In a comment on my latest book review Insurance Logic, Mike asked what a Mortality Swap is. The insurance industry apparently uses another term for this investment strategy - Back-to-Back Annuity and Insurance.
The concept is relatively straightforward. Here is an excerpt from the research paper titled Mortality Swaps and Tax Arbitrage in the Canadian Insurance and Annuity Markets by Narat Charupat and Moshe Milevsky:
"We show that by engaging in seemingly counter-intuitive transactions involving two insurance products, one can create a risk-free portfolio whose after-tax return is greater than that of available risk-free securities. The two insurance products in questions are (i) a standard term-to-100 life insurance policy; and (ii) a single-premium fixed immediate life annuity with no guarantee period.
Consider an individual who invests $100,000 in a fixed immediate life annuity, and then uses part of the periodic income from the annuity to pay the premium on a life insurance policy whose death benefit is also $100,000. This 'back-to-back' transaction, which we shall henceforth refer to as a "mortality swap", will create a constant periodic flow of income and will return the original $100,000 upon the death of the policy owner. This payoff pattern is similar to that of a risk-free investment such as a bank deposit whose principal is redeemed (by the individual's estate) at the time of death."
Another description is here.
The Insurance Logic book provides an an example for a 65 year old female based on actual quotes from insurance companies at the time. The risk-free rate of return pre-tax for the assumed 50% marginal tax bracket was 8% and was described as "much higher than comparable bond yields". The rate of return for this strategy was higher the older the age of the woman, using a joint and last survivor policy with the spouse and using leverage (i.e. borrowing to buy the annuity. The basis for the profitability of the whole thing is apparently that only a "relatively small portion" of a prescribed annuity is taxable.
This strategy came up for discussion in the Financial Webring - see the post by jiHymas on Dec.29, 2005 for an opinion on some cons. I had an amusing time phoning the CCRA today trying to get information to confirm whether this is still a kosher strategy but no one over there seems to have heard of it. They suggested asking an insurance company. Guess that would be the logical next step since they are the ones selling this, though an insurance broker who could arrange the two sides (insurance and annuity) from the required two separate companies would also likely be a good source.
Overall it seems that this could form part of the low-risk part of a retirement cash flow, replacing T-bills or money market funds.