A death bond is a bond which is based on life settlements. Money borrowed through the sale of death bonds is used by the borrower (typically a life settlement fund) to purchase unwanted, transferable life insurance policies from policyholders. When the individuals insured by these life insurance policies die, the borrower collects the death benefits. The borrower compensates lenders who buy death bonds by paying them interest.
Death bonds provide a convenient and low-risk vehicle for investing in life settlements. Instead of the investor having to pay the premiums for life insurance policies throughout the life of the insured individual, they can simply buy death bonds as a one-off investment. While the yields earned on a death bond are lower than the potential return of a life settlement, the risks and effort involved are much lower.
Example of a death bond:
An investment company issues 100,000 bonds, each of which has a 2% annual coupon paid out annually, a 20-year term and a face value of 1000 Swiss francs. The company sells these bonds to private investors at their face value, raising 100 million francs of capital. It uses 10 million francs of this capital to buy 10,000 whole life insurance policies – each of which has a face value of 100,000 francs – from their owners for 1000 francs each. It pays out an average annual life insurance premium of 5000 francs per policy each year, investing a total of 50 million francs in insurance premiums across the bond term. The company pays out 2 million francs per year to bondholders as coupons, a total of 40 million francs over the 20-year term.
The total cost of accumulating and investing the capital over the bond term by the investment company is 100 million francs (CHF 10 million to buy the policies, CHF 50 million in insurance premiums and CHF 40 million in bond coupons).
As the insured individuals die throughout the bond term, the investment company collects the life insurance benefits totaling 1 billion francs. When the death bonds mature at the end of the 20-year bond term, the investment company returns the 100 million francs of bond principal to investors as they cash in their bonds.
So the investment company which handled the purchase and the ongoing costs of the life settlements earns a profit of 800 million francs (CHF 1 billion minus CHF 100 million in bond principal and CHF 100 million in costs). The investors who purchased bonds earn a fixed yield of 20 francs per year per bond (400 francs per bond across the bond term).
Guide to investing in life settlements