Profiting from Longevity, Part I
by Richard
Proof yet again you don’t have to fly to Las Vegas to satisfy your gambling urges.
We already know that insurance is the mirror image of an annuity. The former hedges the risk of premature death, while the latter is a hedge against longevity risk.
Hard to imagine that living a long life could ever be construed as a risk to be hedged, but the stark reality is that those final decades play out when you are drawing down assets, and the race is on to see which event comes first:
Death versus Asset Depletion
The insurance industry has two product categories. The first is the annuity, whether the plain vanilla fixed annuity or the more exotic variable variety.
The second is a product called longevity insurance. Typically, it results from a single premium paid many years earlier, that will not blossom into a payout annuity until you reach your 85th birthday. If you had the discipline and tenacity, you could construct this yourself with a portfolio that you would not touch until you reached the same date.
Sadly, most investors succumb to the temptation to raid the cookie jar, and for them it may make sense.
The Latest Wrinkle: Life Settlements
The Life Settlements phenomenon is the secondary market that has emerged in life insurance. Starting in the eighties, these were called viatical settlements, and helped many in end-stage diseases to sell their insurance at a discount to help fund expensive treatment and end of life expenses.
The market has morphed into something much bigger, and numerous on-line sites compete aggressively for policies to bid on.
The mechanics are simple enough. Two thresholds must be reached:
- The insured must be over 65, and preferably over 70.
- The life insurance policy must have at least $100,000 in death benefits.
The buyers have two tools to help them set their bids. Actuarial tables predicting life expectancy, and a financial calculator, where you input the years ostensibly remaining, the ongoing premium expense, the ultimate death benefit, and the rate of return acceptable to the investor(s), known on the street as the “hurdle rate”.
With these variables known (or predicted, in the case of longevity) you solve for the present value, which is what they will bid, less any frictional transaction costs such as commissions or finders fees.
Ladies and Gentlemen, Place Your Bets…
Now you have a choice: Do you hold the policy, keep up the payments, and have your beneficiary ultimately collect at your demise…or do you unload the policy on the new buyer, let them pay premiums, and worry not a jot about having strangers ultimately profit from your death.
Once you get past the creepy factor, it’s just another investment option. If you end up on the short end of the longevity range, the buyers rate of return is higher. But if you live well past the expected range, their return diminishes greatly. It’s a function of the time value of money.
In our next post, we’ll discuss this further, and explain why the insurance industry is howling mad at this incursion onto their turf.
