GAO Warns On Life Settlement Oversight

(Dow Jones) Life settlements are not wildly popular investments. But they are wild investments. And to that end, federal regulators and lawmakers are fast at work trying to tame these slippery products, which promise a much higher return over more traditional conservative offerings.

A life settlement is a transaction in which an individual with a life insurance policy sells that policy to another person, who then assumes responsibility for paying the premiums.

Last week, the Government Accountability Office (GAO) warned consumers about participating in life-settlement transactions "due to a lack of clear, consistent state oversight." The Securities and Exchange Commission recommended that life settlements be clearly defined as securities so that the investors in these transactions are protected under the federal securities laws.

In its report, the GAO noted that 12 states and the District of Columbia have no laws or regulations pertaining to life settlements.

Indeed, insurance policyholders can complete a life settlement without knowing how much they paid in fees or whether they received market value for their policy, because brokers are not required to disclose such information.

The SEC--as did the Financial Industry Regulatory Authority (FINRA) in 2009--came to a similar conclusion as the GAO. The SEC, for its part, said that investors in individual life settlement transactions, or pools of life settlements, would benefit from the application of baseline standards of conduct to market participants.

"The (GAO) report shows that regulation desperately needs to catch up to this growing industry," Sen. Herb Kohl (D-Wisc.), chairman of the Senate Special Committee on Aging, said in a release. "We need to improve oversight not only of individual transactions, but of the bundling and trading of life settlements."

What impact do these regulatory rumblings have on those who are selling their policies and those investing in life settlements?

Typically, the seller no longer wants the policy or can no longer afford to pay the premiums. In exchange, the insured party typically receives a lump-sum payment that exceeds the policy's cash surrender value, but is less than the expected payout in the event of death.

The bet being made is this: The investor is hoping that the insured dies at or around--or better yet, before--his or life expectancy. That's a money maker. But if the insured lives beyond life expectancy, the policyholder loses.

The investor gets a return that in effect reflects the difference between the buyout price and the death benefit, taking into account the cash flow.

But in the absence of any rules and regulations, are these investments a good deal?

Stephan Leimberg, publisher of Leimberg Information Services Inc. and editor of Tools and Techniques of Life Settlement Planning, said the major advantage of investing in life settlements is that it's an asset, the performance of which is not tied to the performance of a stock market.

Brian Casey, partner with Locke Lord Bissell & Liddell, added that there's a chance for low double-digit returns and that credit risk of the life insurance company is less than for many other types of creditors.

There are, however, certain "ordinary" investor risks, according to Leimberg.

The first is longevity risk--"that due to medical advances or lifestyle changes, the insureds break the expected lifespan barrier," said Leimberg.

"When that happens," he added, "the buyer of the insured's policy will have to pay more premiums and that equates to lower than expected profits."

The second risk is that the underwriters got it wrong, Leimberg said. In other words, the underwriters underestimated how long the insureds will live. Remember, the shorter the lifespan, the higher the investor's profits. Underestimating life expectancy leads to lower than anticipated returns or a loss, said Leimberg.

And that's not a small risk according to Leimberg. "Life expectancy tables have not been accurate--particularly for small face-value policies," he said.

Third, there is a legal risk or what Leimberg calls a "polluted" portfolio.

"That's the risk that comes when due to fraud or a lack of insurable interest, the insurer doesn't pay the proceeds and the investor's premiums may--or may not--be returned," said Leimberg. "This is the problem investors face when greedy or less than careful buyers purchase 'Stranger Originated Life Insurance' policies."

Fourth is liquidity risk. "If for any reason investors can't pay premiums for as long as the insureds live, the policies may lapse--in which case investors may lose everything," said Leimberg.

And then there's risk that expenses will increase due to possible SEC oversight, though Leimberg suggests that that could be balanced by fewer frauds and better informed investors.

In addition, there are three "extraordinary" risks, according to Leimberg.

These include the promoter guaranteeing extraordinary returns which never materialize; the outright Ponzi scheme; and fraudulent life-expectancy valuations in which investors are led to believe insureds will die at a faster pace than underwriters think they will.

To Casey, there are even more disadvantages to these investments. There's withholding tax for investors in non-tax treaty countries. Plus, it's typically an asset that's long-term in nature, but one without a certain maturity. And there aren't many places to trade the life settlement. There's only what Casey calls an illiquid market for resale.

Put that together, and especially given the uncertainty over potential SEC regulation, the risks of life settlements are greater than the potential rewards.