The economic turmoil of the past few months has rocked the life insurance industry and caused upheaval in insurance planning. But it is less well-known that related hot markets such as premium finance and life settlements have also been particularly hard-hit, leaving many policyholders and insurance advisors wondering "What happened?" and "What now?"
The pain is especially acute in the life settlement, or secondary insurance, market, where life insurance policyholders sell their unwanted policies to investors. This market was previously prospering; it had grown exponentially in the past decade, with an estimated $12 billion of U.S. life insurance face value sold in 2007. Life settlements typically involve policyholders aged 65 years or older, who seek immediate cash in excess of what they could obtain by surrendering a policy to the insurance company. Investors find the market attractive because secondary policies have no correlation with volatile stocks.
Growth in life settlements also fueled developments in the premium finance market by allowing policy owners to borrow using the market value of their policies as collateral. While premium financing has existed for some time, lenders have developed new programs that offer borrowers a variety of options for securing loans, including non-recourse financing (where the policy is the only security) and partial recourse or "hybrid" financing (where the borrower personally pledges some collateral in addition to the policy-for example, 25% of the loan amount).
For many older individuals, this access to credit and their ability to sell a policy in a life settlement made the acquisition of life insurance easier and more appealing, and it led to a boost in both the initial and secondary sales of life insurance policies.
In 2008, however, a perfect storm of economic, market and legal crises ripped through the industry, hobbling the operation of both the life settlement and premium finance markets and bringing many of these transactions to a halt.
Economic Collapse
The
economic turmoil that began last October has hurt the life insurance
industry on multiple levels. The credit crisis triggered by the
collapse of the subprime mortgage market required a federal bailout of
AIG, one of the world's largest insurance carriers. The resulting stock
market decline reduced the investment account value of several other
insurers as well, slashing their profitability and putting significant
pressure on their capital reserves.
Rating agencies responded by downgrading several U.S. life and annuity companies. Other insurers were forced to seek out new capital, and several of them also applied to receive assistance from the federal bailout program. Life insurance policies issued by downgraded carriers declined in value, while the lack of available credit forced some investors and lenders to withdraw from the life settlement and premium finance markets altogether. All this significantly hampered policy owners wanting to sell. It also curbed premium financing, particularly the non-recourse and hybrid programs that relied on a policy's market value as the primary or only source of security.
Market Shake-up
The
secondary insurance and premium finance markets were rocked again when
21st Services, one of the major independent companies offering life
expectancy reports on policy holders for the life settlement market,
announced that it would lengthen its life expectancy evaluations by up
to 25%. Another major provider, AVS Underwriting, soon followed suit in
November 2008, saying it would lengthen life expectancies by up to 10%.
Such reports are crucial in life settlements and premium financing because they project the longevity risk associated with a particular policy-in other words, how long an insured will live before the payout of the policy death benefit. Shorter life expectancies generally result in higher policy values, since the policy will require fewer premium payments for the buyer before maturity. If the reports have underestimated the insured's actual life expectancy, however, then the investor or lender will have overestimated the policy's investment return, and thus overvalued the policy.
The longer life expectancies have increased the longevity risk of many policies and forced a downward adjustment in the life settlement market. Some investors concerned about the accuracy of the reports have withdrawn from the secondary market or demanded that the reports be updated. Premium finance lenders, meanwhile, have found that the value of their collateral for outstanding loans-namely, the policies-has been impaired. As a result, many policy owners have found it difficult to finance or sell their policies, or they have received offers that were much lower than they expected.
Legal Challenges
The
secondary insurance market has also faced significant legal challenges
to "stranger-originated life insurance," where speculators solicit
individuals to acquire life insurance policies for later resale to
investors. These deals, also known as STOLI transactions, usually
target the elderly, who may receive up-front cash payments and some
form of non-recourse premium financing as inducements to take out a
policy. The problem with STOLI is that the speculators originating the
transactions have no interest in the insured individual's continuing
life. Since all states require that a policyholder have this "insurable
interest" in the insured when the policy originates, STOLI transactions
may violate state laws.
Several major insurance companies, meanwhile, have filed suits to rescind alleged "STOLI" policies. They claim that the insured customers committed fraud by misrepresenting (1) their intentions to sell the policy to an investor, (2) the existence of premium financing and (3) their true net worth. Certain companies have gone further and charged the policyholders with conspiracy, claiming that they conspired with insurance agents to carry out a scheme to defraud the insurers. The carriers want to rescind the policies, retain the premiums and collect additional damages and attorney's fees from the named defendants.
As a result, insureds who participated in these arrangements could face significant personal liability. Furthermore, if the carriers win the right to rescind the policies and retain the premiums, the investors and lenders involved in these transactions may also sue the insureds personally in order to cover their losses. Such cases have also hurt sales of premium financed policies in life settlements by making investors wary of such financed policies because of the STOLI association.
What Now?
Despite
these recent events, life settlements are here to stay. Investors
continue to buy policies and are adjusting their policy valuation
models to reflect longer estimated life expectancies and to ensure more
accuracy in policy valuations.
While longer lives may lead to lower policy values for policy sellers, in the long run more accurate valuations should increase investor confidence and bring more funders to the market. The divergence of life settlement performance from that of the turbulent stock market also continues to attract investors. For that reason, even some life insurers are getting in on the action by launching life settlement subsidiaries designed to purchase policies or by offering lending programs that let individuals borrow against the market value of their insurance. A significant growth in life settlement investing, however, will require the fuller development of a derivatives market based on settlements.
Shift In Supply And Demand
The
economic crisis has somewhat shifted the balance in the secondary
market's supply and demand. Before, investors flooded the market,
creating a high demand for policies. Now, more individuals are trying
to sell their policies in order to supplement their dwindling savings
and retirement accounts, but there are fewer buyers in the marketplace.
This increased supply is reducing policy values for consumers. In some
financing cases, policy values have dropped below the outstanding loan
obligations. Buyers with available investment capital, however, may be
at an advantage under the circumstances, as they could be in an ideal
position to buy policies at discounted rates.
Changes in Marketability
The
types and quality of policies sold also has changed. The market for
small face-value policies will likely increase as the economic downturn
and tight credit market force more individuals to find other sources of
cash. In addition, investors are seeking "quality" products and "clean"
paper; this means a higher demand for properly issued policies that are
acquired by policyholders with a valid insurable interest in the
insured individual and that are supported by full and accurate
applications for insurance coverage. Policies that involve third-party
financing, incomplete or inaccurate applications or other questionable
practices will likely be sold at a discount or will otherwise be
unmarketable.
Tough Times For Financing
Unfortunately,
the premium financing market may continue to struggle under current
conditions. The freeze in the credit markets has severely limited the
availability of premium financing. It has also made it extremely
difficult for policy owners to refinance maturing premium finance
loans. With these obstacles to refinancing or selling a policy, owners
who financed through hybrid loan programs may face personal liability
if the lender requires them to "make good" on their personal
guarantees. Alternatively, policy owners who are able to negotiate
workouts with their premium finance lenders could face unexpected tax
consequences if some or all of their personal liability is forgiven.
Increased Regulation
These
developments and the increased litigation in the secondary insurance
market have prompted more state regulation in the industry, with
lawmakers focusing on transparency, disclosure and consumer protection.
Regulators will likely emphasize increased transaction transparency,
asking life settlement brokers and/or providers to divulge transaction
commissions and fees. Regulators will also want these parties to
develop and follow a code of ethics and best practices that includes
fiduciary duties owed to policyholders and insureds. Although 12 states
passed new life settlement regulation in 2008, major life settlement
markets such as California, Illinois and New York remain unregulated.
Each of these states has life settlement bills currently pending, so it
appears likely that they and other states will pass life settlement
legislation in 2009.
A New Operating Environment
Ultimately,
individuals entering the premium finance or life settlement markets
will play in a drastically changed environment. Policy owners seeking
premium financing will need to meet much higher standards, demonstrate
their creditworthiness and properly document their net worth. They also
will need to be ready to take on some substantive level of personal
liability, since the market value of a life insurance policy likely
will no longer be sufficient to collateralize most of these loans. The
cost of financing may go down as these standards become
institutionalized.
Premium finance seekers should anticipate, however, that a financed policy may have limited marketability, and that a sale of the policy may not offer sufficient funds to pay off a loan. So it will be important for them to come up with an alternative exit strategy.
Those seeking to sell their policies must also change their expectations about how much they can get for them. Investors are now going to be far more selective and will likely lower their prices. They will also look more closely at the insured's life expectancy and medical reports. The increased scrutiny means transactions may take longer, as investors will likely use more exhaustive due diligence procedures to confirm the validity of a policy. The process will take even longer if the policy is financed, if there are any inaccuracies or blanks in the original insurance application, or if there are any other discrepancies in the information provided to the policy buyer. It may be more common for insurance trusts selling policies to use corporate trustees because of the increased potential for liability exposure.
Finally, individuals acquiring life insurance will want to preserve its potential investment value by ensuring full and accurate disclosure on their insurance applications, particularly regarding their net worth and the source of the premium payments (if it comes from premium financing, for example). Individuals should avoid any transactions where there is an up-front payment or some other inducement to purchase the policy. They should also be wary of any agreement or understanding to sell or transfer the policy to an investor from inception. These "schemes" could make policyholders and/or insureds personally liable, since carriers are actively challenging fraudulent insurance transactions and targeting all parties involved.
Jonathan M. Forster is the national chair of the wealth management group and the co-chair of the insurance regulatory and transactions group at Greenberg Traurig LLP. Jennifer M. Smith is an associate at Greenberg Traurig LLP.