Asks Matt Levine in two columns on April 30 and May 2:
People could take out new life insurance policies specifically to sell to investors. Go to an insurance company, get a $5 million policy, have it pay out to a trust, make an investor the beneficiary of the trust, have the investor pay the premiums, and charge the investor a fee for the exposure. This is called “stranger-originated life insurance,” or STOLI, and it is largely not allowed.
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There is just a lot of money sloshing around here: On a deal like this, the investor has to pay the insurance premiums, it has to pay the insured a 3% commission to get her to take out the policy, it has to pay the agent a commission for signing her up, and of course it has to pay lawyers and take the risk that the policy will be invalid. And yet there’s apparently still enough money in it to make it a good, securitizable investment. Who is selling all this underpriced life insurance?
And there’s this wonderful question embedded in here – why?
The thing that I found weird is: How can Bob expect to make money on this trade? He is betting on Alice’s life span, with the life insurance company on the other side; why should he expect to win that bet? Presumably Alice is a stranger to him and to the insurance company, and both of them can ask her for her medical history and do physical exams. What is Bob’s informational advantage?
As it turns out, a reader wrote in to explain:
Some large fraction of life insurance policies are not optimally exercised. So traditionally life insurance companies sold insurance that was significantly underpriced if the recipient was going to optimally exercise it, and yet profitable because some reasonable fraction of their clients let their policies lapse sub-optimally.
The informational advantage is that the investor (Bob in this hypothetical) knows he will keep paying the policy no matter what.
Bob, in our example, is no better at predicting Alice’s death than the insurance company is. But there is an information asymmetry: The insurance company thinks that Alice has, say, a 40% chance of letting the policy lapse before she dies, and Bob knows that the actual chance is 0%. He’s paying the premiums, he’s a financial investor, he bought this policy as a bet, his circumstances are not going to change, he’s going to keep paying until he gets the death benefit. The insurance company priced the policy at, intuitively, a 40% discount to its purely mortality-risk-based value, because it figured there was a 40% chance of suboptimal lapse. That 40% discount is — in expectation, over hundreds of policies that he buys — profit to Bob.
There are people in the world who will say finance is ridiculous, and that being smart in order to make money is gross. That might be true. However, the infinite depth of human genius has to be directed at something and for now that answer is “making money”.
Imagine what the people who dream up these trades would do all day if they didn’t have the ability to gain fabulous wealth while doing it. Would that benefit society, or destroy it?