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.