New Collateral: Whole Life Insurance

As a life insurance agent, I am well-versed in the virtues of dividend-paying whole life insurance policies issued by mutual insurance companies and recommend that they be added as collateral to MakerDAO. What is whole life insurance? [https://www.life-benefits.com/what-is-participating-whole-life-insurance/#:~:text=Participating%20whole%20life%20insurance%20]

Whole life insurance is a contract that is designed to remain in force for the insured’s entire life and requires premiums to be paid every year otherwise the policy will lapse (i.e. become null and void). Premiums are level and the death benefit is guaranteed as long as you continue to pay the policy premiums. The contract is between the policyowner and the insurance company where the insurance company contractually guarantees to pay to the beneficiaries of the policy a certain death benefit upon the death of the insured and to share with policyowners the excess profits the company generates. This profit sharing is referred to as a dividend and for tax purposes is treated as a refund of premiums paid (i.e. tax-free). Dividend-paying life insurance contracts also provide for the buildup of something called cash value. You can think of the cash value as equity that grows the more premiums you pay into the policy. This cash value is contractually guaranteed to be made available to the policyowner through the policy loan provision. The only requirement to initiate a policy loan is by completing a simple loan request form referred to as a collateral assignment of life insurance which assigns the collateral in the policy to the lender.

A collateral assignment is a conditional assignment appointing a lender as the primary beneficiary of a death benefit to use as collateral for a loan (https://www.investopedia.com/ask/answers/111714/what-collateral-assignment-life-insurance.asp). If the borrower is unable to pay, the lender can cash in the life insurance policy and recover what is owed. In the event of the borrower’s default or death before the loan’s repayment, the lender receives the amount owed through the death benefit, and the remaining balance is then directed to other listed beneficiaries. For example, Alice has $100k in cash value and a $1 million death benefit. Alice assigns $100k of her death benefit to the insurance company in order to borrow that amount. If she defaults or dies before paying off the loan, the insurance company keeps $100k and pays $900k to her beneficiaries. The collateral assignment is like a lien on the policyowner’s death benefit similar to a lien on a property with a home equity line of credit that mitigates the risk of loss to the lender. The lender can be the life insurance company, a bank, or a private third-party lender.

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The only way the lender can lose money in this scenario is if the policyowner decides to not pay the annual premiums and the contract becomes null and void. A way to eliminate this risk is by only lending to policyowners of whole life insurance that is paid-up. This simply means that the policy is paid in full, remains in force, and the policyowner no longer has to pay any premiums out of pocket. As a result, the contract cannot lapse and the collateral will be guaranteed to grow over time. This means that there is no risk of liquidation since the collateral is not volatile. If MakerDAO were to establish a Special Purpose Vehicle (SPV) to onboard life insurance policies using NFTs similar to the Real World Assets being onboarded through Centrifuge, then it can be the source of high uncorrelated risk-adjusted returns. MakerDAO would use the SPV to designate it as the lender in a collateral assignment of life insurance to mitigate the risk of default. MakerDAO would not need an oracle since the collateral is only going to appreciate. This is why banks treat cash value lines of credit as risk-free bonds.

This is an example of a dividend-paying whole life insurance policy from Guardian which illustrates the fact that the net cash value and death benefit grow at the same time that the base policy annual premiums fall. This is due to the policy becoming a paid-up policy in year 8. In other words, after 7 years the policyowner no longer has to pay out of pocket for their insurance because the dividends have grown to be larger than the annual premium. At this point, there is no risk of the policy lapsing which means MakerDAO has no risk of loss since the policy is guaranteed to be worth more every year. MakerDAO can use the SPV to lend 25% of the death benefit to the borrower by using a collateral assignment of life insurance. For instance, a reduced paid-up policy with a $1 million death benefit and $100k in life insurance loans. The SPV can loan $250k based on the death benefit minus any outstanding life insurance loan plus a 10% loan origination fee. The outstanding life insurance loans should be paid off before the borrower gets the money to mitigate interest from accruing which allows MakerDAO to collect all of the dividends. The loan origination fee is similar to that of a home equity loan origination fee but much higher because MakerDAO is going to be paid annually rather than monthly. Hence, $250k - $100k - $25k = $125k lent at 6-7%.

This has the potential to create a win-win-win scenario. The insurance company wins by locking in a stream of income for the rest of the policyowner’s life. The policyowner (i.e. borrower) wins by purchasing a cash-flowing asset when premiums are cheap and leveraging the power of compounding interest over their whole life with no risk of losing their principal. The lender MakerDAO wins by owning high-yield assets that are completely uncorrelated from traditional finance and are extremely liquid. @LongForWisdom This collateral can also serve as an elegant solution to the concentration risk of DeFi evinced by MakerDAO’s $475 million in stablecoins, $350 million in ETH, and $105 million in WBTC. Adding recursive assets like aDAI/cDAI as @SebVentures has proposed would help stabilize the DAI peg, but it might raise the probability of catastrophic failure due to smart contract risk whereas whole life insurance does not have any of the issues associated with DeFi. In conclusion, if MakerDAO is going to quickly scale it must do so in a sustainable fashion by bringing low-risk high-yield Real-World Assets to DeFi.

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Thank you for your contribution! I was fortunate enough for my family to purchase and then fund annually a whole life policy for me (as well as my two brothers) upon birth and these have been high performing and treasured assets for the three of us. I am perhaps bias in that I have had the luxury of watching these policies grow ever since I found out about them, but I love assets like these and agree that they can be a a big win for MakerDAO once they are tokenized and onboarded into MCD.

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Thanks for commenting, I hope this can start a back and forth discussion on the merits or lack thereof in whole life policies. I further point that I did not bring up is that some policies like Guardian’s have an index participation rider. So if the S&P goes up, the dividend credited goes up to a ceiling of 12.5% and if the S&P goes down it still goes up by the floor of 4%. In a falling interest rate environment, this can result in massive tax-free compounded growth.

That seems interesting. Is there already done elsewhere (borrowing from such kind of insurance policy)? If not why?

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So I assume the insurance company will be Asset Originator opening up the Vault?
It sounds to be this could be a Centrifuge asset with 100% DROP?
If we work with Whole Life Insurances that are not fully prepaid then it would just lower the bar to 80% DROP, 20% TIN etc etc. You could make this work with a whole range of insurances.
Or did you have a different construction in mind?
Are insurance companies allowed to invest in crypto or crypto assets? @ejbarraza?

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Yessss, in leverage everything America this is possible, but not common–check out this article that explains how easy it is to borrow against your whole life insurance policy:https://www.valuepenguin.com/life-insurance/borrow-against-life-insurance#:~:text=How%20much%20you%20can%20borrow,cash%20value%20of%20your%20account.

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Yes, many traditional banks and shadow banks lend on whole life policies. Since they are not financial securities legal compliance should be much easier. My idea is that MakerDAO would be making a bridge loan to get the policy from the early years where the dividends are growing slowly to the point that they are growing exponentially. By the time the loan is paid off, the borrower now has the collateral assignment/lien removed and gets to keep the accumulated cash value and reaps larger dividends from the years of compounded growth. Also, the mutual insurance companies that pay dividends since the mid-1800s. In other words, they have made it through all market cycles and interest rate cycles with flying colors. This is because they are fully reserved. For example, if they have $1 trillion of death benefits that means they must have $1 trillion of cash on their balance sheet. Also, every state forces insurance companies to pay into a kind of FDIC insurance to prevent catastrophic failure for their customers. This is the only asset with guaranteed cash-flow growth and it is not volatile at all.

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No insurance companies are not into doing anything risky like DeFi. Since they have very well-paid actuaries doing the underwriting for their policies they know the collateral is good which is why they are willing to led to their policyowners without any credit check. I was suggesting that MakerDAO directly create an SPV or partner with someone like Centrifuge to indirectly create an SPV. The SPV would do a simple collateral assignment application that verifies the policy does indeed belong to the person applying for the loan, the policy is fully paid up, and verification of the cash value/death benefit. Then, make a 25% LTV based on the death benefit. Currently, banks are willing to lend 90-100% LTV of the cash value, but they ignore the equity of the death benefit which is multiple times larger and equally safe. This is where MakerDAO can compete and charge a premium for taking that extra bit of risk because banks charge between 3-4% interest. MakerDAO can’t compete with that low interest given that they are getting 0.25% loans from the Federal Reserve. So, in order to charge 6-7% MakerDAO has to be willing to offer something different to justify that extra bit of yield. Namely, lending more money based on the death benefit rather than just the cash value. By the way, if MakerDAO ever needed a bailout they can quickly liquidate the cash value in their policies which is allowed by the collateral assignment. I think the only insurance policies that should be used are paid up policies because if the insured misses a single premium and it is not paid up, the policy lapses eliminating all of the equity built up. In other words, the contract becomes worthless. Once paid up there is no risk of lapsing the policy. Term Life and others do not have the same guarantees that whole life has which is why I don’t recommend anyone buy them. Underwriting for this asset is very simple and insurance companies are well-versed in it.
https://www.massmutual.com/efiles/life/pdfs/f5308.pdf

The way high net worth individuals build their net worth in a risk-free fashion is by using whole life insurance as a kind of Roth IRA. Paying the premium out of pocket and borrowing the cash value so that they only pay the difference. Then, they let time compound their returns and leave a legacy of wealth in the form of a large death benefit. I know people who have a portfolio of insurance policies. They pay $20k to policy #1, they borrow $18k, pay $20k to policy #2 and borrow $18k, and pay policy #3 and borrow $18k. So they have triple the cash value and death benefit with only spending a little out of pocket. To illustrate my point look at the premiums paid for this policy over 2 decades the insured paid $400k in premiums but could borrow all of the cash value for that year. Year 1 he can only borrow $17.5k because the dividends are very small. Year 20 he has $617k in cash value, $2.7 million in death benefit, and the dividends have grown to $10k which is well above his annual premium. This strategy is known as premium financing and it is quite popular among the initiated. Similar to the way COMP farming leverages DAI to maximize ROI. The loan from MakerDAO is for the sake of bridging the gap between the small dividends and large dividends. If young people knew this was possible they would prioritize getting life insurance over buying a house since a house can fluctuate in value. Also, the cash value can be used to buy a house mortgage-free which is going to save massive amounts of money over 3 decades. To use real estate as an analogy think of the dividends as rental income, the cash value as a HELOC, and the death benefit as the property value. This would be a game-changer for MakerDAO specifically and DeFi in general because I suspect that a liquid secondary market for these NFTs would soon develop such that they could be sold at a premium.

I need to research this a bit more, but I have noticed the non-guaranteed part. In France, whole life is really the most garbage product I ever saw. Rates are low, costs are high. But it’s a guaranteed product (currently the death benefit is often below the amount of paid premium, no interest beside a tax arbitrage). And we can’t put the policy on a third person except for regulated cases (at least that’s my understanding). We might have pushed the concept too far 300 years ago by having Child-Backed-Assets.

I get the feeling than in all your examples, the borrow rate on the life insurance is lower that the interest rate (or dividend rate) of those policies (cf your “MakerDAO would not need an oracle since the collateral is only going to appreciate.”).

The major proposition you make is to lend above the cash value of the contract. You need the person to die to liquidate the loan in that case. That’s a bit extreme.

Regardless of those points, the first step, if we are going wholesale, is to have a willing asset originator to set up the SPV, originate and manage those loans. Most likely a shadow bank or a broker (not sure why a bank would be interested)? Centrifuge might help with the token platform. For Maker to create the SPV we need to solve [Discussion] Legal structures of MakerDAO first.

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For legal purposes, the insurance company cannot guarantee that there will be dividends. However, since inception they have never gone a single year without paying a dividend since this represents a surplus and they have to operate at a surplus otherwise they would not stay in business. In fact, they have billions of dollars in surplus thanks to their actuaries being highly conservative and mortality tables being often wrong which means that the policyowners reap larger dividends than was illustrated since people are living longer which means they pay premiums longer. You can also lookup their balance sheet and see that they have their liabilities matched 1:1 with 25-30 year A-, AA-, AAA-rated treasuries. This goes a long way to mitigate falling interest rates. Also, there are add-on features known as riders that allow the insured to get upside exposure to the S&P with zero downside risk. This is known as an index participation rider and it credits the cash value between a floor of 4% and a ceiling of 12.5% per year depending on the returns of the S&P. This you can easily research for yourself since its public information. I would start with the largest which are MassMutual, Guardian Life, and New York Life. If MakerDAO lends 25% LTV on the death benefit and every year the death benefit is guaranteed to increase and the cash value is guaranteed to increase because the premiums paid act as a kind of dividend reinvestment program where the higher the cash value the higher the dividend received which leads to a higher cash value creating a positive feedback loop. This would lead to a falling LTV every year, but in the beginning, the dividends will be smaller, and as time goes on the dividends grow exponentially thanks to compound growth as evinced by the conservative illustrations. At maturity, the cash value is guaranteed to equal the death benefit which can be 4X larger than the death benefit in Year 1. This makes for ultra-safe collateral. The longer the person lives the more interest accrues for MakerDAO, but the sooner the insured dies the sooner the insurance company pays the loan in full thanks to the collateral assignment ensuring MakerDAO is paid first and the remainder goes to the beneficiaries. So, the longer the insured lives the more MakerDAO profits, and the sooner they die the sooner MakerDAO gets paid principal plus interest and the loan origination fee which can be recycled into more loans. When the loan is paid in full, the person will want to take out another loan which creates a revolving door of business since they never had to think about paying anything out of pocket. Yes, the first problem that needs to be solved is finding an asset originator with an SPV already set-up. Perhaps partnering with Kensington Financial or someone like them that is willing to act as middleman bridging the gap between TradFi and DeFi.

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@ejbarraza, @FourthStreet, @SebVentures, @Planet_X, @ElProgreso thanks a lot for the post and followup answers.

I am totally ignorant on this topic but, by reading this, I feel i have learnt a lot.

I hope this discussion can move forward as (again, in my superficial understanding) this seems a huge market and a perfect use case for Maker.

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The life insurance secondary market is very much on my radar for mid-2021 to bring forth to the community as a scope increase. I have assembled life settlement debt structures in the past. Most certainly something for the community to consider as we bring credit to the real world from Maker.

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I think life insurance assets are safer than other assets. For us, this brings more opportunities and room for development, which is very good. I hope to speed up the introduction of such assets into Maker as a priority.

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This is not the real challenge. A LendCo can provided a secured loan to an SPV holding the assets. The challenge is that the transaction must be simultaneous. It needs to include PSAs from the portfolio and a recent actuarial appraisal. Further, the portfolio itself must be over-collateralized to support a defined term. The entire structure must be secured with a first position lien.

Also critical, the Maker facility is young and while technically and legally stable, interest rates are not stable (we have only been through one supercycle with high rates and now one with low rates… what impact with the DSR have in truly containing the rates in the future… we all believe it will be powerful, and I tend to agree… however the reality is we do not yet truly know yet). There will be secondary markets that help with rates.

Point being is that while a US Treasury is actually the ideal collateral, there is a reason why adding it is complicated and almost dangerous (not for Maker but the for the LendCo). The reason is rate variability.

Maker needs highly stable assets that are good credit quality. At the same time, they need to assets that can handle some rate changes (e.g. as Maker over time ups the DSR). A Lender for UST cant handle 20bps swings before being priced out of the market. Life Insurance products are not that far above that given the outstanding credit quality.

Summary: Will life insurance get added as collateral? Over time, with no doubt.

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There is a stigma in the US as well about life insurance being a scam. The reason is that life insurance agents have a conflict of interest in selling policies that are not structured properly. For example, whole life insurance (WLI) policies can be designed in a 10/90 split, 90/10 split, or anything in between. In the former case, 10% of the premiums pay for the death benefit and 90% goes to the cash value. In the latter case, 90% of the premiums pay for the death benefit and 10% goes to the cash value. The insurance agent is paid a commission equal to half of the cost of insurance for the first year which means that they are incentivized to sell a high volume of policies that build minimal cash value for the sake of realizing a larger commission check. If you have $10,000 worth of premiums and half go to your agent in the first year, they don’t mind if the policy lapses the very next year. Whereas a properly structured policy would only net them half of $1,000 which is a substantial drop in income for the same amount of work. So, it is not that insurance itself is a scam it is that many insurance agents are scammers which give the industry a bad reputation (at least in the US).

Looking at my own illustration you can see the guaranteed values which have a worst-case assumption of zero dividends (i.e. no surplus). The non-guaranteed values are the best-case scenario which is that they maintain their current dividend. Assuming you don’t lapse the policy, in both cases you will end up with more money than you started out with thanks to compounding interest and a guaranteed death benefit. In the same way that owning real estate will always make you more wealthy so long as the property is not repossessed. By the way, in the US policies can be purchased on yourself, your spouse, your kids (if the parents are insured), and a business partner or key employee. For instance, Tesla had a key man insurance policy on Elon Musk. So, if Elon had died prematurely Tesla would get the death benefit since they paid the premiums. In fact, many real estate investors get life insurance on their property manager which compounds their returns in a passive fashion.

Perhaps a viable legal structure to invest in WLI is through a Trust and closed-end fund (CEF). MakerDAO loans DAI to the Trust which uses Kraken Bank to swap into USD. The Trust uses the USD to establish a CEF similar to ArCoin’s CEF except we would invest in WLI. This would create a proxy insurance-linked security that institutional/retail investors could buy. The CEF would determine the weighted-average yield and pay a monthly distribution. The loan origination fee should mitigate part of the expense ratio of running the fund. This would effectively offload the legal liability to the CEF and bring in a steady stream of income in perpetuity. The CEF coins can even be deposited into the treasury as a strategic reserve. The customers that collateralized their WLI can use their loan to invest in CEF coins that have long-duration, high yield, low-risk assets through a diversified bond portfolio. Since the CEF should be free of defaults, it would create the most stable of stablecoins in DeFi which can be onboarded as collateral on MakerDAO thereby creating recursive leverage similar to aDAI/cDAI but using a real-world asset instead. This would lead to a positive feedback loop for the borrower, the lender, and the investor.

@mrabino1 Any thoughts on whether this is doable?

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More or less. Important components in my eyes really comes down to:

  • Whole life vs. universal (rate certainty).
  • The portfolio of policies (and what % of them are contestable).
  • Servicing of the portfolio
  • Actuarial analysis of the portfolio (eg. an appraisal).
  • Then, of course, the over-collateralization to support a debt structure.

Insurance companies in this context make spectacular collateral, though the construct is more rate sensitive that other capital sinks.

2021 will be a great year for MakerDAO… :slight_smile:

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@mrabino1 The capital raised from selling shares to investors through an IPO would be used to originate life insurance loans, similar to the way closed-end funds sell shares and then invest in CLO, MBS, ILS, etc. Furthermore, I think that it should be seasoned whole life insurance (i.e. paid-up) policies that have passed the 2 year contestability period and have plenty of cash value and dividend growth. The CEF should have a legal compliance officer, underwriter/actuary, portfolio manager, and so on just like a 144A bond fund would have. The CEF can loan 95% LTV on the cash value and a 5% origination fee with a 5% APR and a monthly payment to match the dividend schedule. If the borrower does not pay, then the collateral assignment of life insurance would be used to liquidate the outstanding loan. In the event that the borrower gets liquidated the CEF keeps the principal, interest, and loan origination fee. Unlike mortgage-backed securities, prepayments would be positive since the APR would not drop and the capital can be reinvested to earn more loan origination fees which subsidize the expense ratio.

I just wanted to say that I think this is an excellent idea and I would love to see you pursue it @ejbarraza

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