Their proponents say they could represent a multibillion-dollar business for investment banks. Their opponents say they are risky, poorly understood investments that place bets on human lives. And Canada's biggest credit rating agency has found itself caught in the middle of the debate.
They're called "death bonds" - or, more formally, life settlement securitizations - a burgeoning class of financial products that have caught the eye of financial innovators at some of Wall Street's biggest banks, which are eager to find new ways to make money after the popping of the mortgage bubble. The bonds are created by intermediaries that buy up life-insurance policies from policy holders - typically seniors looking to cash out their policies - bundling them together, and selling off small slices to investors. The profit comes when the policy holders die and the investment funds, as the designated beneficiaries, collect the payouts.
It may sound macabre, but the products have become increasingly popular in private investment transactions this decade - and have suddenly caught the attention of U.S. lawmakers. They are worried that Wall Street is preparing to repeat the same mistakes it made with subprime mortgages, and that bond rating agencies will be willing to put their stamp of approval on dubious offerings, just as they did during the credit boom earlier this decade.
Toronto-based credit rating agency DBRS Ltd. provides an interesting case in point.
Still trying to live down its willingness to rate the asset-backed commercial paper products that turned into a near-disaster for Canada's financial community during the credit meltdown, DBRS was called to the mat by a U.S. congressional committee last month to answer questions about life-settlement securitizations, after The New York Times ran a prominent story about the potential growth of the products.
Last year, DBRS became the first mainstream credit agency to lay out criteria for rating death bonds, placing it at the vanguard for eventually issuing ratings on life-settlement securities - a move that would open them up to a much broader investment base.
Never mind that DBRS has never given a rating to death bonds, that industry insiders say that they may never be more than a minor sideline for Wall Street firms, and that some of the biggest names rumoured to be considering issuing securities (such as Goldman Sachs and Credit Suisse) say they're aren't pursuing public death-bond issues. Washington is nervous - not so much about poor seniors selling their policies to the highest bidder, but about voters becoming exposed to another risky Wall Street scheme.
"I was a little surprised that all of the concern wasn't about life settlement companies buying and selling policies, but about the possibility that they would be securitized," said Dan Curry, president of DBRS Inc., the U.S. arm of the Toronto company, who testified before the House financial services subcommittee on capital markets. "This is not another mortgage-backed securities market."
The most obvious attraction of life settlement investments is their certainty: insured people will eventually die. But perhaps even more compelling is their lack of correlation with other financial asset classes.
What happens in the stock market or bond market has little, if any, bearing on whether and when an insured life will end. The appetite for uncorrelated investment assets, particularly among hedge funds, has become more acute in the wake of last year's financial market collapse, which buried virtually every traditional asset class in its path - even ones that had historically moved in opposite directions.
Yet there's a big ethical catch. The cold reality of life settlements is that the sooner an insured person dies, the more profitable his policy is for the investors. This is where, some critics say, life-settlement investment products cross an unacceptable line.
"From an ethical context, you're betting that someone will die. It doesn't have the right smell," said Frank Zinatelli, vice-president of legal services at the Canadian Life and Health Insurance Association.
"It's not good public policy for investors' returns to be driven by the early demise of a policy holder," said Steve Finch, executive vice-president of life insurance at John Hancock Financial, the U.S. arm of Canadian insurer Manulife Financial Corp.
Life settlements themselves are nothing new. After some false starts in the 1980s, the life-settlement industry in its current form took hold in the late 1990s in the United States - it's legal for outside parties to purchase life policies in all but a handful of states. By 2008, life settlements were a $16-billion (U.S.) industry (based on the face value of policies acquired that year), up eight-fold since 2001.
In Canada, third-party purchases of life insurance policies are banned in six provinces and all three territories. Quebec, Saskatchewan, Nova Scotia and New Brunswick are the exceptions, but life-settlement transactions in those provinces have remained sporadic. (However, the trading of securities related to life settlements is legal in this country, as the Ontario Securities Commission established in a 2006 ruling.) It was only after the once-lucrative subprime-mortgage-backed-securities market crumbled in mid-2007 that Wall Street started more seriously exploring larger-scale opportunities to securitize life settlements. Responding to growing interest from clients, DBRS published its methodology for rating life-settlement securitizations in February, 2008.
Unlike subprime-backed securities, the big risk for life settlements isn't defaults. Rather, it's when policy holders will die. The longer they live, the lower the return on the securities, because the issuer is obliged to pay the premiums while waiting for policy holders to pass away.
Investors learned that the hard way in the first incarnation of life settlements in the 1980s, when there was a flurry of interest in "viaticals" - the buying of policies held by the terminally ill, in that case AIDS patients. Medical advances quickly and dramatically lengthened the life expectancy of AIDS sufferers. Investors were decimated, and the life-settlement investment industry was sent into a decade-long dormancy.
But by creating a big and diverse enough pool of policies in a death-bond portfolio (it would take at least 1,000, according to Standard & Poor's), the theory is an investor could mitigate those risks by investing in a wide range of policies. The other advantage of death bonds is they ensure a steadier flow of cash to investors - because in a pool of 1,000 or more policies, there would be steady stream of deaths.
But there are other risks, too. Timely payouts on policies can be disputed by insurance companies for any number of reasons. The life-settlement agents and brokers, as a group, have developed a spotty reputation for the tactics they employ convincing seniors to sign over their policies, which leaves the payouts open to legal challenges from both insurers and family members. And there's the risk that some insurance companies themselves could fall into insolvency.
That's why DBRS set the bar high for even considering life-settlement products for ratings. The firm has received 14 serious proposals for issues over the past year and a half, and none have passed its muster; Mr. Curry says only two of them remain as active possibilities.
"I think there's some sticker shock when [clients]find out what's required," he said.
That's fine with DBRS. After the firm's bad experience with mortgage-backed-security ratings, it is not eager to put its stamp on anything but top-quality death bond issues.
"I think the entire industry understands how damaging that was," Mr. Curry said. "We don't want to let that happen again."
The life insurance industry's opposition to life-settlement securities might goes well beyond ethical principles. A considerable portion of life insurance policies never reach the point where insurance companies pay out a claim - policy holders allow them to lapse. But if large numbers of policies are held by third-party investors with a vested interest in maintaining premiums until death, that would drastically increase costs for insurers.
In this regard, perhaps the most troubling trend for the U.S. life insurance industry is a practice known as STOLI - stranger-owned life insurance - under which people are paid to take out life insurance policies specifically for the purpose of signing them over to a life-settlement broker.
The fear is that growing Wall Street demand for life-settlement assets would trigger a boom in these dealings. That could potentially leave life insurers overexposed to a whole new level of risk - just as mortgage companies were during the subprime rage.
"You don't have to be a rocket scientist to see that this could get you in trouble," said Steven Weisbart, senior vice-president and chief economist with industry group the Insurance Information Institute.
But Doug Head, executive director of the Florida-based Life Insurance Settlement Association, dismissed suggestions that life-settlement securitizations are destined to become a big issue for the investment and insurance industries.
"Down the road, perhaps you'll find someone who can put one of these together," he said. "It's certainly not going to be in the trillions."
"I think this will be a very, very small securitization market," agreed DBRS's Mr. Curry. "I'd be surprised if it's more than a handful of transactions."
David Parkinson