life insurance

When the earnest scoldy public-interest journalists at ProPublica take it upon themselves to defend a financial scam artist who tricked terminally ill people into signing documents that they didn’t understand,* you have to figure there’s a pretty good story behind it. Oh God is there. I challenge you to find a better story about mispriced derivatives in the last week of August than ProPublica’s story this weekend about Joseph Caramadre.

The scam – and I say that with some affection – is this: life insurers offered products (call them variable annuities or death-put bonds, but you can abstract them to just one-period investments) that allowed you to invest your money in stuff and then, when a “reference life” or “annuitant” – a person, normally but not necessarily you – died, you got back the greater of (1) your original investment (plus interest sometimes!) and (2) the value of the stuff. So if the stuff went up, you profited; if it went down, you broke even (or did a little better). In exchange for this guarantee you paid a tiny fee every month, and I guess actuarially those fees were supposed to add up to the fair price of the put that the insurer was selling you.

But the trick comes when you decide, as amazingly you can, to make the annuitant not you but rather someone you found in an AIDS hospice and then bamboozled into signing up for the scheme by giving him a $2,000 payment that you told him was a charitable donation so he didn’t have to report it to the IRS. Then you end up paying almost nothing – well, $2,000 and change – for that put that the insurer is selling you, meaning that you get it for way under its fair value. And if you have a free put, you might as well combine it with the most volatile thing you can find. And our guy did. Actually he did a little better than that: Read more »