BENEFITS OF A SECONDARY MARKET FOR LIFE INSURANCE POLICIES, THE

Real Property, Probate and Trust Journal, Fall 2003 by Doherty, Neil A, Singer, Hal J

B. Catastrophic Risk Insurance

The asset sold on the secondary market for catastrophic risk insurance is the insurance company's position in a policy; in essence, the risk insurance is the excess of the present discounted value of payments by a policyholder over the present discounted value of the potential liability. Catastrophe risk insurance first became securitized in 1992, and in 1993 the Chicago Board of Trade began trading a contract for this risk. Catastrophe risk is a useful tool for asset diversification because catastrophe losses are not correlated with either the stock or bond market.25 Prior to securitization, however, catastrophic risk was too risky for most investors. The securitization of catastrophic risk insurance has mitigated much of this secondary market risk, and thus, it has prompted an increase in secondary demand.

This demand, in turn, significantly has improved the liquidity of an insurance company's position in catastrophic risk policies and reduced credit risk by providing a superior financial vehicle to insurance firms to hedge against downside risk.26 These improvements in the secondary market have increased the valuation that issuing insurance companies place on their positions in these policies. As a result, issuing insurance companies correspondingly have increased their demand for catastrophe risk and extended greater quantities of risk insurance.27 The increased demand of insurers has translated into both a greater availability of policies and lower rates for those policies.

C. Analogues to the Life Insurance Industry

The examples examined above provide useful illustrations of the benefits of a robust secondary market in the life insurance industry. The emergence of a secondary market for home mortgages, and their subsequent securitization, has increased the liquidity of the underlying asset to mortgage lenders and reduced the credit risk associated with the purchase of the asset in the primary market. The emergence of viatical and life settlement firms, by the same process, has led to an increase in the liquidity of life insurance policies. Furthermore, this liquidity has fostered a decline in a credit risk, of sorts, for consumers in the primary market. Consumers now know that if they experience a decline in life expectancy and no longer need (or can no longer afford) their life insurance policies, they will be able to sell the policies for their market value instead of having to surrender them for the low price offered by the insurance carrier. The secondary market for home mortgages caused mortgage lenders to place a higher value on mortgage payments and to demand a higher quantity of these payments. By the same process, the modem secondary market for life insurance has caused consumers to place a higher value on life insurance policies, a positive result that has affected the demand for life insurance in the primary market.

In the case of catastrophe risk, the enhancement to the secondary market brought about by securitization allowed insurance companies-the purchasers of catastrophe risk liability in the primary market-to retreat more easily from, or hedge, risk liability. Just as the secondary market for catastrophic risk insurance mitigates much of the downside risk from the original acquisition of a risk liability, the secondary market for life insurance mitigates the downside risk from the purchase of a life insurance policy on the primary market. Consumers know that should they need or desire to sell their policies in the future, they will not have to accept amounts less than the market price. This mitigation of downside risk led insurance companies to purchase more catastrophic risk liability in the primary market, and it should likewise be expected to cause consumers in the primary market for life insurance to demand a greater quantity of coverage.