How Not To Invest: Viaticals

death_eatersI’m a big fan of niche financial markets as well as learning about how NOT to invest. This leads me this week to the “life settlements” industry, and a subset of that business known as “viaticals.”

Living owners of life insurance policies sometimes seek to sell their policies on the secondary market to receive a lump sum of money as well as to relieve themselves of the obligation to keep up expensive life insurance premiums. Life settlement investors pay that lump sum, maintain the policy premiums, and then collect the death benefit when the original policy owner dies.

The purchasers of secondary life insurance policies, investment funds seeking an above-market return, usually take over policies of elderly or terminally-ill patients who no longer can afford, or who no longer wish to afford, the life insurance premiums on the policy. For the investor, ideally, the insured person dies quickly, before the premium costs eat up returns.

While regulated and considered legal transactions in 42 states, there’s an obvious ick-factor to life settlements, as investors essentially bet on, and benefit from, the early death of policy sellers. The faster the death, the greater the profits. Which when you think about it, you know, ugh. A life insurance policy for someone who beats the odds and lives a long time will end up costing investor the money, who pays too much in premiums, for too long, to ever make a profit.

Viaticals, a subset of life settlements, refers specifically to investing in policies of terminally ill patients, with less than two years to live, or the chronically ill, unable to perform two “activities of daily living” like eating or dressing oneself. For the policy purchaser, you can see how a life insurance policy of a terminally ill person on death’s door is worth a lot more than the life insurance policy of a healthy person.

The legitimate financial cases for buying a secondary life insurance policy are twofold. First, terminally-ill or elderly folks may need access to their cash today for end-of-life care. The industry first grew up as a response to the crisis of terminally-ill and relatively young men with AIDS in the late 1980s. They needed money right away and worried less about heirs or estate-planning.

Those earliest pools of viaticals, dedicated to purchasing AIDS policies, blew up catastrophically for investors in the mid 90s, when a miracle cocktail combining protease inhibitors and two other drugs transformed HIV from a death sentence to a chronic illness. The insured survived, and investors lost everything.

The second major category of sellers today are often older high net-worth folks who purchased life insurance as an estate-planning tool, but who later find their estate-planning needs have changed, and they no longer want to maintain their policy.

The “ick factor” associated with viaticals is not the main reason why I’d urge you to avoid this business opportunity, should it ever come your way. Rather, I’d avoid life settlements because the industry seems to attract both fraud and financial blowups like a jelly donut on my counter attracts ants.

The fraud probably happens because life settlements and viaticals are just niche-y and opaque enough to attract a certain type of scheme-promoter, who knows how to appeal to a risk-taking investor. That risk-taking investor in turn usually thinks they’ve found a relatively hidden, low-risk, high-return way to invest.

Fraud in the industry has been perpetuated in a variety of clever ways.

My friend Michael Stern, a successful industry veteran of the life settlements industry over a dozen years, described to me a few of the classic scams.life_partners

In Texas, one of the industry’s most notorious operators, Life Partners Inc, filed for bankruptcy in 2015 following $46.9 million in court-imposed fines against the company and its main executives for fraud and insider trading. The Wall Street Journal reports that Life Partners depended upon a physician – working on commission – who assigned shortened life-expectancies to policies where independent estimates would have been much longer. Those short-life estimates juiced the price at which the operators could sell life insurance policies to relatively unsophisticated investors.

Following that, maintaining the policies sometimes got too expensive for those investors, so the Life Partners executives repurchased policies from their customers to the financial benefit of insiders, leading to insider trading fines. The executives seem to have avoided jail time, and the business exited bankruptcy in December 2016, to be liquidated for the benefit of investors.

Stern explained to me that because policies are expensive for existing investors to maintain, some operators have fallen into the illegal practice of paying off old investors with new incoming investors, the classic definition of a Ponzi scheme.

us_virgin_islands
USVI suffered some problematic pension investments

Stern also mentioned that his industry now has learned to blacklist or avoid purchasing policies from certain zip codes with a preponderance of fraudulent medical reports, where a medical examiner is likely boosting the value of policies by diagnoses which exaggerate the risk of imminent death.

In the US Virgin Islands last year, a viatical investment gone awry blew a $50 million hole in the territory’s government pension plan, a plan that was already in distress. The 2016 auditor’s report reads like a “what the heck just happened?” story.

Although the life settlements industry remains a relatively small few billion dollars in policies per year, compared to the maybe $20 trillion in face value outstanding of the traditional life insurance business, large and sophisticated sponsors do participate, such as Apollo Global Management (APO) and American International Group Inc (AIG).

As a side note, I decided long ago that when I write my first novel – a financial thriller obviously – the main plotline will involve a hedge fund dedicated to viaticals. Could a certain unscrupulous hedge fund manager, maybe, put a thumb on the scale to speed along the process of death? Nothing too obvious, you know, just some prudent risk management and juicing of returns on the margins. The patients were already pretty sick, you understand, so it’s a mercy, really. Think Robin Cook’s Coma meets Michael Lewis’ The Big Short.

While viaticals make a brilliant premise for a creepy novel, my financial advice is to leave this investment opportunity entirely to the professionals, partly for the ick factor, and partly because they are best equipped to navigate the fraud and blowups that seem to follow this industry niche.

 

A version of this post ran in the San Antonio Express-News and The Houston Chronicle.

Please see related posts:

 

Book Review: The Big Short by Michael Lewis

Annuities: Loved By Insurance Companies and Death Eaters

 

 

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On Insurance, Part III – Life Insurance Calculations

Bill MurrayI previously argued that insurance is useful for risk transfer, but less attractive as an investment.  I also think that under certain conditions – such as responsibility for minor children or limited savings, you need life insurance. 

I thought a quick post using compound interest calculations could help illustrate why life insurance can be an effective risk transfer, but an ineffective investment.

As a 41 year old non-smoking man, $100,000 of pure life insurance would cost me $91.07 per month, for the rest of my life.[1]  I would need to maintain those monthly payments – without fail every month – in order (for my heirs) to receive the $100,000 benefit when I die.  I cannot access the $100,000 myself at any time, and I cannot waiver from the monthly contribution, or I lose my entire life insurance coverage.

Another option with $91.07 per month would be to invest it myself.  Assuming a 4.35% return annually on that same amount of money, and assuming I live to precisely my expected life of 37 more years, l would have accumulated almost exactly $100,000 in savings, to match the life insurance policy payout amount.

The big difference?  I don’t have to die to use that money, either at the end of 37 years or at any point along the way.

Not only that, if I could beat the 4.35% return and achieve a 6% annualized return on investment instead, my 37 years of investing $91.07 per month would be worth $149,397.

Of course, if I die early, my investment return goes up.  So I’d have that going for me.  But then, of course, I’m dead.[2]

In addition, if I’m unfortunate enough[3] to live longer than my expected 37 more years, my implied ‘return on investment’ via life insurance looks a lot worse versus a potential return available elsewhere.

Most importantly, if I skip a few months of investing $91.07 monthly, I still control all of my invested money.  I have access to that invested capital at any point along the way in my lifetime, for other investments – or consumption – as I saw fit. 

With life insurance, if you miss a few payments, your policy lapses and all of your money disappears.[4]  In fact, the life insurance business depends on the expectation of policy lapses, as I explained in an earlier post.

So insurance as an investment never matches up attractively, at all, to other investment options. 

As a risk-transfer policy, life insurance works great, but keep that function apart from your investments.

Please see other posts on

 Insurance I – Risk Transfer Only

And

Insurance II – The Good, the Optional, and the Bad



[1] That’s the quote I got today from my life insurance company USAA.

[2] Although the Lama did grant me total consciousness.  Which is nice.

[3] Yes, that’s sort of sarcastic.

[4] Yes, there are versions of whole life insurance which allow you to skip a few monthly payments, or in which you get to borrow against ‘accumulated value’ in the policy, but I’ll make two quick points about that.  1. That skipping option gets reflected in your premium price (which will be higher than the $91.07 that I got quoted for a very stripped-down policy, and  2. That option to access ‘accumulated value’ is a way to ease you into the unholy alliance of risk-transfer and investment, violating my cardinal rule of insurance, which is to keep those two functions entirely separate.

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