Wall Street’s Latest Darling: Life Insurance Settlements

Many of us have never heard of life insurance settlements. Actually, they have been around for several decades and have become quite popular among investors like Credit Suisse, Deutsche Bank, Berkshire Hathaway and hedge funds. In fact, the annual cash volume of life insurance settlements in the U.S. today exceeds US$10 billion and is constantly growing.

A life insurance settlement is the sale of an existing life insurance policy to a third party, the investor. The life insurance policy is sold for more than its cash surrender value but less than its face value or net death benefit. If the policy is a brand new one, the insured and/or the owner must wait up to two years to get beyond the so-called contestability period.

To make sense to both the seller and the buyer, the insured is usually over 65 years old and/or in poor health. The insured is willing to sell his/her policy because of the immediate receipt of cash — cash that can be used for any purpose. Part of the purchase process requires that the beneficiary of the policy be changed, replaced with the name of the investing company.

How It All Began

The investing company is willing to buy the policy because it expects that its cash outlay for the policy plus the premiums needed to maintain it will be less than the proceeds of the policy when the insured passes on, thus hoping to realize an acceptable return on its investment.

The genesis of the industry occurred during the AIDS crisis in the ’80s. At that time, unfortunate individuals who were stricken with AIDS had a very limited life expectancy. Some of them were approached by hedge funds that offered to buy their policies at less than face value, knowing that the investment would be returned with a handsome profit in the not-too-distant future.

This rather macabre beginning of the industry morphed substantially when AIDS victims were given a second lease on life through the creation of “chemical cocktails” that substantially extended the life of an individual, in some case to that of a normally healthy person. Hedge funds soon realized that they could appeal to people whose health was not in extremis. They were, however, somewhat elderly and had a naturally shortened life expectancy because of that fact.

What Drives Investors?

Life insurance settlements have now become a mainstream industry with very little negative publicity attached to it. Sheer numbers drive the investors — they do an actuarial analysis of each prospective insured, determining whether it would pay off to purchase a policy given the person’s state of health, age, etc.

Additionally, most investors in life insurance settlements have such a large actuarial base of policies that when a particular person lives an extraordinarily long time, the investors can, on the average, do well with their portfolio of life insurance policies because other insureds will pass on earlier than expected. From the investor’s point of view, it is merely an actuarial exercise that usually pays off for them.

From the insured’s point of view, he will benefit by taking advantage of the intrinsic value of a policy and getting a return for all the years they have been paying the premiums. They have instant access to cash, which usually far exceeds the policy’s cash surrender value.

Who Are the Naysayers?

The only group that I know of that isn’t thrilled with this burgeoning industry are the life insurance companies. There is a very valid financial reason that they look askance at the industry. The reason is that a majority of life insurance policies are allowed to lapse. The insureds either feel that they can’t afford the policy anymore or there is no longer a need for coverage.

What this lapsing phenomenon does is give life insurance companies excellent profits because they are not paying out life insurance proceeds on so many of their insureds, since so many of the policies have been allowed to lapse. They are therefore garnering inordinate returns for themselves. If I were in the life insurance business, I would not be thrilled with life insurance settlements either.

Who Is Controlling the Industry?

Each state has an insurance commissioner who is responsible for insurance transactions in that state and who assures that transactions meet the state’s laws. The insurance commissioners are tasked with watching for any violations of compliance among licensed insurance companies as well as licensed insurance agents. Serious violations will lead to the suspension or revocation of the company or agent’s right to do business in a particular state.

It seems to me that this is now such an established industry that it is unlikely that any laws will be enacted that will dramatically constrain its operation. What might happen is that life insurance companies could feel the need to increase premiums in the future to make up for so many policies that aren’t in fact lapsing, but are paid right up to the death of the insured.

From an elderly insured’s point of view, there isn’t much of a downside. However, I would strongly recommend that anyone considering selling his or her life insurance policy or purchasing a new one with an eye to a sale two years hence consult with an attorney, certified public accountant or financial adviser. If a trusted adviser sees no downside, then it might very well be a good idea to participate in Wall Street’s latest darling and enjoy the proceeds while one is still healthy. Good luck!