Would you sell your life insurance to a stranger? Millions would, and Wall Street wants a piece of the action.

A life settlement is the process by which an individual, usually of senior status or declining health, sells his life insurance policy to a settlement company in exchange for a lump sum. The settlement company then sells the policy or shares of the policy to investors, who then become the beneficiary when the insured senior passes away.

It’s marketed as a win-win because the senior receives an immediate settlement for a life insurance policy he would otherwise never benefit from, and the investor receives the potential for very high returns on his money.

Regardless of what your moral view may be on such a transaction, it is big money and that means Wall Street wants a piece of the action.

Investment banks plan to purchase these life insurance policies, and package them up for resale as bonds to institutional investors – pension plans, hedge funds, etc..

This is very similar to the securitization of sub-prime mortgages in the last decade. The thinking is that the risk of loss (i.e. the original elderly policy holder outlives his policy, and the investors lose money) is spread out among many investors.

As I said, the potential market for this is apparently pretty big. Industry predictions are that the market for these bonds could be a large as $500 billion, and firms like Credit Suisse Group (CS) have been entering the life settlement arena.

Also, Goldman Sachs Group Inc. (GS) has been developing an index of life settlements for trade, effectively allowing investors to bet on whether the insured senior will out live his policy or die sooner than expected.

While the potential for systemic collapse, like that caused by defaults in the sub-prime mortgage business, seems limited there are risks and repercussions involved with life settlement bonds.

For example, the trend of average life span is moving upward suggesting that the odds of the insured outliving the policy rises year after year. Additionally, the fact that the policies are now held by institutions and trusts that have no limit of mortality means that insurance companies will likely being paying out more claims than they would if the policy holder remained the insured. This will likely cause a rise in life insurance rates.

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