Tuesday, January 4, 2011

The Magic of Diversification Revisited

Yesterday, the Wall Street Journal tells us investors are fighting back against life insurance companies that seek to default on their promises to pay claims from policies originated not for "protecting loved ones", or even "estate planning" but for investor speculation.

In this previous post, I argue that investors should not be restricted from trading life insurance policies on people they don't know. I make three points: First, the fact that you will die at some random point in the future has intrinsic value, and everyone should be able to extract that value, not just wealthy people who can buy their own policies. Second, you and I benefit all the time from the premature deaths of others.  (As a resident of the Garden State, I think our only hope for solvency might be the premature deaths of every state employee pensioner!) Lastly, murder is illegal.  Very few investors are going to kill people to reap the rewards of their investments.

While the article itself says nothing new, the comments from the moderately financially informed public (my interpretation of the WSJ readers) seem to hold life insurance companies, hedge funds and convicted violent criminals in roughly the same regard.  They have only slightly more compassion for the elderly seeking a quick buck.

Their disdain puzzles me.  Investors are trading real risks faced by each of us individually.  Liquid,  efficient markets in genuine risks provide something we all need.  Very few natural buyers exist for the risk that a group of people live longer than expected.  (Here's a possible example: Brookdale Senior Living.  Suppose the cost of filling an empty bed is very high.  Thus, they lose money when resident turnover is high.  That means they lose money when life expectancy falls short.  They could hedge that risk.)

So, why the excitement?  As best I can figure, the controversy arises out of a lack of diversification.  Somewhat stinky smelling investments on their own just smell bad and seem risky.  (Whether it's a hedge fund that engages in life settlement transactions, or an bank that writes a reverse mortgage for your grandmother, they both stink.)

When you mix them together with a whole lot of stuff you see the magic of diversification, where no one stinky investment draws too much attention, and the basket provides the complex, pleasant aroma of great investment decision-making. (In 2004, Berkshire Hathaway "lost" over $200 million by buying life settlement contracts that were extremely attractively priced.  No one called Warren Buffett anything unseemly. See page 65 of the annual report for that explanation!)

[Note: One of my friends who knows I've been actively looking at a particular life settlements transaction raised this issue with me.  I'm therefore putting back in the disclaimer I had in an earlier draft.  So, here it is: I spent much of the past three weeks on due diligence of a life settlement transaction.  I am not completing the transaction.  And, while we're at it, I happen to own equity in The Phoenix Companies, Inc.]

1 comment:

  1. The most interesting part of this post is the premise -- that it matters if the public has respect for people who invest in the insurance industry.

    Maybe the biggest social shift resulting from our recent financial meltdown is that high-risk investors actually care what the public thinks of them.