Years ago, in my PhD days, I was working as a consultant for a fund investing in so-called “life settlements” in Munich, Germany. Early in my time there, I remember one of the managers raising his fist into the air and exclaiming jubilantly, “Mr. XYZ is in the pipeline!” I looked around the room and everyone seemed to be in celebratory mode. Apparently, policyholder Mr. XYZ’s wife had died, and given the statistical mortality pattern of couples, Mr. XYZ might be soon to follow. So the fund’s investment position in the sizable life insurance policy that would pay on the last survivor’s death just appreciated significantly, leading the employees to celebrate.
Incentivized to sell
If you’re hearing this for the first time, you might be appalled. Speculating on someone’s death? How horrible. But the secondary life insurance market, or life settlements market, is more complex than it appears at first glance. I’ve studied different aspects of this quirky market across several papers, learning the ropes early on in my research career.
Life settlements are a tiny slice of the insurance market, and a somewhat exclusive one, since investors normally don’t look at policy amounts less than $1 million. These legal transactions between policyholders and investors exist because they can be mutually beneficial. Policyholders can sell their life insurance policy to a third party investor, using the money to make their remaining years more enjoyable, while investors can make money off of the deal (even if they are hoping for an early death…).
The decision to sell often comes on the heels of a bad health diagnosis. Policyholders think, ‘I have this gigantic asset. I made my premium payments, I should be able to sell because it’s my money.’ If they go back to the original insurer, policyholders might get cash surrender values only amounting to a mere fraction of what an investor might pay. The investor option, therefore, is individualized; a one-to-one contract that offers an attractive risk-return profile that, importantly, doesn’t depend on financial markets at large.
The settlement-survival correlation
So taking what we know above, if you are a policyholder who has received a serious health diagnosis and are ready to sell, you probably present your situation to the investor in as dire terms as possible. You may have private information about your condition that you don’t want to reveal—you may present your longevity at five years when it may actually be a decade—in order to maximize your payout from the investment company.
In my most recent paper with co-authors Jochen Russ of Ulm University and Nan Zhu of Pennsylvania State University, we looked at this issue of asymmetric information—when one party, like the policyholder, knows more than the other—in the context of the life settlement market. Using two separate data sets from Fasano Associates, one of the three largest medical underwriters in the life settlements space, for the period of 2001 through 2013, we looked at the relationship between settling and individuals’ future lifetime using this survival data. We found a significantly positive settlement-survival correlation. Policyholders who decided to take the deal actually lived considerably longer than those who did not settle.
Contributions and policy implications
Our study contributes to the literature in several ways. First, while there are several well-known papers studying asymmetric information in primary insurance markets, as far as we are aware our study is the first to explore informational frictions in a personal secondary insurance market. Second, our results suggest that individuals in our sample are competent in estimating their relative mortality (more or less than the average person with a similar profile to the individual). This is distinct from the literature’s stance that individuals fare poorly in assessing their mortality prospects, though our results may not carry over to all populations, given the larger, more exclusive life insurance policies examined here.
Our findings carry implications for the life settlements market and beyond. If you are in the business of making estimates and pricing policies, it’s beneficial to understand that your counterpart may have an informational advantage and adjust your estimate accordingly. In the bigger picture, if insurer surrender profits decrease as a result of greater numbers of policyholders taking advantage of this market, then insurance prices may rise, which affects everyone. The public policy question remains: is this a good thing, or a bad thing? Are we better served by forbidding this market? We think the jury is still out, but our study sheds light on how to address this question in future studies.
Read the papers: “Asymmetric Information in Secondary Insurance Markets: Evidence from the Life Settlement Market,” (PDF) working paper; “Evaluating Life Expectancy Evaluations,” published in North American Actuarial Journal; “Coherent Pricing of Life Settlements Under Asymmetric Information,” published in The Journal of Risk and Insurance.
Daniel Bauer is the Hickman-Larson Chair in Actuarial Science and an associate professor in the Department of Risk and Insurance at the Wisconsin School of Business.