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:
With decent gains locked in, he would take flyers on the riskiest investments possible. Sometimes, he would invest his clients' money in two variable annuities, one that paid out if the market went up and the other if it declined. It didn't matter. When the annuitant died, Caramadre's client, at the very least, would get both principals back plus the gains from whichever fund paid out.
AAHAAHAAH THAT IS AMAZING. I think I love this guy even more than ProPublica obviously does. I mean, not the scamming dying people. But the scamming insurance companies! It's so ... efficient.
Anyway, the story goes on: the insurers figured it out, they sued him repeatedly, they lost every time because this was obviously allowed by their documents, they revised their products, and ultimately the FBI decided this was pretty shitty - to the dying annuitants, they say, though you might cynically read it as "to the insurers" - and so they're accusing the guy of criminal fraud, basically because he tricked these dying reference-life people into signing the documents.
Which, yeah, if the prosecution is even half-right, he wasn't exactly nice to those people, though be careful about exactly how they were harmed - they got $2,000 for signing a piece of paper, and it's not like that signature lost them or their survivors any other benefits. Forging a variable-annuity signature isn't like forging, say, a mortgage signature: no one owed any money or damaged their credit or anything by signing these documents. They just felt confused and exploited, which certainly isn't nothing.
But the insurance companies! What dopes! The hard-to-grasp thing about the "fraud" here is that, while the insurers were maybe misled, they weren't misled about anything that would be relevant to their decision about how to price their product. It's stuff like this:
It was part of the scheme to defraud that CARAMADRE and RADHAKRISHNAN fraudulently represented to Insurance Companies that the terminally-ill persons named as annuitants knowingly and intentionally agreed to do so by submitting applications which contained signatures obtained by fraud and the identity information of terminally ill individuals, without their knowledge or consent.
And you might reasonably ask: so? If they'd consented, they'd be just as dead as if they hadn't; nobody lost money because the annuitants didn't knowingly and intentionally agree to be annuitants. They lost money because those people died. And because they did nothing to protect themselves from that risk - as ProPublica points out, "[f]or policies under a million dollars, they didn't check the health status of people receiving variable annuities."
But why would they? People just don't do this kind of thing: you can't, if you're a regular human, go up to a dying person and say "hey, would you like your death to do some good, specifically in the form of making me a lot of money?" Instead they take out annuities referencing their own life or that of their spouse, and if they mostly do that then actuarial models should mostly work. The insurance companies clearly used this tendency in their pricing - they asked Caramadre how he knew the annuitants, even though no insurable interest was required in the annuitant, and were willing to accept the answer "acquaintance." Because what were the odds you'd ask this even of an acquaintance?
That's how retail financial services work: you make money because your clients often do not what has the highest expected value but what seems right. So debt collectors can convince people to pay off debts that they're no longer legally obligated to pay, and mortgage banks can expect at least some people to keep paying underwater non-recourse mortgages - just because they think it's the right thing to do. And nobody goes around choosing the sickest person they know to be a co-annuitant, because for most people no amount of money is worth having that conversation with a dying acquaintance.
In the, um, wholesale, financial world, not so much: no company pays a non-recourse debt on a valueless asset. And buying insurance on something you think is going to die - well, at least figuratively, that is kind of a thing. The financial firms got screwed here, basically, because they expected their clients to behave like humans, but instead attracted clients who behaved like financial firms. Which makes it hard to feel too bad for them.
* Allegedly! But. I dunno, read the complaint, or even the end of the ProPublica piece, it doesn't look great for him.