What is Death Bond
A death bond is a security backed by life insurance which is derived by pooling together some transferable life insurance policies. Similar to mortgage-backed securities, the life insurance policies are combined, repackaged into bonds, and sold to investors.
A life settlement company will purchase existing policies and sell them to a financial institution, who will repackage them into the investment product.
BREAKING DOWN Death Bond
Death bonds provide investors with an unusual instrument that is less affected by standard financial risks. One risk of holding a death bond lies with the underlying insured person. If the person lives longer than expected, the bond's yield will begin declining. However, because the creation of death bonds from an underlying pool of assets, the risk associated with one policy is spread out. Diffused risk makes the instruments more stable.
In general, a life insurance policyholder transfers their policy to a life settlement company. In exchange, the settlement company will pay more than the cash surrender value of the insurance policy. The cash surrender value is always less than the face value, or death benefit. The life settlement company resells the policy to an investment bank. The bank then pools and repackages the life insurance into bonds to be sold to investors.
Pros of Death Bonds
- Death bonds can provide diversification for investors with holdings in commodities, housing, and other financial markets.
- They have a high yield that is not impacted by market forces. Indeed, if the seller of the life insurance policy dies earlier, the buyer will benefit.
- Death bonds offer tax-free income because life insurance policies carry neither capital gains taxes nor regular taxes because they are typically used to pay the funeral expenses of the deceased.
Cons of Death Bonds
- The returns on death bonds are modest. They are generally higher than U.S. Treasuries, but less than equity investments.
- Some have expressed concerns about death bonds and the securitization of life insurance policies, drawing comparisons to the collateralized debt obligations (CDOs) that contributed to the subprime meltdown and the collapse of the housing market in 2008-09.
- Since there are no regulations or requirements for the industry, virtually anyone can hang a sign on their door and become involved in the life-settlement business. This lack of oversight makes it very difficult for investors to get enough information about how risk appropriate death bonds will be for their portfolio.
History of Death Bonds
Death bonds can trace their origins to viatical settlements in the 1980s. During this time, AIDS and other terminally ill patients needed money to pay for their expensive medicines, so they began selling their life insurance policies and were paid an up-front amount. Their policy payments were taken over by the purchasers, who would receive the policy paid in full when the patients died.