Viatical Bubble: Toil, Trouble?

• Alan R. Elliott
• On 5:38 pm EDT, Friday September 11, 2009

Tech stocks, telecom, real estate, oil: The past decade of market peaks are an archipelago of ruptured bubbles.

Among the many sectors possibly being groomed for future bubble status is a piece of the insurance business once labeled viaticals, now more often called life settlement.

The industry buys up life insurance policies, primarily from seniors under financial duress but also from younger policy-holders diagnosed with terminal illness or injury.

Investment companies purchase the policies, paying policy holders well above what they would receive if they surrendered the policy to the issuer but only a fraction of the policy's benefit, or face value. When the seller dies, the investor collects the benefits. The key is buying policies with rich payoffs at pennies on the dollar and from policy holders with as few ticks left in the old Timex as possible.

The settlement business reportedly got its start in the early years of the AIDS epidemic. Struggling, often dying AIDS patients sold life insurance policies in order to cover medicines and medical treatment.

As AIDS patients began to live longer, the settlement industry ranged further afield. Policies purchased from U.S. senior citizens nearly doubled from 2007 to 2008 to $11.8 billion, according to the U.S. Senate's special committee on aging.

The economic downturn, which made the settlement market a buyers' game by debilitating the investment holdings of retiring seniors, suggests another viatical boom year in 2009.

Financial companies have begun implementing the next step: bundling such sold-off life insurance policies into securitized packages similar to the collateralized debt obligations made famous by both the junk-bond and the mortgage industry meltdowns.

The New York Times reported this month that Credit Suisse and at least eight other financial firms and private investors have life insurance securitization proposals in the works.

What does the development of this morbid frontier mean for life-insurance industry itself?

If the growth projections of life-settlement proponents hold true, life insurers will pay more, earn less and perhaps lose money on that segment of their business, according to Steven Weisbart, chief economist with the Insurance Information Institute.

"It would not be positive," Weisbart said.

But Weisbart says the actual target constituency for such policy sales is comparatively small. Settlements must occur in late-stage policy holders -- the longer a policy holder survives after the sale, the less profitable the deal is for the buyer. In addition, most life insurers now offer accelerated death benefits, providing up to two-thirds of a policy's benefit right away upon a terminal diagnosis.

The real threat is in securitized settlements following a similar track to the recent mortgage securitization debacle. There, securitizers placed increasing pressure on originators to write more business in order to feed the securitization market, leading to sub-prime and other high-risk lending.

"That's going pretty far out on a limb," Weisbart said, "but we can't ignore the fact."

1. Business

IBD sorts the insurance industry into five segments. The three leaders among those groups cover essentially everything other than medical insurance. Life insurance is, by far, the largest of the five groups. Accident and health is the smallest.

Aflac (NYSE:AFL - News) and Unum hold the top EPS Ratings in the accident and health group. Among life insurers, the best ratings go to China Life (NYSE:LFC - News), Delphi Financial Group (NYSE:DFG - News) and American Equity Investment (NYSE:AEL - News).

Life insurers do just what you think they might: primarily, underwrite death benefit policies. This provides fat cash flow, but thin margins.

The same holds true for disability coverage, which is the mainstay of the accident and health insurance group.

Both businesses, however, tend to collect premiums over a long period of time before payout. They put the lapse to use by investing the capital. Those investments generate the lion's share of their profit or, in situations like the recent downturn, loss.

Name Of The Game: Risk management is job 1; investment savvy, job 2. But balancing a long list of other disciplines, including product development, sales and customer service are also crucial in keeping all the business's many moving parts aligned.

2. Market

The life insurance industry benefits from aging populations in the U.S. and Europe. Indemnity and disability insurers do well when employment is high and payrolls are on the rise.

Both insurance segments benefit when markets, particularly bond markets, deliver healthy returns. They suffer when investment markets slump. The industry across the board has taken a broad hit from too much exposure to derivatives and higher-risk bond markets.

"Insurance companies have very large bond portfolios," said Mark Finkelstein at Fox Pitt Cochran. "While the environment has improved more recently, the credit environment is still having an impact on the fair value of those assets, and we are not fully through the cycle in terms of actual impairments."

Some insurers focused over the past several quarters on culling the higher risk elements of their portfolios. Those sales amplified the decline in profits and total assets.

The top players in the leading insurance groups are now reporting declines in unrealized losses or increases in total assets. That has been a key driver in the groups' rebounding into leading industry ranks.

But Aflac is just one example of a stock whose price remains well below its prior, long-term trend, despite EPS performance well above those that supported the prior levels. Why?

"The stock is still being weighed down by concerns over investment losses," Finkelstein said.

3. Climate

One thing that hasn't weighed on the life, and the accident and health insurers group: the debate over medical insurance reform. The threat, or at least the fear, of federalized health care coverage triggered an avalanche among hospital and HMO industry group stock prices in January.

Life and indemnity insurers slipped near the same time, but that decline was due to the impact of credit markets on bond debt and concerns over how much of those assets would become defunct.

Elizabeth Malone with Wunder-lich Securities said the health care issue remains largely undefined, and beyond the perimeter of markets for accident and health group leaders like Delphi.

"There is some discussion about disability products as a part of the health care reforms," Malone said, "but it is not a significant part."

4. Technology

Risk assessment and modeling software and programs is the key locus of technology in the insurance business. That technology has evolved incrementally over the years, but shifted among many insurers in recent years with regard to long-term medical care coverage.

Initially, underwriting for people who bought long-term care insurance focused on physical well-being, mobility, etc. Over the past several years, underwriting for long-term care has become more focused on mental condition, and the potential for Alzheimer's and other mentally debilitating diseases.

"It's become obvious to the issuers of long-term insurance that that's where the people who use significant long-term benefits are to be found," Weisbart said.

5. Outlook

Life insurers see some impact from rising unemployment. Accident and health insurers, which include disability and worker's compensation lines, take a more direct hit.

The economy has a role in demand and revenue for them, Malone says, because disability and worker's comp premiums are based on payrolls.

"So if payrolls are not growing, or are declining, that means that revenues generated by disability and worker's comp are also not growing," he said.

Players like Aflac and Unum see a large portion of their revenue from small and midsize businesses. These tend to be more durable during economic slumps.

In its second-quarter earnings call, Unum management said pricing in the U.S. has been stable. Their outlook, however, was for pricing to start to see pressure in the second half of the year, as employer belt-tightening makes new sales and expansion increasingly difficult.

Mergers and acquisitions could also grab a portion of the outlook. After several years of vigorous M&A activity, the number of deals approached an all-time low in '08. That trend appears set to reverse, as financial institutions part-out their business segments seeking to recoup steep recent investment losses.

An April industry report from Deloitte looked for "growing activity in potential sell-side insurance M&A as a number of large banks and other types of financial institutions seek to divest noncore insurance operations as part of broad-scale efforts to fund capital shortfalls."

Upside: Rebounding investment markets point 15 rising investment income among insurers.

Risks: Life and disability insurers have yet to thoroughly work through questions regarding fixed-income investments and the full-impact of historically high unemployment and sagging payrolls.

Buzz up!