CAUTION. There may be a time bomb in your life insurance policy.

The problem lies in whole life and endowment, including education policies.

We hold over $75 billion of these, which comes to a whopping $75,000per household. That makes it the largest investment after our home.

A big problem is that no one knows where the $75 billion is invested. Insurers refuse to tell.

The latest worry is that some insurers have invested some of the money in a popular but risky new investment called CDOs. It stands for collateralised debt obligations. These are a hot topic now because they are losing tons of money.

CDOs look like a bond fund. But instead of a bond, you buy a queue number.

A low number, like 1, means you are first in line in case of default. While the risk is high, so are the returns if things work out as planned.

Unfortunately, they haven't.

CDOs have been defaulting in waves. For CDOs linked to sub-prime US home loans, the wave has been a tsunami.

Some are so risky, they have acquired a nickname: Toxic waste.

Moving up the safety bar, there are also B, BB and BBB tranches. Next are A, AA and AAA. The AAA rating makes up the safest 25 per cent. The lower 75per cent must default before the AAA CDOs suffer any loss.

Now for two problems.

First, there is no way to know how much of your money the life insurer has invested in CDOs.

Worse still, you don't know which CDO tranches it purchased on your behalf. Was it the safe or the risky ones? You could own 'toxic waste' and never know it.

UNDER-ESTIMATED RISK

In the beginning, no one quite understood CDOs.

Then, agencies Moody's, S&P and Fitch gave them ratings, like AAA, BBB and B. It is similar to bonds. But when applied to CDOs, the ratings mean something very different.

Moody's data shows that from 1983 to 2005, the average default rate on BBB corporate bonds was only 2.2 percent. For BBB CDOs, however, it was 24 per cent. That's a huge difference.

On top of that, the default rate for all CDOs has increased dramatically. The most risky are those linked to sub-prime US home loans.

Its AAA tranche traded in June at 100 cents on the dollar (full value). Now, it sells for 80 cents. The AA has gone from full-value to 50 cents on the dollar. No one has ever seen anything like it. The losses are in the billions.

Compare this to the previous crisis. That was in 1998 when hedge fund, Long Term Capital Management defaulted on $6.7b in debt. The US Central bank stepped in to avoid a market melt down.

Now, that looks like peanut shells. (Not even peanuts.)

The current crisis has losses of $300b, as estimated by JP Morgan Bank. Of that amount, at least $100b has not been disclosed yet.

It remains hidden.

How much is hidden in Singapore? More important, how much is hidden from you?

First, consider banks. They have been quite transparent about their CDO exposure. The losses are large but manageable.

Most important, it is shareholders - not depositors - who bear the losses.

There is no need to worry about your bank investing your fixed deposit in a risky CDO and then sticking you with the loss. It simply won't happen.

The same cannot be said for your life insurance. It faces three big problems:

First, insurers have invested our $75 billion somewhere. We just don't know where. Most troubling, we don't know how much they have sunk into risky CDOs.

Second, not only do some insurers decline to say where they invested our money, they also won't reveal the losses, if any, on those investments.

Third, if you buy life insurance now, you are a 'new' investor. That could be a problem since you cannot buy at the net asset value (today's price) as you do for unit trusts and ILPs (investment linked products).

Instead, newbie policyholders share in the life fund's past profits or losses. Insurers call it 'income smoothing'.

If the fund had past profits, income smoothing is an advantage to newcomers. But it is a drawback if there were losses. These days, the big fear is undeclared CDO losses.

The big question is: 'How to avoid buying whole life and endowment policies sold by insurers who are sitting on a mountain of CDO losses?'

Sorry but it can't be done since all but one life insurer refuse to reveal their CDO holdings.  Back to Columnists