Valuing Life or Valuing Regulatory Budgets?

This piece in the NYT on valuing life has many interesting angles.  The writer discusses the origins of cost-benefit analysis in regulations, as well as the variation (dare I say manipulation?) of the value of life implicit in calculations by the EPA, FDA, etc.

My first reaction: These numbers are political jockeying.  If I run a regulatory agency, I want the highest number possible. 

Why?  First, I look most attractive to the public.  Who do you support, the incompetent hack who says you're worth $150,000 or me, the sophisticated thinker, who values your life at $2,000,000?  What about $10,000,000?

Second, I get the biggest budget.  The marginal cost of saving a single life goes up very quickly as the number of lives lost falls.  However, I know I cannot run a "zero risk" regulatory organization.  Everyone will see through that quickly.  (Imagine the head of the NHTSA saying "we cannot tolerate a single death on US highways."  Everyone knows that's too costly.  Traffic and the economy would grind to a halt.  Heck, you'd have the TSA running the whole country!!!)  However, if you hike up the value of the lives as you slowly nudge down the number of tolerable deaths, you will impact your agency budget very nicely.

What if The People vote with their wallets?  According to the American Council of Life Insurers, the total life insurance in force in the United States is about $18.1 trillion at year end 2009.  There are 308 million people in the United States.  So, collectively, we only insure ourselves to the tune of $58,766 per person.  Not very much. 

You could say that number is no good because not everyone buys life insurance.  Surprise:  That $18.1 trillion covers 291 million policies!  (Yes, many people have more than one policy.)

So, let's bump that number way up:

• Maybe poor people don't buy life insurance.  (Not exactly true, especially since this includes group policies, but what the heck...multiply the number by 10 because only the top 10% of wealthy people buy life insurance) Make it $587,660.
• We don't insure children.  (I certainly think children are not a positive cash value asset, and cash doesn't compensate for losses, etc.  Oh, and we already accounted for them in the "poor" adjustedment.)  Double the number again: $1,175,320.

We're still covering only a fraction of what politicians think we're worth!

This leads to my third reason the government numbers are useless: Behavioral finance tells us that we, as individuals, over estimate our risk of remote events, and under estimate our risk of the mundane.  In other words, we worry more about plane crashes than crossing against the light in New York City.  Government "value of life" calculations feed that irrationality.

Diversification Deja Vu

I've written before about life settlements.  Generally, I'm a fan of allowing the business.  More recently, I argued that people don't like unseemly parts of their investments when they draw too much attention.  It's really a matter of diversification.

This brings me to the latest controversy over the company Life Partners Holdings Inc., a seller of fractional interest in life insurance policies.  The company has just reduced their return expectations touted to customers, at least partially as a result of pressure from a WSJ story.  I know, this is a shocker: They could not deliver on their promised returns!!  Oh, and they're being investigated by the SEC.

Here's the idea: Think of a life insurance policy as a negative coupon bond with an unknown maturity.  Instead of receiving coupons, you pay coupons.  Instead of getting back your principle at a known future date, you get it back at a random date.  The longer the person lives, the lower your return, because you pay the coupon longer, and you get paid back your principle at a later date.  Variable maturity combined with negative coupons makes these bonds much riskier than typical bonds.  (Of course the upside can be huge if the insured falls short of life expectancy.)

How risky are they?  How many stories have you heard of people with months to live surviving years?  My understanding is that there's excellent medical evidence that the grumpier the old man, the longer he lives. 

The math isn't very difficult.  If you expect someone to die in three years, and they live for four, intuitively you're at least 30% worse off, right?  they lived 33% longer than expected, and you had to pay another year of premium.  (At least there's upside: The insured may live less than three years.)   

Many factors drive life expectancies, and they are just expectancies: Half of all people will live longer than expected. 

Moreover, those that are highly likely to live less than expected probably know this, and won't sell their policies.
Life actuaries will tell you your sample needs thousands of observed deaths to draw credible conclusions.  In other words, you need massive diversification to reduce risk.  Why is that?

In contrast, diversification in the stock market takes relatively few positions.  Twenty or thirty stocks in various sectors get you most of the way there.  A two or three thousand stock portfolio isn't going to deviate much from "the market" or our "expectations."

In it's history, LPHI has only sold 6,400 policies to 27,000 investors.  It seems unlikely many of those 27,000 investors hold even 1000 different lives.  They're undiversified and unrealistic about risk and return.

Frankly,  it doesn't matter if the doctor in Reno, NV who performs all their medical evaluations is any good.  He could be "perfect" at calculating expectancies, and results may be lousy for undiversified investors.  (However, giving him the benefit of the doubt is worse than giving credit rating agencies the benefit of the doubt when you buy mortgage backed securities!)

Think of it this way: Suppose the SEC were investigating an equity index mutual fund.  Rather than holding all 500 S&P stocks like Vanguard, it held 10 or 15.  Would you be surprised at the results when the fund underperformed the index?  (But your friend would still brag at the party that his IRA beat yours!)

How Much For Those Eggs? Yes, Give Me The Sperm Too!

I love this Wall Street Journal article about Social Security benefits!  Apparently, depending on the state, children born posthumously receive social security benefits as surviving child of their parents.  This has developed into a serious issue because of fertility technology.

This should massively impact the secondary market for eggs and sperm!  Can you imagine going to the sperm bank for a donor:

Bank Teller: How may I help you?

Potential Customer: My God!  Mr. Jones must have had a PhD from MIT, been 6' 5" and very handsome. $132,000 for some sperm??

Bank Teller: No, ma'am, that's not quite right.  He had an IQ of 87, and mopped floors in the California state house for 53 years. Mr. Jones actually retired at age 72, only six months ago.  He then, tragically, I am sure, dropped dead immediately.  His children will each receive social security benefits and a California state employee pension until they turn 18.  We expect that a family of four can comfortably live in most major metropolitan areas once they birth his child.  A bargain, really. 

Potential Customer: Hmmm...that's a bit out of my price range.  Do you have something in a reasonably old, moderate health who is likely to die before I have to pay for the child's college?

I see a new business line for Wall Street: We can combine the demonized "stranger owned life insurance" products with a fertility operation!  Insurable interest abounds if you own the eggs or sperm of some elderly individual!

One last thought that I know is nagging my siblings: What if we clone our parents?  Do we immediately start collecting survivor benefits because of our grandparents?

My Take On "The Looming Pension Disaster"

I could give you a list of a thousand problems on this topic.  I won't.  I'll pick one, maybe two.  I wrote a while back about the problem in New Jersey.  New Jersey hardly has a monopoly on pension problems.  Here's another nice one by Alan Sloan at Fortune.

In the FT today, there's a piece about securitizing pension risks. Before I tell you what the heck this means, I'll tell you it cannot work.  Too many regulatory problems.  The risk cannot be unloaded or hedged.  This all ties back to my moving and storage piece, (which, by the way, I will continue to link as frequently as possible, because if you haven't read it, you don't get half of what I'm saying!)

Securitizing pension risks means figuring out a way for another party to hold the risk that people live longer than expected.  Put another way, construct a security that allows large groups of people to hedge the risk that they live longer than expected.  Let's think about buyers of this security.

Making Money When Others Die

Periodically, the financial press gets excited over the business of investors making money when other people die.  Do you own life insurance?  Does your employer provide life insurance? Do you own an annuity?  Then you make money, or have cheap insurance, because other people die.  There's nothing terribly wrong with this, and in other contexts people seem to agree.  Some deep seated discomfort with death seems to make people squeamish when we remove the veil around profits that depend on death.

Diversification drives the "value" of death.  Just like when you invest in a portfolio of stocks to diversify your risk and raise your returns, life insurance companies diversify their insureds to reduce prices to them, (and, of course, raise their profits.)  If MetLife wanted to provide you a life insurance policy that solely depended on your life, they'd charge you far more than they do because that would be risky.

In fact, you can have a life insurance policy that depends only on your life if you want it!  We'd call it a savings account! You contribute every year, and the benefits would build up naturally!  If you want giant death benefits compared to your premium, you need other people's lives on the line. That's why insurance companies exist: They pool risks, thereby reducing risks and costs to the underlying insureds.

Additionally, often your life insurance company sells annuities.  Annuity providers definitively make money when others die.  An annuity pays a small payment as long as the insured lives.  This makes your life insurance cheap.  Why?  annuities (almost) perfectly hedge life insurance.  Life insurance policies involve small payments from the insured to the company while the person lives, and a large payment from the company to the insureds estate when they die.  Annuities involve large payments to the insurance company at the start, and small payments from the company to the insured as long as they live.  The combination mkes the insurance company into a "moving" business, not a "storage" business! (You need to understand that post to understand many of my ideas, btw.)

Last point, for now: Of the two certainties in life, death and taxes, only one has value to you: death.  You cannot lose this asset against your will. Not even bankruptcy.  You can only realize the value of this asset in one of two ways: Buy life insurance, or allow someone else to buy it for you.  Preventing individuals from selling their insurable interest destroys the value of that asset for anyone who cannot afford or does not need life insurance.  That's just not fair.

Oh HECM, someone drank my STOLI!

You've never heard of either of these, I assume.

HECM is the FHA program called Home Equity Conversion Mortgage. In common parlance, this is a reverse mortgage. I don't know why they call it a reverse mortgage because that's confusing. I'd call it a factoring forward sale or something that that, but then again that isn't any easier to understand. HECM allows a home owner (typically elderly) to receive current cash payments that look like monthly loan payments, where the collateral for the loan is their home. The "trick" is that they don't have to pay back the loan until they die, and the home is sold.

Another way to describe this transaction is converting your house into a "residential annuity" (you get to live there until you die) plus a cash annuity.

From the lender's perspective, this is a mortgage combined with life expectancy risk. Their loan may be good, but they aren't sure, probably, until the borrower dies. (Or, to be precise, sells the house, moves into a nursing home, etc.)

So here is the Government supporting a loan program that depends on old people dying. In the popular press, they call this "death pool" investing, or worse.

That brings me to STOLI. Stranger Owned Life Insurance. This is a rather obscure part of the life insurance world, that got an especially bad reputation in the early '90s. Suppose you own a life insurance policy on yourself, and no longer want to make the payments. Someone else might. You could sell the policy to another person. They continue to pay premiums, they get the death benefit when you die. (Viaticals were the early transactions involving AIDs patients who sold policies on terrible terms. The ONLY solace, I suppose, is that HIV cocktails bankrupted most of these early buyers.)

The thing is, in the popular press, this is called "death pool" investing, or worse. Oh, and state governments are outlawing these types of transactions left and right. Often at the behest of the life insurers who monopolize the market via incredibly low "surrender values" of policies, that do not reflect the potential embedded value of mortality risk. In polite company, these are called "life settlements."

Why might there be embedded value in life settlements? This isn't going to sound very nice, but here goes an extreme example...You bought a $1 million policy as a healthy 60 year old. Ten years later, you have a massive heart attack, and survive. You are now a 70 year old who just had a massive heart attack. Your life expectancy is now much shorter than a 70 year old who didn't, (at least for a while.) The policy you own was priced based on the average 60 year old. You are now not the average 70 year old from that pool of 60 year olds. Thus, your life insurance policy has an expected value much greater than the average when it was written. Someone will buy it from you. It's a perfectly good investment.

Preying on the elderly is not a virtuous activity. However, both of these transactions serve a purpose. Both provide payments to (presumably) consenting adults. They both depend on the fact that "insurable interest" , (that is, an individual's ability to obtain life insurance, and thus transact in the security that pays off in the state of the world in which they die,) has value. This insurable interest has significant value, and individuals ought to be able to access that value.

A competitive market in HECM would allow lenders to differentiate based on health not just age. This would be better for the elderly. And, STOLI significantly benefits the elderly.