My friend Rajiv Rebello has helped both my family and extended family navigate the complexity of insurance contracts. That world is coated simultaneously in both exploitive grease and heavy regulation. Rajiv is our white knight. Brilliant, honest, and experienced. He’s an actuary who help individuals find policies and understand the opaque pricing and incentives. He has helped buy-side firms price policies as investments.
He was instrumental in my research when I investigated and published Using Insurance For Tax-Free Investment Growth.
A few days ago I sent him Matt Levine’s article Apollo Had Some Death Bets.
“Rajiv, pretty please explain what the hell is going on here in more detail for Moontower readers”.
He hits it out of the park.
He breaks down the incentives, arbitrages, pricing and chicanery in the life-settlement primary and secondary markets. And you will learn plenty about insurance that is directly actionable and applies to your own policies!
Before we start, give his Substack a follow (especially since I selfishly asked him to start one): Separating Value From Bias
Life Settlements: A prime example of markets finding a way—albeit in an unbelievably messy fashion
When it comes to financial decisions, humans tend to behave in ways that are suboptimal and not in their best interests—and entire industries are made to profit off this. The only thing that holds them accountable is another industry trying to make a profit off the first.
When the first Jurassic Park movie came out in the summer of 1993, I, along with the rest of the country was blown away.
I was only 12 years old, but had never seen anything like it.
For god sakes, they brought dinosaurs to life.
If you haven’t seen the movie, here’s a quick synopsis: A couple of paleontologists visit a secret animal park that’s managed to clone dinosaurs and bring them back to life. They’re supposed to go on a straightforward tour of the park and give their approval so that they can open the park to the public.
It’s supposed to be a very controlled experience with numerous safety protocols and checks and balances to prevent anything from going outside of what was planned.
There’s a line in the movie that summarizes the gist of it well. One of the scientists of the park is trying to explain how the dinosaurs in the park can’t reproduce because they were genetically engineered to all be female.
To which, Jeff Goldblum’s character—whose primary role in the movie is to point out the human folly in trying to suppress the insuppressible—says:
“If it’s one thing the history of evolution has taught us is that life will not be contained, life breaks free, it expands to new territories and it crashes through barriers, painfully, maybe even dangerously, but……
…life finds a way”
And as we’d later find out, all hell breaks loose, life finds a way, and the best laid plans of mice and men oft go awry.
I can replace that same Jeff Goldblum quote except by replacing “life” with “markets” that perfectly encapsulates the life settlement industry.
“Markets will not be contained, markets break free, they expand to new territories and they crash through barriers, painfully, maybe even dangerously, but…..markets find a way”.
Since Moontower often takes deep dives into how opposing counterparties of a trade value an asset and the psychologies involved, I thought it might be worthwhile for readers to explore the life settlement industry from the position of a counterparty trying to even out an asymmetric imbalance of power and control between the life insurance industry and the consumer.
Ultimately the life settlement industry is forcing the life insurance market to be less predatory with its own consumers—it’s just that the life settlement industry is using the same exploitative tactics that the insurance industry is in the first place.
Matt Levine/Life Settlement Summary
Matt Levine’s article centers around the story of a $5 million life insurance policy that was sold to a woman in her 70s.
While this sounds like a non-descript transaction, the unique element of the story is that an investment entity—unrelated to the elderly woman (i.e. the insured)—paid for the premiums on the policy on condition that the investment entity would receive the death benefit when she passes.
On top of that, the investment entity paid the insured a $150,000 bonus as an incentive to apply for the policy all so the investment entity could have the obligation of paying all the premiums on the policy and the right to receive the death benefit when she passed away.
You might be wondering why an investment entity would do this.
The transaction, when done properly and legally (i.e. not what was done in this case) is called a life settlement.
A life settlement is when an existing policyowner of a life insurance policy sells his or her interest in the policy to a third party for an amount larger than he or she could get if the policy were just canceled.
This particular transaction wasn’t a legal transaction because the investor can’t entice the policyowner to buy the policy in the first place. Doing so violates the insurable interest provision required of a life insurance policy since an outside investor who doesn’t know the insured doesn’t have a vested interest in the insured staying alive.
The investor can only legally acquire the policy after the insured purchased the policy on his or her own without influence from the investor.
While the Levine article gives off the idea that there are a lot of illicit transactions happening in the life settlement space, the truth of the matter is that this policy was issued back in the mid-2000s when there was a lot less regulation of the space than there is today.
Today this transaction would have been most likely caught in the due diligence phase of the life settlement process and wouldn’t have proceeded.
The reason why the investors in this case enticed the policyowner to buy the policy and sell it to them in violation of the law was because they saw a huge arbitrage to be made between the cost of acquiring the policy (premiums to the insurance company and payout to the insured) and the value of the death benefit.
The investors believed they had an upper hand over the insurance company that was worth them violating the law.
Levine quotes this as being a pure mortality bet, that’s not the full story.
Remember that the insured was applying for a life insurance policy. Which means she would have had to get a medical exam and all her medical records would had to have been sent to the insurance company.
So it wasn’t a pure mortality arbitrage here. The insurance company had the same medical information as the investment entity.
The arbitrage came from the fact that the cost of the insurance policy relative to the health of the insured was low and the investment entity planned to pay premiums on the policy in a manner that exploited this.
The investment entity was exploiting the pricing design of the life insurance policy as opposed to just a bet on the mortality of the insured.
Which should bring up an interesting question for you as a reader.
Why would an insurance company ever design a policy in which the cost of insurance they were charging was lower than the underlying mortality cost of the insured?
The answer is that they expected that the policyowner would behave in ways that would reduce their risk of having to actually provide that insurance.
Pricing of a Life Insurance Policy
In order to understand why an insurance company would charge a cost of insurance that was less than the cost of mortality, you need to understand how a life insurance policy is designed.
We all know that the chance of someone dying increases as they get older.
If you were to design a life insurance policy the natural assumption would be to charge a cost of insurance that was higher than the cost of mortality for every year that the insured was alive.
So for example, if there was a $1M policy and there was a 1% chance of the person dying in the first year, that means you would expect a $10,000 loss due to that policy. So if you wanted a 10% profit margin on your risk you would charge $11,000. That would give you a $1,000 profit.
Analogously, in the second year if there is a 2% chance of the person dying, to keep that 10% profit margin you would charge $22,000. Now you have a $2,000 profit in the second year.
If you were to price a life insurance policy like that the economics would look something like this:
Normal Profit Margins of a Company
We can notice a couple of things here.
- While the profit margin is always 10% greater than the cost of mortality, the absolute value of the profits increase over time because the underlying cost of mortality increases over time.So the bulk of the profits come in the later years.
- Equivalently, the insurance company could price the product such that they take larger profits in the earlier years and then losses in the later years.
Unequal Profit Structure
While the chart isn’t exactly drawn to scale, you might notice that the losses in the later years are larger than the profits in the early years. However, remember that the net present value of those later year losses are smaller than the profits in the early years.
In both pricing examples, the net present value of the profits are the same as the earlier chart which charged a cost of insurance that was always a multiple of the true cost of mortality. So the insurance company would, in theory, be indifferent.
While the second pricing design introduces a future liability, part of the large profits in the early years would be used as a reserve to meet those future liabilities.
Premium and Lapse Supported Pricing
However, it’s important to note that policyowners typically behave in ways that significantly reduce the cost for the insurance company to provide the insurance:
They pay more for the mortality cost in the early years of the policy and less than the mortality cost of the policy in the later years
Most of you reading this probably have a term life insurance policy to protect your spouse and kids. Maybe you got a 20 year term or 30 year term policy. However, even though the chance of you dying increases as you get older the premium you pay every year is the same regardless if you are in year 1 or in year 30.
What this means is that you overpay the cost of the policy in the early years, and you underpay the cost of the policy in the later years.
Level Premium Payment vs Underlying Cost of Mortality
So the cost of you dying earlier in the term is partially offset by the fact that you also overpaid for the policy in the early years as well.
2) They cancel the policy before the term is over
If you buy a 30 year term policy, approximately 60% of you will cancel the policy before the 30 years are over and about 40% of you will cancel it within the first 10 years.
This further reduces the liability for the insurance company—especially when we consider the fact we mentioned above about policyholders paying more than the cost of the insurance in the early years of the policy.
It’s a win-win for the insurance company: you pay more than you should in the early years of the policy and then you cancel the policy before it ever gets to the part in the term in which you are underpaying it.
The insurance company collects excess premiums for the coverage they offered you.
This is why an insurance company can design a policy that has high profit margins in the early years and large liabilities in the later years. The insurance company expects the profits to materialize in the early years and the liabilities in the later years to never come due.
When insurance companies do this too aggressively, it’s called lapse-supported pricing. “Lapse” is insurance jargon for “cancel”.
While not all life insurance companies are this aggressive in their lapse-supported pricing, all life insurance policies are based on the design of a large number of policyholders paying a level premium — overpaying in the early years and then canceling before they can ever receive the benefit.
Policyholders are humans. And humans act on emotions which they use to justify their logic instead of the other way around.
Insurance companies know this.
Policyholder behavior reduces the cost of mortality for an insurance company. This increases the present value of the insurance companies’ profits and reserves and reduces their future liabilities.
Policyholder Behavior Reduces the Underlying Cost of Mortality of a Life Insurance Policy
It also reduces the cost of the insurance to the policyholders who keep the policy for the long-term at the expense of those who do not.
If everyone were to keep the policy and behave the way an optimal investor would, the cost of your life insurance policy would be 2.5-3 times higher than it currently is.
So if you have a life insurance policy and are actively paying the premium, you should thank the 60%-70% of people who pay more than they should and cancel it early for subsidizing your policy.
What the investors in the Matt Levine article did was identify life insurance companies that were using a high degree of lapse-supported pricing. They realized that if they purchased enough of these policies on elderly individuals and paid just the cost of insurance on the policy and nothing more, they could profit off of the design of the policy by acting in ways that the average policyowner wouldn’t.
It allowed these investors access to an investment in which the underlying cashflows were not correlated to equity markets. By acquiring multiple policies on multiple insureds, it allowed them to diversify their investment risk.
Exploiting the Insurance Company that is Exploiting its Customers
Back in the mid-2000s when the policy in the Levine case was sold, overly aggressive lapse-supported pricing in the life insurance space was a lot more prevalent than it is today.
If you think about it, it’s an almost perfect design.
The design reduces the cost of mortality for the insurance company. This means that the insurance company can reduce the premium it charges for the insurance product.
Which of course means it can sell more policies since it’s a cheaper product and capture a larger share of the market in comparison to its competitors that don’t use that design.
The problem comes about when sophisticated investors like the ones in the Levine article act in ways that maximize the value of the policy as an investment for themselves at the expense of the insurance company.
When investors do this, all of a sudden those large future liabilities that the insurance company never expected to come due are in fact poised to come due.
However, insurance companies have an out here which is protected by law.
Insurance companies are allowed to use future assumptions to price their life insurance products. If those future assumptions with regards to policyholder behavior prove to be inaccurate they can later say, “whoops, my bad” and increase the cost of insurance for all policyholders.
It’s another win-win for the insurance industry.
Price the product below the true cost of mortality to gain market share and collect early profits. If you end up being wrong later, just increase the cost of insurance across the board for all your policyowners who purchased a long-term contract from you and are now stuck with it.
If this seems deceptive and like a bait-and-switch, it more or less is.
Doing this not only damages the brand and reputation of the insurance company at hand and they expose themselves to large class action lawsuits.
Interestingly enough in these class action lawsuits the life insurance companies have actually acknowledged that the reason they had to increase their cost of insurance was that sophisticated investors purchased these policies and utilized them in ways that they didn’t anticipate.
This is indirectly saying that they expected their policyholders not to be sophisticated and NOT to act optimally.
The pricing design only works the way it’s expected if the insurance company is exploiting individual policyowner behavior and those policyowners are not en masse using the policy design of that said insurance company in a way that benefits the individual policyowner.
Which is, of course, where the life settlement industry comes into the fray.
Life Settlements: Exercising an Embedded Option
While life insurance companies can increase the cost of insurance across the board for policyowners based on aggregate policyholder behavior or mortality assumptions, they can’t do it on an individual level.
For example, if you are in great health when you buy a life insurance policy and then a couple of years later put on a lot of weight or have a serious health event, the life insurance company can’t raise the cost of insurance even though the chance of you dying has increased.
There is a mortality arbitrage between the cost of insurance of the policy and your underlying health.
The policy, as an investment, is worth more now than it was when you bought it.
However, the insurance company won’t compensate you for this additional value.
If you can’t afford or no longer want to pay the premiums on the policy you have limited recourse other than canceling the policy for a fraction of what it’s worth—which is of course what the life insurance company is expecting you to do.
This is where the life settlement industry steps in.
It understands there is value being lost here and helps bridge the gap between the low value the insurance company is offering you if you cancel versus the intrinsic value of the policy as an asset.
So when you buy a life insurance policy, you are also getting a free out-of-the money put option from the life settlement market—it’s just that the insurance company doesn’t want you to know about it.
That option only becomes in-the-money if you have a health event that changes your underlying cost of mortality, or the pricing design of the underlying insurance product can be exploited, or some combination of both.
If your only options are to cancel the policy or sell it on the life settlement market, you are undoubtedly better off exercising that option and selling it on the life settlement market.
That being said, you and your family are better off keeping the policy and paying the minimum cost of insurance until you pass away because of the economics involved than selling it in the life settlement market.
In the case example we discussed above, the insured was paid $150,000 upfront so that the investors could pay the premiums and receive the death benefit when she died.
However, if the insured would have not taken the upfront offer, and knew to pay only the cost of insurance and not more, she could have paid the premiums and received the $5M death beath benefit tax-free. Her tax-free IRR on the transaction would have probably been close to 20%.
It’s hard to beat that elsewhere.
Instead the insured received a fraction of that value so that the life settlement investment entity on the opposite side could take the longevity risk and receive the bulk of the rewards.
Life Insurance Industry vs Life Settlement: Choosing between the Velociraptor and the T-Rex
In the climactic scene of Jurassic Park at the end of the movie, the velociraptors trap the paleontologist and 2 kids in a museum and are about to pounce and eat all of them when the T-rex busts in the door and starts attacking the raptors allowing the paleontologist and the kids to escape.
That’s how I look at the battle between the life insurance industry and the life settlement space.
The life insurance industry is like the raptors.
The whole movie they have created an elaborate trap for you to walk into without you realizing that you’re walking into it.
Because that’s what people do—we walk into traps.
The only thing that ruins their trap is another brutal goliath also looking to devour you.
The life settlement industry doesn’t have your best interests at heart either.
When you sell a policy your the life settlement market you pay 15% to 30% in commissions just to give an investor the opportunity to purchase your policy and make a 15% to 20% IRR that you could have been making if you kept the policy.
They are the T-rex in the scenario.
Being trapped between the two isn’t the ideal situation to find yourself in.
But much like the protagonists in Jurassic Park, it’s the fact that the one monolith opposes the other that gives you the chance to walk away without being completely eaten alive.
On Markets Always Finding A Way
And that’s why markets always find a way.
One party can lay a trap for an innocent passerby, but as soon as another party realizes that they can eat off that same trap too, they’ll find a way to disrupt the first party’s business model.
It’s why Dennis in Jurassic Park turned off all the safety systems and tried to escape with dinosaur embryos so he could sell it to someone else.
The reason why the life settlement industry is messy and inefficient as opposed to other disruptive industries is simply because it can afford to be.
It’s not like other industries where you have to struggle to add additional value just to compete.
There’s plenty of profit to be skimmed off the consumer without them understanding the value that’s being lost.
The consumer is ill-informed and buying off emotion rather than logic or value.
That’s what led them to be stuck in the trap in the first place.
But Jurassic Park only works the way it’s supposed to if the animals in the park behave the way they’re expected to.
As soon as they start to test the boundaries and limitations of the fence it built to contain them, it has a problem.
If the average consumer understood the trap being laid for them, they would have exploited it for themselves instead of needing the life settlement industry to help them do it—all while the life settlement industry keeps the bulk of the economic benefits for itself.
The consumer is just a pawn being played in the middle of a trap they don’t know they are in.
They lose on the front-end when they buy a life insurance policy they don’t fully understand how to utilize in their best-interests.
And then they lose on the back-end when they sell an asset on the life settlement market for a fraction of what it’s worth.
The calamitous effects on the end consumer in the life insurance and life settlement industries highlight some of the most problematic elements of capital markets that invariably bring up questions of fairness and equality.
Is it fair that a large majority of policyowners overpay for a product so that a few can get the benefit?
Or that the majority of those getting the worse end of the deal are from lower income brackets so that those in higher income brackets can get the benefit?
You might say no.
But then if I ask you if you want to pay 2.5-3 times more for your life insurance policy you’d also say no.
But you can’t have one without the other.
Is it fair that if a policyowner can no longer afford or no longer needs their life insurance policy their best option is to sell it on the life settlement market for only a fraction of what it’s worth?
Again, you might say no.
But if it wasn’t for the life settlement market you’d cancel the policy to avoid the obligations of future premium payments that you can’t afford or don’t want to pay and receive a much lower payout from the insurance company than what the life settlement industry is willing to provide.
So what’s the answer here?
The answer is for more people to understand the mispriced opportunities in the life insurance market and exploit them in the same way and start making better decisions.
And the opportunities here are endless because they’re all designed around poor policyowner behavior and consumers making bad decisions.
It’s not like traditional capital markets where in order to get an advantage you have to be smarter than the trader on the opposite side of the table who has a PhD in statistics and decades of experience.
In this case, you just have to make better decisions than the average consumer.
So if you and a friend are being chased by the velociraptor that is the insurance industry and trying to gain an advantage, you don’t have to be faster than the raptor to do it.
You just have to make better decisions than your friend.
And your friend is making poor decisions based on emotional biases over a product he or she doesn’t understand.
It’s not rocket science, but does require intention, discipline, the willingness to learn and admit your flaws, and find people with the right expertise and intentions to assist you.
Exploiting these loopholes forces the industry to adapt.
Aggressive lapse-supported life insurance products are no longer as prevalent in the life insurance space as they were in the mid-2000s in part because the industry got burned heavily from life settlement investors exploiting this design.
Competition is what forces industries to deliver higher value to its consumer.
In the absence of this competition—and a misinformed consumer base—there is no incentive for the life insurance industry to change.
It’s easier for the life insurance industry (and many other industries) to just sell its consumers a story based on a false expectations and have them fall into the trap it designed for them.
About the Author
Rajiv Rebello is the Principal and Chief Actuary of Colva Insurance Services. He helps HNW clients implement better after-tax, risk-adjusted wealth and estate solutions through the use of life insurance and annuity vehicles.
He also writes a Substack called Separating Value From Bias where he explores inefficiencies in the financial and insurance space and how to utilize financial planning tools more effectively while connecting these issues to broader capital and social systems.
He can be reached at rajiv.rebello@colvaservices.com