“What I didn’t know is that these polices still paid off even if the employee no longer works for the company. Meaning if the company took out a thirty year term policy on John in 1980 and John died in 2005, the company still gets paid the benefit even if John left the company in 1983. Very, very morbid and something that could be quite profitable.”
That is how “Dead Peasant” insurance got its name. It’s a reference to Gogol’s “Dead Souls,” a story about a guy who bought the services of dead serfs from feudal lords and reported them as assets on his balance sheet when he went to procure loans. Record-keeping was so poor back then that there was no way for the bank to know whether the serfs were dead or alive. One agency active in selling this insurance referred to insured former employees as “dead peasants.” (Contrary to popular belief, the term had nothing to do with deceased employees - it was purely a metaphoric reference to former employees.)
"So, here are the questions:
“1: From what I have read, companies purchased thousands upon thousands of these policies. You could have one on your life right now and not have any clue. Being there are so many, how does a company know if you died if you have left the company?”
Most companies paid a small death benefit to the family, so the family would announce deaths. Also as I understand it, the Social Security Administration will tell you whether the holder of a certain SSAN is alive or dead, and companies involved with this insurance would ask about all of the numbers in their database periodically.
“2: Playing the game, term insurance is very inexpensive. For myself, when I bought life insurance when my first child was born, I got $500,000 for $32 a month for thirty years. If I wanted to, could I buy life insurance policies on a couple of thousand random people picked from the phone book?”
No. You need to have an “insurable interest” in their lives, which you do not have in the case of strangers. In some states, sellers of these large programs were able to procure legislation giving an employer an “insurable interest” in all employees. The policies were issued in those states, regardless of where the employees lived. The legal status of such insurable interests was always somewhat iffy.
“If only 2 or 3% meet an early demise, I am in the money in a big way. (I don’t don’t know if that percentage is correct, I didn’t run the numbers, but you get the point)”
LinusK has the right answer: Actuaries are not stupid. If you can buy this insurance, then someone has to sell it to you. Do you really think the house loses that bet consistently? Indeed, this is the point that should make you wonder if you are hearing or thinking clearly. HOW ON EARTH can a company buy a gazillion insurance policies from a commercial insurance company and hope to make money on deaths? It’s not possible. And if it’s not possible, odds are it isn’t really happening.
What IS happening - or was, before the IRS shut it down - was an elaborate tax scheme which, to make a long story short, paid off for the employer while the insured employees lived. Thus, contrary to your initial assumption, every death was a BAD event, removing, so to speak, a tree from the tax orchard. The insurance company and the employer had a side-deal under which any mortality gains by either side were essentially canceled out by future premiums and dividends. The insurance company and the employer structured their arrangement essentially to share the tax benefits, which arose from the fact (until it stopped being a fact) that insurance gains were tax exempt, but interest paid to finance them were tax deductible.
Because the object of the game was to get tax benefits from insured employees, this insurance gave an employer a reason to EXTEND the lives of its employees, not end them. Which is why, returning to the Gogol story, the employer would want to continue to insure former employees - the tax benefits continued after the employee left, and it was the tax benefit that the employer sought. Indeed, thanks to a quirk in the tax code for a while, it appeared that former employees might support a larger tax break opportunity than actual employees. Analyses of proposed programs would, therefore, segregate present and former employees, which is why a separate designation was needed for the former employees, and “dead peasants” was the obvious choice.
It all sounds macabre, but no one was put at risk. Indeed, as mentioned, the employer’s interests were best served by the survival of insured employees. And when a price competitor like Wal-Mart saves on its taxes, who do you think REALLY benefits? We have met the enemy, and he is us.