Clients may benefit from selling policies, but due diligence is a must.
An active secondary market for life insurance
policies is quietly blossoming for individuals in their sixties and
seventies who have outdated or unwanted coverage and burdensome
premiums. The ability to sell such a policy in the secondary market,
through a transaction known as a life settlement, could provide
financial advisors with an alternative to letting client policies lapse
or accepting a low cash surrender value. In some cases, a life
settlement can also mean a sizable commission.
But consumer advocates and advisors warn that
instances of fraud and spotty regulation in this nascent industry make
due diligence a must. "In certain cases, life settlements can be a
useful financial planning tool," says Brian Brooks, an attorney with
O'Melveny & Myers LLP, Washington, D.C. "But
this is a brand new industry that is not consistently regulated from
state to state. I think it will take a number of years before people
feel comfortable with them."
The pitch for life settlements is relatively simple:
For a variety of reasons, life insurance coverage that was once
desirable becomes unnecessary. Seniors who do not wish to continue
paying premiums can sell the policy to an investment company, either
directly or through a broker. The company continues premium payments
and, when the seller eventually dies, collects the death benefit. The
amount the seller gets depends on life expectancy, the type of policy
and other factors.
Life settlements follow the same basic principal as
viatical settlements, which take place when the policy owner has a
terminal illness and is expected to live two years or less. While some
use the terms life settlements and viatical settlements
interchangeably, the latter have acquired a somewhat notorious
reputation.
Several viatical investment companies that bought
life insurance policies from the terminally ill became the subject of
scrutiny in the 1990s when state and federal authorities investigated
them for fraudulent practices. In some instances, unlicensed brokers
sold investments in policies that did not exist. The industry also
suffered a decline in profitability when new drugs dramatically
extended life expectancies for AIDs patients.
But proponents say life settlements are a more
refined, less ghoulish beast. The transactions are marketed to
individuals over age 65 who are expected to live between six and
twelve years, and who have policies with face amounts of $250,000 or
more. Although they may have experienced a decline in health from
conditions such as a heart ailment or hypertension, most do not face
the same desperate need for money that the terminally ill do. The sale
of the policy may simply be motivated by a desire to use premium
payments on coverage they no longer need for other purposes.
"Viatical transactions are generally viewed as
lower-end or seedy, whereas life settlements are more of a financial
planning transaction," says Brooks. "States believe there is more
potential for fraud with terminally ill individuals who have a
desperate need for money, so companies involved in viaticals face
greater litigation risk."
The increasing participation by institutional
investors, particularly over the last three years, adds both capacity
and legitimacy to the life settlement industry. Two years ago, a
subsidiary of Berkshire Hathaway provided a $400 million cash infusion
to Living Benefits Financial Services, a Minnesota-based life
settlements buyer. Industry sources say insurance giant American
International Group is a major financial backer of Coventry First, the
country's largest life settlements buyer.
Coventry First CEO Alan Buerger acknowledges
institutional backing, but declines to name specific companies. He says
his company is on track to acquire policies with a face value of around
$2 billion this year. Other names reportedly linked to the life
settlement investment business include Merrill Lynch and HBK
Investments, a Dallas hedge fund.
Transactions are gradually expanding from
insurance-based professionals to the broader financial planning
community, with some broker-dealers quietly adding life settlements to
their menus. Buerger says Coventry First "works with quite a few
broker-dealers." Other broker-dealers do not have a formal relationship
with his firm but sanction life settlement transactions, while a
sizable number prohibit life settlements altogether. "I think there is
a lack of understanding about these transactions that relates to the
old viatical days," says Buerger. "There is a lot of misinformation out
there."
Others say concerns about relationships with
insurance companies that benefit financially from policy lapses have
kept some broker-dealers gun-shy about the transactions, and that
insurance companies often prohibit their captive agents from engaging
in life settlements as well.
Despite the cold shoulder from some corners,
evidence suggests that life settlements are changing the secondary
market for life insurance. Gloria Wolk, a consumer advocate and
viatical expert in Laguna Hills, Calif., says the industry is moving
away from viatical settlements to more lucrative life settlements,
which typically pay a much lower percentage of face values because of
longer life expectancies. "I used to see viatical settlements of 60% or
80% of the policy's face value," says Wolk. "Now, I haven't seen an
offer of more than 30% made to someone who is terminally ill. The
market is abandoning those with serious illnesses and focusing on the
wealthy who don't need their policies anymore."
For financial advisors, that focus could translate
into a source of business. Jason Hyatt, a vice president with life
settlement broker 1st Life Financial in Orlando, says that 6% of the
policy's death benefit is a standard commission. If a financial advisor
refers someone to him, Hyatt splits the commission with the advisor.
"In a typical scenario, a financial advisor will
contact my firm to discuss a client who is interested in a market
appraisal of a policy," says Hyatt. "He'll tell me what the insurance
company is offering for the policy, and will ask if I can do better.
Many times, I can."
Beyond financial motivation, say industry advocates,
is a fiduciary duty to explore every possible alternative before
letting a policy lapse or accepting a low surrender value. "Any
financial advisor who does not fully analyze a life insurance policy as
a transferable asset is not doing his job," says Doug Head, executive
director of the Viatical & Life Settlement Association of America.
Coventry First's Buerger sees "potential liability by not providing a
life settlement option to a client where it may be appropriate."
The question, of course, is which situations warrant
a life settlement, and when other options may be more advisable. Brooks
says an appropriate candidate might be someone in his sixties or
seventies who has paid off a mortgage and college expenses, and is
outside the window where a death benefit is necessary. "That person
might be faced with coughing up $30,000 a year in premiums, or letting
the policy lapse," he says. "In some cases, a large life insurance
policy can have substantial value." A policy might also be sold in
cases where it was originally purchased to pay estate taxes, but is no
longer necessary because of new estate tax laws. Key person insurance
that a policyholder no longer needs due to the sale of the business may
also have value on the secondary market.
Jonathan Proby, national sales director for the Life
Settlement Alliance, a life settlement brokerage firm in Fort
Lauderdale, Fla., says much of his firm's business comes from the sale
of underperforming universal life insurance policies. During the 1980s
and 1990s, many of these were sold as "vanishing premium" policies.
"But when interest rates dropped, so did the crediting rate," he
explains. "So people are paying premiums for a lot longer than they
expected to." The poor performance of variable rate universal life
subaccounts, he adds, can also lead to unexpected premiums that prompt
policy sales.
Wolk says financial advisors should explore other
alternatives before considering a policy sale. These include donating a
policy to charity, or keeping some of the insurance and selling only
the coverage they no longer need. Those who are terminally ill should
find out whether their policy offers an accelerated death benefit,
which allows policyholders to collect a percentage of the death benefit
before they die.
Bernard Krooks, a New York City attorney
specializing in elder law, says that in some cases policyholders may no
longer need to continue making premium payments if the policy has
sufficient cash value. "The insured will keep getting bills for
premiums, and seniors are usually pretty meticulous about paying their
bills," he says. "The insurance agent may not tell them that they can
stop paying, and their insurance will not be cancelled."
Wolk warns financial advisors to be on the lookout
for aggressive sales tactics. "A lot of salespeople won't talk about
other options, or will lie about the possible tax consequences of
selling a policy," she says. "You need to get all the facts." Krooks
concurs. "This is not a bad industry," he says, "but it has its share
of bad apples."