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Looking Hard at Life Settlements

Information is key to finding a fair price and avoiding unscrupulous intermediaries.

Judith A. Hasenauer, 10/08/2009

You have a 73-year-old retired married man with more than $3 million in face amount of life insurance that has been in force for a significant number of years. He and his spouse live on Social Security, a modest company retirement plan, and investment income. Their children are grown and have children of their own. The cash surrender value of his various life insurance policies is about one fourth of the face amount. Premiums for the life insurance along with increased living expenses and the drop in the value of their investments have strained their income. Your client is considering surrendering the life insurance policies for their cash values to supplement their income and to reduce the expenditures for premiums. They have already implemented a reverse mortgage on their home but are still suffering a shortfall in their income needs. However, he recently had a pacemaker installed to correct a heart problem and is worried about giving up his life insurance coverage.

This scenario presents the quandary of a number of people who are "insurance poor." It also indicates the lack of understanding many people have about the hidden value in many life insurance policies. For many elderly owners of life insurance policies, particularly those with health impairments, there is very likely a hidden value in their insurance represented by the greater likelihood of death because of the advanced age and health impairment. For such a person, it does not make sense to surrender a policy or to borrow out all the cash values when there is an alternative that more truly represents the value of the death benefit for which the insured has paid since the inception of the insurance. This alternative has come to be called "life settlements," where an owner of life insurance sells the policy for the present value of the future death benefit.

The life settlements business has been around for a number of years and first developed from the viatical settlements business that developed at the same time as the HIV/AIDS epidemic of the 1980s and early 1990s. The viatical settlements business developed somewhat of a tainted reputation and found itself the subject of numerous regulatory and legislative inquiries. A lot of the taint was well deserved, as some of the people engaged in the viatical settlements business utilized tactics that were questionable. In addition, the advances in medical treatment of HIV slowed down the death rate among AIDS patients and a significant number of investors in viaticals lost money when the insureds did not die when originally predicted.

The life settlements business has also been surrounded by controversy. Although virtually every observer states the belief that an owner of a life insurance policy should have the right and freedom to sell the policy for whatever price can be negotiated, there have developed some practices that have cast a shadow over the life settlements business. As a result, virtually all state insurance regulators have taken steps to regulate the life settlements business, and the SEC has created a task force to investigate life settlements and determine what regulatory structure is appropriate or if a legislative solution is necessary.

One of the main questionable parts of the life settlements business does not really involve the type of transaction outlined above. Rather, it revolves around what has come to be known as "stranger-owned life insurance." This situation is where promoters get an elderly, well-off individual to purchase a life insurance policy with the intent to sell the policy to the promoters as soon as the two-year contestability period ends. The legal implications of such transactions are complex. The business of insurance has been more or less reserved to the states for regulatory purposes. Thus, life insurance companies (unless they are publicly traded) are not subject to federal securities laws. Likewise, insurance policies themselves and the sales process is also not subject to federal securities laws. However, although the business of insurance and life insurance itself is exempt from federal securities laws, a transaction involving the sale of an existing life insurance policy as an investment, rather than as insurance protection for a loved one may well be subject to federal securities laws. It is this "secondary market" for life insurance policies that has given rise to increased regulatory oversight of the life settlement business.

There has been a great deal of publicity recently regarding proposals to "securitize" life settlements by the creation of investment pools of such life insurance policies. It would certainly seem that such a securitization would result in an investment that is subject to federal securities laws.

Many of the problems in the life settlements business is a result of the basic lack of understanding about life insurance and how it works. As a result, it is difficult to arrive at a true value of a life insurance policy that is to be sold. Actuaries will tell you that the statistical mortality elements involved in the process are determinable mathematically. However, the more complicated element involves the health underwriting that is a critical factor in determining the true value of a death benefit on an insured that has not yet died. The purchaser of a life settlement needs to have as accurate a prediction of the likely life expectancy of the insured under the life insurance policy to be purchased. This involves not only mortality tables of the population in general, but also an accurate prediction of the longevity of the insured taking into consideration the insured's health profile at the time of the life settlement purchase. In essence, the purchaser of a life settlement has a hope that the insured will die sooner, rather than later. As ghoulish as this sounds, it is really a predictable event and a legitimate business transaction (after all, no one considers it ghoulish for life insurers to bet on the life or death of their insureds). As a result a life settlement purchase is really an attempt for the purchaser to "arbitrage" the difference between the insured's life expectancy at the time the policy was originally issued and the life expectancy when the life settlement purchase takes place.

Insurers do not always look favorably on life settlements because a key element in their pricing of their products is the anticipated lapses or surrenders of policies before death. Obviously, it is more profitable for an insurer for the owner of one of their policies to surrender it for a cash value that is lower than the present value of the death benefit. However, the owner of a life insurance policy should get the bargain of the benefit he has purchased. Therefore, most insurers are reconciled to the continuation of the life settlements business.

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