What Is a Death Bond?
- A death bond is an asset-backed security (ABS) derived by pooling transferable life insurance policies, which are then repackaged into bonds and sold to investors.
- Death bonds can provide diversification for the portfolios of investors with holdings in commodities, housing, and other financial markets.
- A death bond's yield is correlated to the insured person's longevity.
How a Death Bond Works
Life settlement companies purchase existing life insurance policies and then sell them to financial institutions, who then repackage them in order to create the investment product called a death bond. The settlement company will pay more than the cash surrender value (the death benefit, which is always less than the face value) of the insurance policy to the seller.
A death bond is similar to mortgage-backed securities (MBS) except that they are backed by life insurance policies which are then combined, repackaged into bonds, and then are finally sold to investors.
Death bonds can trace their origins to viatical settlements in the 1980s. Spurred by the onset of the AIDS epidemic, terminally ill patients sold their life insurance policies to pay for their desperately needed, expensive medications. Their policy payments were taken over by the purchasers, who would receive the policy paid in full when the patients died.
Death bonds are unusual instruments because they are 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 death bonds are created from an underlying pool of assets, the risk associated with one policy is spread out. Diffused risk makes the instruments more stable.
Advantages 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; life insurance policies carry neither capital gains taxes nor regular taxes because they are typically used to pay the funeral expenses of the deceased.
Disadvantages 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 (CDO) that contributed to the subprime meltdown and the collapse of the housing market in 2008.
- 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.