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                                              Life Settlements: Beyond the Hype

Proper considerations in selling a life insurance policy on the secondary market

BusinessWeek  hit the newsstands last July 30 with a cover image of the Grim Reaper  behind the headline: “Death Bonds: Inside Wall Street’s most macabre investment scheme yet.” In the opening paragraph of the article, author Matthew Goldstein gibes about the gathering of financial bigwigs in New York to talk about life settlements: “With all the happy banter, you wouldn’t have known that they were there to learn about new and imaginative ways to profit from people dying.”

The mainstream media has frequently portrayed the life settlements industry as intimidating, both in terms of its explosive growth and apparent morbidity.

The media hype can make it difficult for a consumer to separate the fluff from the facts; NuWire set out to investigate the perceptions that surround the industry and discover the reasons why consumers should agree or not agree to a life settlement.

Life insurance is no longer just part of an estate, but a potential investment

Life settlements: past, present and future

The concept behind a life settlement is simple: a life insurance policyholder sells his or her policy, usually through a broker, for a lump sum of money that is usually three to four times the amount they would obtain by simply surrendering their policy to the life insurance company. The buyer, usually an institutional investor, takes over payment of the premiums and collects the death benefit once the insured person passes away.

The life settlements industry originally sprung from a weakened viatical settlements industry in the late 1990s and early 2000s. Before that, viatical settlements had become a way for patients afflicted with AIDS to obtain money from their insurance policies, which they critically needed. However, viatical settlements became less profitable with the development of medical advances that effectively treated and extended the life expectancy of AIDS patients. The industry was further troubled with allegations of fraudulent dealings.

Although the viatical settlements industry has all but disappeared, the life settlements industry is here to stay. Life settlements involve the same basic premise of buying policies for an amount based on the insured’s actuarial life expectancy, but have been expanded beyond the terminally ill to an elderly, wealthy population.

“The real change between life settlements and viatical settlements is that life settlements are done by people that do not need the insurance anymore, rather than people that need the money,” Zohar  Elhanani, chief operating officer at Legacy Benefits, LLC, said. “The average policy that we currently purchase is around $2 million dollars [in] death benefit...so these are wealthy individuals who have reached [an] average age...around 80, and they simply don’t need the insurance.”

The life settlements industry has been gaining momentum and credibility as it attracts capital from large institutional investors such as Goldman Sachs , Morgan Stanley  and Credit Suisse .

“The industry is evolving rapidly,” Elhanani said. “[According to] the Conning research report that came out at the end of the year...about 9 to 12 billion dollars of life settlements [were] concluded in 2007...and they project 90 to 140 billion on average in the next decade or so.”

Life settlement risks: the true and the false

The most well-known myth surrounding life settlements is that persons who sell their life insurance policy put their lives at risk should they live past their actuarial life expectancy. Although it is true that the continued payment of premiums will eat away at a buyer’s potential profits, the fear that such a situation might motivate the buyer to kill the insured is largely an irrational assumption. Policies are almost always purchased by institutional investors, not individuals.

“If I was protected for eight years [under life insurance], and...by selling my policy to an investor this investment [should] realize a 12 percent [annual] rate of return, [but I live for] ten years...why aren’t they going to send somebody to my house to exterminate me so they can get their money back?” David Kane, president of the benefits division at York International, said. “That was a very legitimate concern...in the early days when it was more private-type of money, but now most of the money is coming in through...large institutions...[and] people are generally not afraid that someone’s going to come ‘get them’ anymore because of [that] fact.”

A more realistic risk for life settlements involves the downside for beneficiaries who would otherwise receive the death benefit sold to an institutional buyer. For example, the family of a person who agrees to a life settlement should be aware they won’t be able to realize the value of the policy when that person dies because someone else has been deemed the beneficiary, Eugenia Vecchio, an estate planning attorney in New York, said.

There is also the risk that sellers could become unknowing victims of fraud. Former New York Attorney General  Eliot Spitzer  filed a lawsuit against Coventry First, a financial services company considered to be one of the pioneers in the life settlements industry, in October 2006, alleging the company bribed life settlement brokers into suppressing competitive bids from other settlement companies. More than 90 percent of that suit has been thrown out by the court on a motion to dismiss , according to a Newswire release last November by Forbes. The Florida Office of Insurance Regulations investigated the same allegations and reached a settlement with Coventry Oct. 1, 2007.

While state regulations to compel greater transparency in life settlement transactions are pending, large broker-dealers and agents have been putting their own compliance measures in place to make sure every bid submitted is recorded and offered to the seller, Elhanani said.

“The main issue…is really the fiduciary duty  of the agent and that’s heard more and more since the whole Eliot Spitzer allegation,” Elhanani said. “The fiduciary duty of the agent...[is] to get the best possible offer and to present that offer, not to keep it hidden in any way...and the stronger the definition of that fiduciary duty becomes, the better off the consumer [will be].”

A broker’s commission fees as well as the tax that would be deducted from the life settlement value are an additional matter of concern among policy owners who consider life settlements. Thus, experts advise sellers work with a representative they trust. An experienced and trustworthy estate planning attorney is a good source for understanding factors such as market trends and changing tax laws in developing a complete integrated estate plan, Vecchio said.

“[A life settlement] is not an appropriate methodology for every client to employ,” Vecchio said. “It’s only under specific and tailored circumstances that it is appropriate.”

Life settlements have also raised concerns over privacy issues on behalf of insurance policyholders. In order for a life settlement transaction to take place, the identity and some personal information about the insured will have to be disclosed to the buyer and downstream investors, and “that’s just the reality of the way it works,” Head said.

“If you sell a house, frequently you have to fill out a disclosure form and tell the buyer what you know is wrong with the house,” Head said. “Is that an invasion of privacy or is that just a bare market consideration?”

Conversely, a seller who wants to obtain identifying information about potential buyer and downstream owners is usually able to obtain that information. “We feel that it brings a lot more credibility to the transaction...[and] it’s a legitimate requirement,” Elhanani said.  

Payouts are much higher than surrender values, to the consumer's advantage

Some states even require that this information is provided.

“A lot of states require that when there’s a new owner of the policy, that the name and the identity of the new owner be disclosed to the original seller of the policy that flows through the process and I think that’s a good idea,” Head said.

The consumer’s advantage

The risks associated with selling a life insurance policy on the secondary market  are manageable for many consumers. “This is a fantastic marketplace for an individual who wants to sell their policy,” Kane said.

Before the market existed, the only value a consumer could realize in giving up their life insurance policy was its stated cash value, or the amount of reserves in the contract based on the total principal and interest in the account, Kane said.

More specifically, the surrender value is typically about 5 percent of the face value of a universal life policy, Head said. Life settlements, on the other hand, provide a much higher payout.

“It has generally been seen...[that the] settlement value of the policy is about 20 percent of face, so essentially [the seller would get] three to four times the surrender value being paid for settlement,” Head said. “That’s certainly a benefit to a consumer who is looking or is planning to surrender or lapse a policy.”

From the standpoint of an estate planning attorney, having the option to conduct a life settlement is an advantage in serving the interest of the client.

“I think that if a client has a contract that he or she willingly purchased, and there is an opportunity for that client to translate that into a lifetime benefit and they are represented by competent council in entering into the transaction, then certainly [a life settlement] should be one of the choices,” Vecchio said.

Attention Investors

As consumers come to grips with the reality of life settlements, a growing number of large institutional investors are realizing the huge potential for returns and are jumping into the multi-billion dollar industry. But where does the small investor fit in?

In spite of what the corporate landscape may suggest, there are ways a small investor can capitalize on the newly regarded asset class. Investors should proceed with caution, however, as the speculative quality of life settlements remains a topic of heated debate.

Taking another look at life insurance

With the decision by the Financial Accounting Standards Board (FASB ) a few years ago to recognize the true market value of a life insurance policy, life insurance is now considered a legitimate asset as well as insurance, Doug Head, executive director for the Life Insurance Settlement Association, said. Still, “a lot of people have not looked at it that way,” he said.

As word gets out about life settlements as an alternative to surrendering or lapsing a life insurance policy, consumers are catching on to the fact that their human life value–or the maximum amount of life insurance they can obtain, based on income and assets–can be realized in the life settlements marketplace.  

Source: Conning  Research report 2007

“Before this marketplace opened up, [a person’s human life value] was just a mere statement of fact, maybe interesting at a cocktail party, but really meant nothing to the individual who had that ability,” David Kane, president of the benefits division at York International, said. “Now that ability has become an asset and many people will say ‘well let me buy four million dollars worth of insurance, and [after the contestability period], I’ll sell it.’”

Thus, the life settlement marketplace  presents consumers with an intriguing opportunity to invest in their own life insurance. In other words, the fact that life insurance is an asset that can be bought and sold like other types of property might encourage consumers to purchase more life insurance coverage once they know there is liquidity  for that asset in the future.

Life insurance companies adjust, react

Life settlements only capture a sliver of the market, at 0.1 percent of the total face value of insurance policies issued in 2006, according to research by Conning. However, life insurance companies are anticipating the effect that a growing number of life settlements will have on their business operations. This is because life insurance companies traditionally price their products based on an anticipated amount of lapses, some of which may not happen as consumers conduct life settlements as an alternative to surrendering their policy, Kane said.

“The insurance industry as a whole is in a bit of an uproar, because they have some fear about…[having] adequate reserves to pay all these claims [they hadn’t expected to pay],” Kane said.

As a result, insurance companies may re-price their products in order to accumulate adequate reserves to pay off these claims. Consumers may need to brace themselves for higher premiums, but those may not come to pass.

“We feel that the insurance companies…will start playing an active role in the industry [and buy] policies essentially as a hedge to the change in lapse rates, rather than [raise] prices,” Zohar  Elhanani, chief operating officer at Legacy Benefits, LLC, said. “If [insurance companies] raise their prices to a point that [is] not economical or [is] prohibitive, [they] will lose their clientele.”

AIG , Phoenix Life and Genworth are among the life insurance companies that are entering the industry space, Elhanani said.  

Some states, such as Maine, are taking strict stances against STOLI deals

The life insurance industry, however, appears to be concerned with a more pressing issue: the regulation and restriction of certain types of life settlement transactions. Specifically, life insurance companies are trying to influence policies meant to crack down on arrangements that have become known as stranger-originated life insurance (STOLI) schemes.

Last March the AALU, ACLI and NAIFA released their first issue of the newsletter STOLI Alert, which describes STOLI as an arrangement in which outside investors initiate the purchase of life insurance on strangers, often offering individuals cash compensation or large amounts of life insurance for “free.” A number of state legislatures  have found such arrangements to be in violation of insurable interest laws, or laws that forbid individuals from taking an insurance policy out on someone else’s life, unless they have insurable interest in that life.

STOLI schemes vary in shape and form. A typical example of STOLI involves “non-recourse” premium financing, in which outside investors induce consumers to buy life insurance with cash incentives and promises to finance the premiums during the initial contestability period of two years; after the contestability period, ownership of the policy is often sold on the secondary market  or transferred to the investor so that the consumer can either pay off or walk away from the debt. In some deals, consumers are required to commit to selling their policies once the contestability period is over.

While some states have taken a firm stance against these transactions, other states interpret insurable interest laws more loosely and non-recourse premium financing schemes are consequently able to slip through legal cracks. Life settlement firms also remain divided regarding the viability of such arrangements; Legacy Benefits, for instance, chooses not to purchase policies that are manufactured and owned through non-recourse premium financing, Elhanani said.

STOLI versus legitimate life settlements

Constituents of the life settlements industry are concerned that regulations meant to crack down on STOLI schemes will negatively affect legitimate life settlement transactions. For example, the NAIC has proposed a five-year moratorium on life settlements once an insurance policy has been purchased.

“We’re hoping there won’t be a snowball effect [as far as] any prohibition on reselling an asset within the first five years,” Elhanani said. “We hope that doesn’t affect the legitimate life settlement business.”

The proposal for the five-year moratorium would allow life settlements after two years if the policy premiums have been funded exclusively by the insured. Although such a provision could act as a deterrent for non-recourse premium financing schemes, the policy would also limit settlements for consumers who have paid for premiums through legitimate financing programs, which Elhanani says have “been available for the past 30 years.”

Head presented a fierce rebuttal to STOLI Alert in a LISA press release last October, asserting that “the truth about STOLI Alert is, quite simply, that it isn’t about STOLI. The publication is about attacking the secondary market, which competes with carriers and provides value for consumers.”

Investors should exercise their own discretion in determining the appropriate structures and rationale that should be in place for purchasing life insurance. Last October, talk show host Larry King filed a lawsuit against a Maryland insurance brokerage in which he admitted to taking out a $10 million dollar policy with the express purpose of immediately selling the policy in a life settlement but later concluded he had gotten a raw deal.

The high profile battle in court should serve as a cautionary tale to consumers and investors alike in terms of exercising proper due diligence before making the decision to invest in their life insurance.

Consumers may also wish to make sure their interest is adequately represented in the legislative process, which is defining the extent to which life settlement transactions should be regulated.  

Unlike market-dependent investments, life settlements are low-risk

The future: asset-backed securities

While life insurance companies and life settlement firms battle for the general public, investments in the new asset class are expected to go public in just a matter of years.

“It’s our belief that as the market matures there will be securitizations that will allow for individuals to invest in a block of policies, [similar to] a municipal bond or something like that,” Head said. “[So far] the industry has not matured and the ratings agencies are not yet satisfied that they understand enough about the business to be able to get to that point….There have been some successful securitizations already, although they have been pretty small.”

Life settlements are a very attractive asset class for a number of reasons, the most prominent being a near elimination of risk. Unlike payouts for most other types of investments, the payout of a death benefit is—by nature—a certainty.

“At the end of the day, [investors] are not going to lose [their] money,” Kane said. “[They] might get a worse rate of return than [they hoped] for, but unlike other investments where [they] could literally lose all [their] money, people must die.”

Life settlement-backed securities  are estimated to yield a rate of return of 8 percent per year and attract attention as “uncorrelated investments,” meaning their performance isn’t tied to what’s happening in other markets, according to an article in Business Week published last July.

Furthermore, the investments will likely yield increasingly favorable returns as the industry numbers continue to climb at an exponential rate. Experts predict explosive growth in life settlements over the next decade as a result of increasing amounts of institutional capital being pumped into the system as well as a growing demographic of elderly, well-off individuals to ensure a generous supply of life insurance policies.

Buying into a pool of life settlements also offers customary advantages such as diversification and sophisticated due diligence measures provided by large institutions.

In conclusion, the life settlements industry has been growing and fighting its way through the courts, Wall Street and juiced up media headlines. Ultimately, an informed investor and consumer base will hold the most sway in influencing the future of the life settlements market, and their ability to be educated about the advantages and risks of any new investment is the very factor that both life settlement and life insurance industries are counting on.