Controversy and critics still shadow
the growing life settlement market.

By Mary Rowland

    Now that the "life settlement" marketplace is beginning to show some signs of maturing, financial advisors should take a look at it and determine if-and how-they might evaluate it as an option for affluent clients in their retirement years. Even those who have a personal distaste for life settlements need to be aware of this trend so they can explain it to wealthy clients who might be approached and asked to buy a policy to resell into the secondary market at a profit.
    This secondary marketplace has sharply divided the life insurance industry. One group says that reselling policies to investors who have no "insurable interest" in the insured is akin to trafficking in human lives. They warn that it will wreak havoc on the industry and ruin insurance companies. Another group welcomes the new marketplace, arguing that it gives the elderly, and their advisors, one more financial asset to tap into in retirement.
    The background: "Viatical settlements" (viaticum is a Latin word that refers to the Eucharist administered when a person is near or in danger of death, as well as to money for a journey) were first used in 1989, when a company in Albuquerque, N.M., called Living Benefits Inc., announced that it had raised $102 million and that it would use the money to pay cash for life policies on the lives of terminally ill insureds. Viatical settlements stirred controversy from the get-go. Some praised the new freedom they offered to help the terminally ill raise money to pay for medical care that might help them be more comfortable at the end of life. Some worried that an insured person who was desperately ill might cash in a policy even though the policy terms were unfavorable to him, and leave his family high and dry after he died. Still others, like Joseph M. Belth, editor of the newsletter Insurance Forum and professor emeritus of insurance at Indiana University, found the whole idea repulsive. Belth wrote in the March 1989 issue of his newsletter that the first company to offer the settlements, Living Benefits, operated a system for the exploitation of the terminally ill.
    Over the years, the market grew and developed to include healthy and affluent elderly people-over the age of 65-who might not need life insurance going forward because of a change in their circumstances or their estate plan needs. The idea is that investors in the secondary market pay the insured something more than the policy's cash value but less than the death benefit. The policies are packaged and sold, as are mortgages in the mortgage market. Some insurance experts-notably Glenn Daily, a fee-only insurance consultant in New York-have argued that, at the very least, consumers need guidance in what is still an untamed market, designed by and for the buyers of insurance policies rather than the sellers.
Daily, who believes consumers should examine all options available to them, began advising clients on how to evaluate a buyout deal and how to decide whether to sell the policy and for how much. In May, Daily set up a Web site, www.whatsmypolicyworth.com, offering customized policy evaluations for $1,895, with a $300 discount for financial advisors, whom he thinks would be better able to communicate the pros and cons to their clients.   
    Over the past several months, Daily has been asked to provide analysis for consumers as well as for hedge fund managers who want to invest in these policies. His service is intended for "the sell side, not the buy side," he says. Daily insists that sellers must not accept the marketplace for what it is because it was designed for buyers, who have a great deal of software and other resources to evaluate policies.
Still, for all their sophistication, buyers are operating at a superficial level, he says. Right now they're just operating off the illustration and discounting off the current interest rate, ignoring uncertainties like a possible change in the cost of insurance. "That's why they can put a price on it," Daily says. "They're not doing due diligence at the level of policy."
    But Daily thinks it can be done. "You own an asset that other people want," he says on his Web site. "Do you know what it's worth?" When you buy a new car, you need to understand how the price gets marked up, he says. In order to figure out what your policy is worth, you must consider the value of the policy to your beneficiaries if you keep it. You must consider that if you sell it, you owe taxes on the part of the purchase price that exceeds your cost basis. The buyer, too, pays income tax, on the excess of the death benefit over the purchase price. And there are other costs: The investor builds in a high return to cover policy appraisal and administrative costs and expenses, a broker's commission and, of course, profit.
    Daily says that one of the reasons the life settlement market exists is because the insurance marketplace is so inefficient. Policies are oversold. Many policies are mispriced in the first place. Investors buy only those policies that are mispriced by 10% to 30%. "You can be a little sympathetic to the life insurance industry because arbitragers have discovered this stodgy industry that misprices its products," he says, and they are taking advantage of it. But Daily doesn't consider the life settlement market unethical if transactions are done with transparency and disclosure. He adds that it's hard to get good numbers on the size of the market, an indication that it's still immature and inefficient.
    If everyone agreed with Daily, there would be no controversy. On April 11, 2006, Belth, a highly respected voice in the industry, spoke at David Schiff's Insurance Conference in New York, condemning life settlements as "speculation in human lives," something that has long been anathema to the insurance industry. Belth expanded on his speech in his June 2006 newsletter, dubbing the life settlement market SPINLIFE for "speculator-initiated life insurance."
    Belth points out that players in the life settlement market troll for wealthy people between 75 and 90 who have a life insurance "capacity" higher than the value of the insurance they hold: A person with $10 million in assets and $2 million in life insurance has an additional capacity of $8 million. Such a person could qualify for a great deal of additional insurance. Belth reproduces letters from brokers in the life settlement marketplace who propose loaning money to a wealthy elderly person to buy an additional large policy. An investor buys the policy from the insured for perhaps 5% of face value. The insured gets a profit but no out-of-pocket expenses, as well as "free insurance" for the two-year contestability period. (If an insured dies after this two-year period, the insurer cannot contest the policy's payout.)
    Belth is bothered by this type of transaction for a number of reasons. For one thing, the "speculator"-perhaps a hedge fund-has no "insurable interest" in the life of the insured. Indeed, the speculator has a financial incentive to murder the insured. Critics of Belth's view would argue that a life insurance policy is an asset and the owner should have the right to enjoy that asset, which includes the right to sell or dispose of it.
Belth also argues that the use of life insurance to speculate in human lives "poses a threat to the survival of life insurance companies" in that it will damage their reputations. The life insurance industry also stands to lose one of its most important advantages: the tax-free buildup of inside interest, Belth says. One of the chief arguments for the tax-free buildup is that life insurance performs a social good by providing benefits to the family at the death of a breadwinner. If policies become tools for speculators, the industry will have a more difficult time defending this tax advantage, Belth predicts in the June Insurance Forum.
    Many life insurers feel threatened by this marketplace. Some have ordered their agents not to participate. In June the American Council of Life Insurers in Washington proposed a 100% excise tax for life settlements, a move designed to shutter that marketplace, according to Investment News. The Life Insurance Finance Association in Atlanta, a life settlement premium finance trade group, says the ACLI is out to protect insurance companies rather than elderly consumers. A growing life settlement market could affect lapse-rate assumptions by insurers because policies sold in the secondary market would not lapse. The issue continues to heat up. One of Glenn Daily's tips is this: "Don't sell your policy to someone who might be willing to kill you." Where do you stand?

Mary Rowland has been a business and personal finance journalist for 30 years, a half dozen of them as weekly columnist for the Sunday New York Times. She speaks regularly about money and values. Her six books include two written for financial advisors: Best Practices and In Search of the Perfect Model.