The origins of death bonds are as macabre as their name. Death bonds grew out of the simple idea that if you get enough life insurance policies, you can group them together and make them into interest-bearing bonds. Pension funds have taken an interest in death bonds as an opportunity for making some serious money. In this article, we'll outline the background of death bonds and offer some pros and cons of investing in a product that makes you money when others die. (Read more about life insurance in Top 10 Life Insurance Myths.)

The Origins of Death Bonds
Death bonds come from insurance policyholders that have decided to sell their life insurance policies for up-front money. They 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 passed away. (For more on viatical settlements, read Haunting Wall Street: The Halloween Terminology Of Investing.)

While viatical settlements are still around, they have been replaced by insurance policies sold by seniors 65 or older who are not terminally ill. These cases are often referred to as "life settlements". The reasons why these sellers decide to sell their insurance policies are varied. Usually, they no longer need them or want to continue the payments. The cash they are given up front is a great incentive for a policyholder to sell his or her policy.

Hedge funds are big participants in the life-settlement arena, as they usually will back companies that purchase insurance policies.

How Life Settlements Work
Insurance policies are owned by 90 million Americans, according to BusinessWeek. As you would expect, the rise of life settlements has come from the aging baby boomers. As of July 2005 there were 78.2 million baby boomers, and modern medicine has continued to enable aging baby boomers to live healthy, longer lives. The average 65-year-old man or woman now has a one-in-three chance of living to the age of 95. (If you are in this massive demographic, read Top 10 Investments For Baby Boomers.)

A person that decides to sell their life insurance policy usually has one of two options:

  1. decide not to continue the payments and allow the policy to lapse
  2. take the cash surrender value (usually very low) that the insurance company offers

A life settlement is a third option that allows a seller to get cash up front - usually anywhere from 20-40% of the total value of the policy. The premiums continue to be paid as usual until the seller's death. (Read more about why people decide to sell their life insurance policies in Rid Yourself Of Unwanted Life Policies.)

A person looking to sell their life insurance policy usually seeks out a broker, who will find three competitive offers from buyers of the life insurance policies. The broker is compensated once the sale is final, and at least a 2% commission will be charged. The policies that are being bought have a minimum value of $250,000, but that number has been coming down since the popularity of life-settlement securities has taken off.

The Good and Bad of Death Bonds
Life settlements are being pooled together to make investment vehicles - death bonds - that are then sold to pension funds and other hedge funds.

Death bonds have a few advantages:

  • Asset Allocation: Diversification is what every investor, both novice and experienced, is looking for in their portfolio. A death bond is an investment vehicle that has nothing to do with the market, since people die all the time regardless of the health of the stock market or the economy. (Read more in Diversification Beyond Equities.)
  • High Yields: They have a high yield that is not impacted by economic forces. The payout is coming; it's just a matter of time. Also, if the seller of the life insurance policy dies sooner rather than later, the buyer actually benefits.
  • Tax-free income: Finally, they offer tax-free income. Life insurance policies carry neither capital gains taxes nor regular taxes, since they are typically used to pay the funeral expenses of the deceased. (For further reading, see Shifting Life Insurance Ownership.)

These bonds do come with disadvantages that an investor should carefully look into. They include:

  • Scams: This industry can have lots of scammers. Moody's pulled a rating from a death-bond fund because the fund's creators were charged with fraud. The biggest scams come from shady brokers that are using pressure tactics to get people to sell their policies without knowing all of the consequences. (Learn how you can steer clear of financial frauds in Stop Scams In Their Tracks.)

  • False earnings: Stranger originated life insurance (STOLI) is when a person is talked into purchasing a life insurance policy not because they want one, but rather because they will be paid to open one. These policies are usually rife with false earnings numbers and net worth of the policyholder.

  • Little Information: The majority of life-settlement companies are privately held, and information is not readily available to potential investors. Finding out about these companies is a difficult and daunting task for investors. (Find out why due diligence is your concern in Don't Blame Your Broker.)

  • Lack of Regulations: Right now there is no regulation regarding life settlements, and with their growing use and popularity eventually regulation will step in. The NASD has released a notice saying that there should be some kind of regulation regarding life settlements. (To learn more about NASD, read Investigating The Securities Police.)

  • Changing Tax Laws: The tax benefits will not go unnoticed by Congress forever. Eventually Congress will see that these policies are being paid tax-free to investors, and will want their piece of the action.

  • Deal with Death: Investors should remember that these investments require people to die. It can be very difficult for investors to know that they are profiting from someone else's death.

Like all investments that are unregulated, the investor needs to do extra homework and not just rely on the reputation of the issuer. 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 makes it very difficult for investors to get enough information about how risk appropriate an investment vehicle like death bonds will be for their portfolio.

The required amount of capital needed to start investing in death bonds is still high. Getting in early on any investment has many advantages, and death bonds are no different. Potential investors need to keep in mind, however, that death bonds can tie up money that they may need somewhere else.

Investors interested in death bonds need to weigh the negative points as well as the upside of such an investment vehicle, and should also take into account the eerie nature of profiting as the result of a person's death.

Read about alternative ways to trade your insurance policy for cash in Cashing In Your Life Insurance Policy.

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