlement market may reach $160 billion in coming years. So we may well see “kings of death bonds” boastfully roaming on Wall Street in the future.
Johnny: That’s true, Jinny. Death bonds seem to be a new method for turning pain into gain.
What: “Death bonds” are backed by cash flows generated out of securitization of insurance settlements.
Where: Death bonds are becoming popular in the US and European markets.
How: Securitization of insurance settlements leads to the creation of death bonds through many layers of transactions.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Mon, Nov 24 2008. 01 19 AM IST