Until the late-1980s, the owner of a life insurance policy who no longer wanted or could not afford it had two options: to let it lapse or surrender it to the issuer for its cash surrender value. The emergence of a secondary market for existing life insurance policies provides a third alternative: to sell the policy to a third party for less than the net death benefit, but more than the cash surrender value. Such transactions are typically referred to as life settlements. The value of a particular life settlement depends on a variety of factors, including the insured's life expectancy and the nature and terms of the policy.
In a typical scenario, an insured sells an existing policy to a life settlement provider which either holds it to maturity and collects the net death benefit, or resells the policy or interests in multiple, bundled policies to hedge funds or other investors. The insured may contact the life settlement provider directly, or through a financial adviser, or may use a life settlement broker which may solicit bids from multiple life settlement providers on behalf of the insured. In most states, both life settlement providers and life settlement brokers are subject to licensing and other requirements.
An investment in a life settlement or a related security whose return of principal and investment income is derived from one or multiple life settlements can be an attractive alternative-class investment but has certain inherent issues and risks to consider. The following is a sample list of the issues and risks an investor should consider:
- Suitability for Purchase. Is the investment appropriate and suitable for the investor in view of the financial, liquidity, regulatory, tax, accounting or other considerations relevant to the investor?
- Lack of Liquidity. The tertiary market for life settlements is less liquid than the equity and bond markets, and while tertiary market trading currently exists, it is limited in scope and there is no guarantee that trading or liquidity will be available in the future. The limited liquidity of life settlements may impair the investor’s ability to realize the full value of its assets in the event of a voluntary or involuntary liquidation. Prospective investors must be prepared to hold the policy and bear the risk of the investment until the death of the insured and payment of the death benefit. The investment in life settlements is suitable only for investors that have substantial financial resources, that do not anticipate that they will be required to liquidate a policy, and that understand the risk factors associated with the investment.
- Pricing Risks and Valuation Issues. The sale and purchase price for a life settlement is determined by market conditions of supply and demand, and by certain state regulations. In addition, the various fees, when aggregated, reduce the potential yield that may be realized from a sale and purchase of a policy. The pricing of a policy is dependent primarily upon the life expectancy of the insured, the net death benefit, and the premium rate payable in respect to the policy. Though medical diagnostics and actuarial-based life expectancy estimates may be available, such data will not always prove to be correct. An error in pricing can reduce an investor’s rate of return or lead to the loss of principal. After the purchase of a life settlement, determining a current fair market valuation of the policy may prove to be difficult as market quotations will not be readily available.
- Time Risks. The primary risk and determinant of return on an investment in a life settlement is time. An investor will not receive a cash return on investment until the policy it owns has matured (i.e. the insured has died and the life insurance company has paid out the death benefit). The actual rate of return on a life settlement cannot be calculated before the insured dies. Advances in medical sciences may prolong the lives of insureds beyond the estimated life expectancy due to, for example, the condition giving rise to a terminal diagnosis being treated or cured. The longer the insured lives, the lower the rate of return attributable to that policy.
- Life Expectancy Estimations. Life expectancies are estimates of the expected longevity of an insured and are inherently uncertain when applied to one individual. There can be no assurance that a life expectancy estimate will be precisely predictive of the future longevity of the insured and there are various unforeseeable events that may cause the life span of an insured to deviate from the estimate, such as:
- Advances in medical therapy that are continually developed, providing new ways to cure or treat disease. An unanticipated medical breakthrough that proves a cure or improvements for a disease will result in lower mortality rates than previously estimated.
- Life expectancy reports underestimating the longevity of the insured, having a material adverse impact on or completely eliminating any expected return on investment in the insured’s policy.
- Optimizing Premium Payments. The amounts payable by an investor for premiums on a purchased policy, which are based on assumptions used by the specific issuing insurance company when setting the level and frequency of premium payments, may prove to be higher than would have been the case if alternative assumptions had been used by the investor. Payment of higher premiums, or for a longer period than expected, to maintain the policy in force will adversely affect the investor’s potential return on the policy.
- Mistakes in Servicing Policies. If the servicer that pays the premiums on the policy pays an insufficient premium or misses a premium payment, a policy may lapse without value or may lose certain policy riders that provide unique economic benefits to the policy.
- Missing Insureds. An insured under a life settlement may become untraceable, or there may be a delay in ascertaining that an insured has died, or in obtaining the required documentation needed to claim the insured’s death benefit. The investor could incur substantial unplanned expenses in locating a missing insured and could experience substantial delays in collecting death benefits which would affect the value of a policy.
- Refusal to Pay Benefits on Certain Policies. Although an investor may perform extensive due diligence to ensure the rights to a policy, insurers may refuse to pay benefits on certain policies on the basis that there was no “insurable interest” at the time such policy was issued. Related litigation costs by the investor could be incurred to protect the policy rights and secure payment, thereby lowering the investor’s rate of return.
- Possible Insolvency of Insurance Companies. Although the insurance companies that issue life insurance policies are regulated by state insurance commissions, subject to certain capital requirements, and most are highly rated by independent financial rating agencies, there remains a possibility that an insurance company could become insolvent and seek protection under the federal bankruptcy or state insolvency laws. Such action could delay or reduce the payment of a policy death benefit and reduce the investor’s value.
- Life Insurance Companies’ Aversion to Investment Transactions Involving Life Settlements. Some major U.S. life insurance companies have voiced concerns about the life settlement industry and the transfer of such policies to investors. These life insurance companies may resist the transfer of a policy to a third party who is unrelated to the original owner/insured. The aversion of life insurance companies can manifest itself in various ways, including but not limited to significant delays in processing of ownership change forms as well as placing unreasonable obstacles in the way of transactions.
- Impact of Increase in Cost on Life Insurance Policies. If a life insurance company is able to increase the cost of insurance charged for any policy, the amounts required to be paid by a prospective purchaser of a policy for insurance premiums may increase and may adversely affect the economic value of such policy.
- Insurance Companies’ Contestability of Life Insurance Policies. Most life insurance policies may be contested by the issuing life insurance company within 2 years after issuance, based upon any material misrepresentation or omission made by the applicant or the insured on the life insurance policy application. If an issuing life insurance company successfully contests any policy, the policy may be rescinded and declared void, and, in such event, the life insurance company would typically be required to return to the policy owner all the insurance premiums paid to the life insurance company for such policy without any interest thereon. In addition, the insurer may be able to limit the death benefits payable under a policy if the insured dies within the first two years from the date of issuance of the policy, and the life insurer determines the death to be a suicide. In such event, the purchaser would likely experience a substantial economic loss. However, most life settlement funds only purchase policies older than 2 years old to mitigate this risk.
- Termination of Policy before Death of Insured. Some life insurance policies terminate under its terms when the insured reaches the age of 95 or 100. If the insured under such a policy should live to the age of 95 or 100, such policy will terminate and no return from the policy’s death benefit will be realized by any investor in the policy.
- Sale Contested By Family Members. Family members of the insured/owner that sells a policy may challenge the validity of the life settlement in court. This could delay payment or result in the purchaser receiving none of the projected benefits under the policy.
- Stranger Originated Life Insurance Policies. Stranger Originated Life Insurance (“STOLI”) is a financial transaction in which an insured uses his/her excess insurance capacity to buy a life insurance policy that lacks insurable interest at the inception of the policy. Some insurance companies have systematically filed litigation in which they contend that these STOLI policies should be rescinded. Insurable interest must exist at the time a policy is issued or the policy may be deemed null and void from inception in some states. If a STOLI policy is purchased as an investment, there is no guarantee that the issuer of the policy will not choose to contest the policy on insurable interest grounds, even years after it was issued. Unlike typical two-year contestability and suicide periods, in some states there may be no limit on the period of time within which an insurer can challenge the validity of a policy on insurable interest grounds.
- Certain Fraudulent Activities. An insured or his/her agent may submit an original application for insurance containing false or misleading information. An insured may misrepresent the condition of his/her illness, may fail to disclose all beneficiaries or may attempt to sell a policy to more than one purchaser. In the event that brokers submit inaccurate life settlement information an investor may not be able to uncover the presence of fraud through its due diligence. There can be no guarantee that in the event of undetected fraud, an insurance carrier will pay a claim on a policy.
- Life Settlements Regulation. Approximately 44 states have some form of viatical and/or life settlement regulation, but the regulatory environment related to life settlements continues to evolve. Unexpected changes in state and federal laws or regulations could impair the value and/or liquidity of a life settlement owned by an investor.
A life settlement transaction may be a valuable option for insureds and policy owners who otherwise would surrender their policies or allow them to lapse. There are many issues and risks to consider when evaluating if selling a policy is the appropriate strategy for an owner. The following is a sample list of the issues that an owner and the insured should consider:
- Possible Alternatives. There are possible alternatives to the process of selling a policy, which may be preferred. Some alternatives, where applicable, are (a) borrowing against the cash value of the policy, (b) surrendering the policy for its cash value, (c) accelerated death benefits that may be available under the policy, and (d) withdrawing some of the cash value and reducing the death benefit of the policy to lower future premiums. Information on these alternatives may be obtained directly from the insurance carrier that issued the policy. Advice should be sought from an insurance producer or other professional before exercising any alternatives.
- Need For Insurance Coverage. The insured and/or one or more of the insured’s beneficiaries may have continued need for coverage.
- Policy Replacement Issues. Selling a policy may prevent the insured from qualifying for new life insurance coverage in the future and may cause other rights or benefits, including conversion rights and waiver of premium benefits that may exist under the policy, to be forfeited by the insured.
- Public Assistance. Receipt of the sale proceeds may adversely affect eligibility for Medicaid, Supplemental Social Security Income, food stamps, public assistance and any other means-based government programs, benefits or entitlement and may result in an interruption of such public assistance benefits. Receipt of sale proceeds may reduce the seller’s risk of becoming impoverished and becoming dependent on public assistance or other government benefits or entitlements. Advice should be obtained on these matters from appropriate government agencies and from legal and financial advisors.
- Rescission. Regulated states provide in their statutes that a policy seller will have a prescribed rescission period. This period varies from state to state and will be described fully in an approved contract for that state.
- Escrow Accounts and Availability of Funds. Regulated states require that a qualified escrow agent be used for a policy transfer and also dictate the maximum time period before an original policy owner must receive their sales proceeds after the transfer of ownership has been completed at the insurance carrier.
- Taxation. Some or all of the proceeds from the sale of a policy may be taxable under federal income tax and state franchise and income tax laws. Advice should be obtained on these matters from legal, financial and professional tax advisors.
- Insured Contacts and Future Disclosure Obligations. The insured will have ongoing obligations to provide notification of significant medical developments to the investor. The insured may be contacted by a policy purchaser for the purpose of determining the insured’s health status. In most regulated states, such contact will be limited to once every three (3) months if the insured has a life expectancy of more than one (1) year and to no more than once per month if the Insured has a life expectancy of one (1) year or less.
- Creditors and Bankruptcy. The sale proceeds may be subject to claims by creditors, personal representatives, trustees in bankruptcy and receivers in state and federal courts.
- Insured’s Identity and Medical Records. Though precautions are taken to assure protection of the insured’s identity and medical records, the risk of unauthorized disclosure exists. All medical, financial or personal information solicited or obtained by a life settlement provider or life insurance producer about an insured, including the insured's identity or the identity of family members, a spouse or a significant other, may be disclosed as necessary to effect the life settlement transaction between the policy owner and the life settlement provider. The insured and original policy owner will be asked to consent to the disclosure. An insured may be asked to renew this permission to share information every two years.