Many economists have stressed the ability of markets to aggregate local knowledge.
e.g. Hayek’s famous AER essay
Recent interest in ability of markets to predict the future:
Political betting markets
Terrorism insurance markets
Life insurance markets (e.g. Mullin and Philipson)
Can Decentralized Knowledge Fail?
The behavioral economics literature emphasizes misperceptions and cognitive errors.
There is limited evidence (except perhaps savings behavior) whether such errors are important in real market settings with large stakes.
What if getting prices right depends upon knowledge that no one has?
Financial Times 9/8/08
“United Airlines temporarily lost most of its market value on Monday after a false report the carrier had returned to bankruptcy court surfaced on the internet.”
“A six-year-old Chicago Tribune story on United’s 2002 bankruptcy filing – spotted on a Google search by an investment newsletter – triggered a sell-off of the carrier’s shares that ended when trading was halted. The stock reached a low of $3, then rebounded once trading resumed to close down 11 per cent.”
“Investors accepted the article as news that the Chicago-based airline had once again sought protection from creditors, a scenario that had grown more feasible in the past year as jet fuel prices skyrocketed.”
Develop evidence from the secondary life insurance market on:
The extent to which market participants have mistaken perceptions regarding their own mortality risks.
The extent to which the market anticipates medical technological breakthroughs.
Why Secondary Life Insurance Markets?
This market is a good setting to test for the presence of cognitive errors.
It requires participants to make complicated evaluations involving their own mortality.
This market is a good setting to test for whether markets are good at predicting the future.
Firms need to know whether technological advances will turn a good deal sour.
A non-liquid asset that can be used to secure a loan (such as a house)
Zero premium life insurance note that pays off at death.
Income can be moved around different times and states by borrowing/lending against the house and by selling/viaticating the life insurance policy.
Why Treat Actuarially Fair Life Insurance as Valuable Asset?
The unit price of life insurance depends on health status at the time of purchase.
For patients who suffer unexpected health shocks, the actuarially fair unit price of life insurance exceeds the original unit price.
Thus, unexpected health shocks generate a valuable new asset for the chronically ill with life insurance.
Trade-offs in Cashing Out Life Insurance
Patients have three options to finance current consumption:
Spend liquid assets.
Borrow against non-liquid assets such as housing—i.e. credit market.
All of these potentially reduce bequests.
Complete Markets in This Context
Viatical settlements and credit markets are complementary in distributing income across time and across different states of the world (uncertain time of death).
Given an arbitrary initial allocation of income in time and in mortality-state space, it is impossible to replicate the time-pattern of consumption achievable with viatical settlements and credit markets combined using only one of these instruments.
Actually, in this setting, any mortality contingent commodity combined with any certain credit note will complete the market.
The health measure binary (whether predicted mortality exceeds an arbitrary cutoff).
Makes interpretation of results easier.
Results are not sensitive to the cutoff (within reason).
Predicted Viatication Probabilities
Viatical settlements and Medicaid program participation
Viatical settlements and taxes
Adverse selection in viatical settlement markets
Differential transactions costs of life insurance sales for healthy vs. unhealthy consumers
Viatical settlements and Medicaid
In most states, funds from a viatical settlement count against Medicaid asset limits, while life insurance holdings do not.
This provides a disincentive to sell life insurance that applies to healthy and unhealthy alike.
Typically HIV patients apply for Medicaid late in the course of their disease.
Medicaid asset accounting rules most likely deter the relatively unhealthy from selling insurance more than the relative healthy
Viatical settlements and taxes
The 1996 Health Insurance Portability and Accountability Act exempts viatical settlements from federal taxes as long as the seller has a life expectancy of 24 months or less or chronically ill.
This fact might explain the relative desirability of viatical settlements for the unhealthy, but cannot explain the pattern of observed interactions between health and non-liquid assets on the hazard of selling insurance.
What if viatical settlement firms cannot observe mortality risk?
Separating equilibria may exist with welfare loss for low risk types (relative to symmetric information).
High risk types (low mortality) impose a negative externality on low risk types (high mortality).
This may make credit markets more attractive for low risk (high mortality) types.
This is inconsistent with the evidence which indicates that the healthy are less likely to viaticate.
This is a reasonable result given that good measures of life expectancy are available for HIV patients, and patients undergo a thorough medical evaluation before viatication.
Also, there is no evidence that prices change with the face value of the policy.
Differential Transaction Costs
What if costs of borrowing are higher for the relatively unhealthy
As banks anticipate transaction costs of liquidating estates of the relatively unhealthy to collect loan payments?
This is consistent with the evidence which indicates that the unhealthy are more likely to viaticate.
But this is an unlikely explanation as
Standard credit applications do not ask for health status and mortality risks
It might be illegal to discriminate (charge different loan processing fees) based on mortality risk
Search costs of finding a viatical company and negotiating a transaction might be higher for the relatively unhealthy who only have a few more months to live.
How Well Does the Market Anticipate Technological Shocks?
Nominal Price of a Viatical Settlement, by Life Expectancy and Year
Number of Viatical Firms by State from 1995 - 2001
What Explains the Declining Prices?
Medical technology shock
HAART increase in life expectancy; but prices declined within life expectancy categories
Increased variance in life expectancy projections, especially for the healthy