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Life Settlements – Life Insurance Rescue

Seems like people will figure out how to make a buck out of anything. Lately, this includes death. Don't get me wrong: Since the dawn of man a lot of people have been making a lot of money on death. Death sells, for the reason that it is the big unavoidable. Morticians and those who sell burial plots are getting ready to go through their biggest up cycle ever as the baby boomers start cashing it in. And life insurance has always been a very lucrative business, though the trouble with life insurance is that you actually have to die to reap the benefit of it.

Not anymore. Seems like some very bright people have figured out a way for you to make money on your life insurance before you die. No, it does not involve being placed into a time machine and being teleported to some future date right after you've been lowered into the ground where you collect on your own policy and then get zapped back to the present where you can spend it. It doesn't involve you faking your death, either.

Nope, these very bright people have figured out a way for you to make money on your own death before you die, in a way that doesn't involve fraud or teleporting. To the contrary, they will show you how to create vast amounts of cash - hundreds of thousands of dollars if not more - seemingly out of thin air without you having to do much than take a medical, signs some forms, receive the check, and then of course at some future date die at your leisure.

The one sure thing about anything this good is that it is sure to get a bunch of other folks all riled up, and indeed this strategy has of late come under some serious scrutiny with some other very bright people claiming that there are some significant and hidden downsides to the strategy. What? You can't get something for nothing? If it is too good then it is not true?

Somewhere between the very bright people who claim that you can make money off your death before you die, and the very bright people who claim that you can't, lies the truth. To find that truth you must first understand the concept of a "life settlement", and to understand that, you must understand what its immediate predecessor, the "viatical settlement" are all about.

Viatical Settlements

Let's say that you are diagnosed with a terminal illness, such as serious cancer or AIDS, but you don't have sufficient money for treatment or even to keep yourself comfortable until you die. But let's say that you do have a life insurance policy, although in such a case you'll find that it does you pitiful little good until you do cash it in. So, you find somebody who will buy your insurance policy now at some reduced value, knowing that very shortly they will be able to cash it in. This gives you the money for treatments to hopefully slow the progress of your disease and also maybe keep you somewhat comfortable until you finally kick the bucket.

From the investors' perspective, they have examined your medical records and prognosis and know with some certainty (depending on what you have, and how bad it is) that you are going to die within a couple of years. When you die, the investors know that your life insurance policy will now pay them as the named beneficiaries, so they will get the money that they paid you for the policy plus some. It is then just a simple matter of taking their total profit on the policy, and dividing it by how many years you actually live, and that is their return on their investment.

So, let's say that you have a $300,000 life insurance policy, your oncologist tells you that at best you have two years to live, and so the investors pay you $200,000 for it and you name them the beneficiaries of the policy. If in fact you die in two years, the investors will have made a profit of $100,000 split over two years, or what amounts to a $50,000 per year return - although this will be a pre-tax profit and income taxes will be owed on it. Still, not bad for a $200,000 investment.

This type of investment in the life insurance owned by a person who is probably soon going to die (with "soon" being somewhat arbitrarily set as being within three years) is known as a "viatical settlement". In the 1980s, there was created almost overnight a multi-billion industry in investing in the life insurance policies of AIDS patients, and later this industry spread to cover terminal cancer patients and in fact nearly any other disease where sure death was a soon-to-be-realized certainty.

The fly in the ointment for investors is of course that you might outlive your physician's prognosis, meaning that when the Angel of Death came for you at the appointed time you told him to take a hike and don't come back until much later. This danger, from the investors' view, arises primarily from advances in medical technology. What might have been sure death a couple of years ago, might become defeatable or at least put into long term remission.

Such was the case with many of the AIDS patients. As medical technology progressed, some of the patients start living longer while with others the AIDS went into remission altogether and they are still alive. Doubtless, there are few investors out there who have been waiting a couple of decades now to cash in on the life insurance policies that they long-ago bought, and there probably are not just a few cases where the AIDS victims have now outlived the investors in their policies.

Eventually, the same thing started happening with cancer patients who also refused to cash in their chips at the appointed time, and investors were no longer willing to take anything but the very worst cases, where no advance in medical technology was going to make a difference. This selectivity started causing a lot of fraud in the viaticals market, as people who actually weren't very sick at all started portraying themselves at death's doorstop and repeatedly sold policies on their own lives. Then, some viatical fraudsters simply collected money from investors and never even invested in policies. This and similar fraud caused the viaticals market to be viewed as very sleazy (as if dealing in death wasn't sleazy enough in the first place), thus inviting state regulators in to further muck up the process with red tape, and driving would-be investors out. More on viaticals fraud at http://www.quatloos.com /Viaticals_ Fraud_scam.htm

Life Settlements

So the viaticals mess left a multi-billion dollar business with relatively few real victims of disease to buy policies from. But one of the great things about America is the ingenuity of our capital markets, and their ability to not just let money sit around but to put it to work. It was just about when the viaticals markets were starting to fall apart that some very bright person looked at the situation and said,

"Hey, what about people who aren't terminally ill, but whose health has gone down since they originally bought their policy? Since the insurance companies are prohibited from lowering benefits to reflect their poor health, their policies are worth a lot more than their surrender value."

Thus was born the concept of investing in the life insurance policies of the elderly, or what is known as "life settlements".

Assume that you have an old codger who is 65 and had a significant decline in health, such as a stroke or major heart attack (their medical records include physician's comments to the effect of "one foot in the grave" or "quite surprised to see him again"), but who once upon a time bought a $1 million life insurance policy. The old codger has since raided all the cash value out of the policy to fund his medical treatments and early retirement. Indeed, because of his age the cost of insurance is now rapidly increasing meaning that the old codger will either have to put more money into the policy or it will expire anyway. His problem is that he doesn't have any more money to put into the policy unless he borrows against the equity in his home or something, which he really doesn't want to do.

Keep in mind that by this time the old codger has forgotten what he bought the life insurance for initially, which was both for tax-free growth and to leave something for his kids. Because it no longer has cash value for him to access, and because he has forgotten that it will pay out a large amount of money to his kids if he keeps it up, it to him is a wasting asset that he would love to get rid of. The life insurance has basically become a "What have you done for me lately" sort of investment, and thus emotionally the old codger is much more willing to hold it than, say, stock in IBM which hasn't paid him much in the way of dividends but still has dramatically appreciated in value.

A quick glance at your handy pocket guide to Actuarial Tables & Life Expectancies reveals that the old codger is supposed to die, on average, within five years. So, you go to the old codger and say, "Hey, I'm willing to buy your life insurance policy from you for $500,000 paid immediately." From your viewpoint, this is a good investment. If he cashes it in by 70 as predicted, then you get paid $1 million on the policy, meaning that you've made $500,000 over 5 years (less any premiums you have to pay to keep the policy up). In round numbers, this is a $100,000 per year pre-tax profit on your original $500,000 investment. That 20% annual pretax return doesn't look too shabby against current interest rates, and the insurance company is arguably much more solvent than any bank. Gosh, even if the old codger lives to 75, it's still not a bad investment, since then you're still making 10% per year. And the odds of the old codger living past 75 (and giving your corporate bond like rates) are somewhat offset by your hope that he will cash it in before 70 meaning that you made a wonderfully nice profit.

As an aside, most of the investors in life settlements are large financial firms and hedge funds who are looking for something that has at least the safety of high-grade corporate bonds, but with a high return (since bond yields are still intolerably low). These firms buy many, many life settlements and pool them together. While these firms can not, of course, predict when a particular old codger will finally kick the bucket, they can employ the Law of Large Numbers to get a pretty good actuarial feel for when most of the policies will pay, thus allowing them to calculate their expected yield for the pool - and sell slices of the pool to investors looking for safe, higher yielding investments.

Who Loses With Life Settlements?

From the old codger's viewpoint, it is a great deal for him too. Since he couldn't afford to make current payments to keep the policy up anyway, in his mind the value of the policy was a precisely calculated "$0". And here you come along and give him $500,000 hard cash for it. Sucker!

Wait, you say, how can this "win win" situation be? Not everybody can be a winner in a transaction, right?

Absolutely right. In this situation there is a loser, and a big loser too. It is the old codger's kids. Had the old codger kept the policy alive, his kids would have been big winners at his death - just like the investors will be, and even more so since unlike the investors the kids will not have to pay income taxes when the policy pays off (although the old codger's estate may have to pay federal estate taxes, depending on what happens with estate tax repeal).

In other words, if this transaction makes so much sense for the investors, it makes even more sense for the old codger's kids. Basically, the old codger is giving up a very valuable future asset for basically pennies now - it is simply not a good trade. However, few of the life insurance salesmen tell their clients to engage in life settlements really work to advise their clients that it is a bad trade to settle their life insurance policy instead of keeping it alive.

To an extent, the insurance company is also a loser. The reason has to do with what is called a policy "lapse", meaning that the insurance company receives premiums but does not have to pay out on the policy. Anytime a policyholder doesn't keep a policy up, there is a lapse. Suppose the old codger did not sell his policy to the investor, but simply let it lapse. In that case, the insurance company would have collected premiums from the old codger for years, but in the end never paid out any death benefits to the old codger's estate.

Policy lapses are sweet money for life insurance companies, and do impact their profitability. A life insurance company can make a bunch of bad underwriting bets but still be profitable if lapse rates are high enough. Indeed, there are some industry analysts who suggest that some life insurance companies are only profitable because of their lapse rates.

Life settlements can theoretically work to reduce lapse rates, because the investors who buy the policy will always contribute just enough money to keep it paid up until it pays off. If enough people hear about life settlements and sell their policies before they lapse, the lapse rates would go to zero and the life insurance companies would be forced to raise rates. This would make life insurance less competitive against other investments, and probably lead to lower sales.

But if you think that any of this causes the life insurance companies to worry, you're wrong. Life insurance companies know that any loss of sales due to higher premium rates will probably be more than offset by the greater sales due to people who start buying life insurance policies as investments with the thought of later selling the policies to fund retirements. Life insurance companies had always been somewhat embarrassed by lapse rates anyway, since they tended to indicate that policies had been improperly sold in the first place. Also, life insurance actuaries already assume that a certain number of policyholder's will have health declines, and thus will hold their policies until their death. From an actuary's standpoint, the concept of life settlements in causing losses to the insurance companies isn't nearly as onerous as the insurance agents try to paint it out to be when making a sale.

Finally, the life settlements markets are limited to a relatively small part of the market since they are only for people over 65 and who have had a dramatic health change. This group probably represents less than 0.5% of all life insurance policies, so life settlements probably are not going to impact life insurance profitability that much. It is, however, an argument that life insurance agents falsely use to try to portray the insurance companies as the big losers, and not the kids of those who are selling their policies.

Problems with Life Settlements

The point is that a life settlement is only a good deal for folks who have no beneficiaries or estate needs of any kind. If you take into both family and charitable aspirations, this is a very small market. If an old codger has heirs that he wants to benefit, or any other estate needs, then life settlements are not a suitable strategy. Instead, the old codger should do anything he can to keep the policy going, just like the investors would do if they got it.

So, there are several significant problems with the life settlements market, and all of this discussion is just my way of meandering around to give you some background on life settlements so that we can discuss those problems.

The first problem is that some bad guys in the life settlement market cannot leave well enough alone. Because there simply are not enough seniors who are situated like the old codger, i.e., have a large life insurance policy that they cannot afford to keep up, these bad guys look to basically "grow" future life settlements by arranging slick-sounding deals to encourage people who don't even have much life insurance yet to buy life insurance with the idea that later they will sell it. With these arrangements, known as SOLI (short for "Stranger-Owned Life Insurance") life insurance truly does become a pure investment with the policies grown like so many fields of corporate bonds awaiting future harvest.

SOLI is a hot topic product right now among many life insurance agents who cater to wealthy people, since they can be pitched that they can get a very high level of insurance for two years (thus allowing the policy to mature past the noncontestability period), and then also make a tidy profit up front just for engaging in the transaction. If they don't have the money on hand to buy the life insurance policy up front, that's still no problemo as the investors will loan them the money, subject to taking the policy after the two years in repayment of the loan. This means basically Free Money (!!!) for those who allow life insurance policies to be bought on their lives.

The problem here is that this is precisely the sort of thing which can - and should - draw Congress' attention to allowing life insurance to grow tax-free. Why these life insurance policies are allowed a tax-free build-up is anybody's guess, since they really are a pure investment that have little to do with protecting the family from the insured's death. Indeed, because of insurable interest requirements for the initial issuance of the policy, most of the people who are approached to engage in this type of transaction already have a large enough estate that they don't need these policies to protect their families, and indeed are almost immediately cashing out of them. In these situations, the life insurance really is no different than a corporate bond, and there really is no sensible reason that they should be taxed much differently.

What is happening is a recognition that wealthy people have a hidden asset, which is their insurability. The bum at the bus station can't qualify for $5 million in life insurance, but many affluent and nearly affluent Americans can. If somebody has an estate worth $5 million, then they have an insurable interest of at least that. So why not take that unused asset and make some money off of it, right?

Whether buying a lot of insurance makes financial sense for a person depends on a lot of factors, including their age, health, and what the internal rate of return will be. But when it does make sense, wealthy people should be taking advantage of their large insurable interest by purchasing as much life insurance as they can reasonably afford so as to either pay estate taxes or to further grow their estate (income tax free) for their children.

Most wealthy people will not do this, of course, because they generally don't like life insurance no matter how much financial sense that it makes. What SOLI does is to turn this dislike of life insurance on its head so that wealthy people think that it is cool that they are not only making money but also selling a policy they never really wanted to these crazy investors.

But in reality it is the wealthy folks who are stupid, and the investors who are smart. On a $10 million policy, a wealthy person might get $500,000 for selling their policy, but the investor will get $10 million on their death, less this $500,000 and any agent commissions, plus maybe a couple of million in keeping the policy going until the wealthy person kicks the bucket - at which time they might make $6 or $8 million in pure profits. You decide who is smart and who is stupid.

If the wealthy people were really smart, they would simply buy as much life insurance as they could and hold it until their deaths. If they didn't have the cash on hand to buy it, they could always use the services of many lenders who are willing to finance the premiums with the loans being paid out of the policy proceeds at death. These days, many lenders are even willing to make these loans on a non-recourse basis, meaning that the policyholder is not even personally liable for the loan (the policy is used as security for the loan until the loan is paid off at death). But as discussed above, wealthy people let their dislike of life insurance (or maybe of life insurance salesmen) get in their way of what would be a really good investment for their families.

The Hidden Suitability Issue

This leads us to the most significant problem involving life settlements, which is suitability. Usually, the issue of suitability relates to the agent selling a senior something which they don't need. Here, the suitability issues relates to the agent incorrectly advising the senior to sell something that the senior should be holding.

In many ways, it really is no different than if the senior held a Certificate of Deposit that would pay $10 million in ten years, and the agent came and convinced them to unload the CD now for only $1 million. What the agent might argue is that the senior was cash-tight, and needed the $1 million now for cancer therapy. In that very limited case, the agent's advice might be correct. But how about if the senior didn't even need the $1 million because the senior had other cash available? In the latter case, the senior would not be deemed to be suitable for the sale of the CD.

In fact, at a speech given May 25th at the NASD Spring Securities Conference, Mary Schapiro, the Vice Chairman and President of the NASD, stated that the NASD considers life settlements to be "securities, subject to firm supervision." If, as the NASD thinks, life settlements are securities then that raises a wide variety of issues, including suitability and whether the life settlement sold must be accompanied by an offering memorandum or prospectus just like any other security. Certainly, all of this opens the door for securities litigation whenever a life settlement is sold - and perhaps most likely against the agent who acts as a de facto securities broker in encouraging the senior to sell. In some states, such as California, one must also wonder whether so-called "senior abuse" statutes might come into play where seniors are being encouraged to sell their policies when they have the ability to continue to fund them.

What goes on in a lot of these cases is that the insurance agent who is encouraging the senior to sell his life insurance policy by way of a life settlement is then also encouraging the senior to "replace" their life insurance needs with a new policy. While this puts the insurance agent into a wonderful double commission situation where they are making money both selling the old policy and buying the new one, it usually makes little sense. The reason is that the insurance costs of the new policy will almost always be higher than that of the old policy, simply because the senior is now older and more importantly, much less healthy than when he bought the original policy, so he will be in a higher "risk" class.

In other words, the insurance agent is telling their senior to sell a perfectly good policy and replace it with a crappy one. This is usually bad advice, since if the senior was really smart he would put enough money into his old policy to keep it alive, and then use whatever remaining excess liquidity that he has to buy as much more life insurance as he can afford and the underwriters will let him buy.

A must-read recent study by Deloitte Consulting LLP and the University of Connecticut discuss the typical higher insurance costs of the replacement policy, see The Life Settlements Market: An Actuarial Perspective on Consumer Economic Value, http://www.quatloos.com /uconn_deloitte_life_settlements.pdf This study concluded in part that at least half of the policy value will be lost by the super-high transaction costs, which exceed by many multiples the transaction cost of selling any other financial asset.

The Insurable Interest Problem

As egregious as the life insurance agent's conduct sounds, many of them are starting to tell their seniors that they can repeat this process "every two years" which leads to the next problem, that of insurable interest.

The concept of insurable interest means that you have something worth insuring. In addition to other things, this keeps people with nothing to lose from buying a lot of life insurance and then suddenly being found dead. The concept of insurable interests is why the bum at the bus depot can't buy $5 million in life insurance, but the person with a $5 million estate whose heirs will need the money to pay estate taxes and other costs can.

The problem with insurable interest is that even though it grows with the wealth of the policyholder, it is still finite. Just as one cannot buy $5 million in life insurance on the bum at the bus depot, one cannot buy $50 million in life insurance on somebody who only has a $5 million estate. Yet, that is exactly what is happening with many of the life settlement deals where a portion of the money is being used to buy new policies.

What goes on to avoid the insurable interest issue is tantamount to fraud, as the insurance agents who fill out the applications either fail to disclose the existence of other insurance, or they inflate the value of the senior's wealth. While in the past the life insurance companies have not paid much attention to the issue, they are now redrafting their forms to pick up these instances of multiple sales of life insurance to a single senior.

A significant risk for wealthy people who engage in these transactions is that their estate could lose - big. If a life insurance company later decides to challenge the insurable interest issue and wins, it means that the life insurance policy held by the investors has become valueless, and the investors will then sue the estate of the person for fraud and seek damages equal to what they would have made had the policy stood up. Of course, this means the face value of the life insurance policy is much larger than the pittance that the wealthy person originally made by selling it.

The investors need not be much concerned about the insurable interest problems because for them it is a "heads I win, tails you lose" scenario. If the policy survives an insurable interest challenge, the investors get the face value death benefit from the life insurance company and go away fat and happy.

But if the policy doesn't survive an insurable interest challenge, then the investors get to sue the helpless (because dead people can't testify in their defense) estate for the fraud of the wealthy person who sold them the now "bogus" life insurance policy, and they can collect the face value of the life insurance policy from the estate. From the investors' view, this is of course another excellent advantage to dealing only with wealthy people.

The Problem with Rebating

Yet, it is not easy to get the attention of wealthy people to enter into these transactions, and they usually don't want to take a medical examination or having people prying into their private lives, so the insurance agent must offer substantial bait. This bait usually comes in the form of large amounts of cash paid up-front.

How much cash? On a $10 million policy, the wealthy person might get as much as $500,000 up front just for taking the medical examination and signing the application. They also get "free insurance" for the two year period until the contestability period expires, and the investors feel safe in buying the policy. Half-million bucks for a couple of hours' work? Sweeeeet.

What the wealthy person isn't told is that this money is coming from the commissions paid on the life insurance policy that is sold, and thus amounts to what is called a "rebate" of commissions by the agent. Such rebates are usually illegal, and we've heard that some state insurance commissioners are starting to look into the practice. While rebating is an illegal practice for the agent, it isn't necessarily illegal for the wealthy person. However, if something happens and the policy later fails, the rebating could be great evidence of collusion between the life insurance agent and the wealthy person.

Who Ends Up Owning Your Life?

So where do all these life settlements end up? Most of them end up in pools owned by large financial institutions and hedge funds. The firms monetize the policies and sell interests in the pools to the investors, which are usually even larger investment or pension funds. That is what happens most of the time.

There is a concern, however, that particular life settlement contracts could end up in the hands of seedy elements. Or as Steve Leimberg of http://leimberg.com puts it, "How well would you sleep at night knowing that your life insurance policy is owned by Tony Soprano, and his rate of return will depend on how quickly you die?"

Although having your life insurance ultimately purchased by a mobster is probably a longshot, it may not be worth the anguish to later find out that your life insurance policy that had been initially purchased by a Cayman hedge fund has since been sold to an obscure company in Colombia. With life settlements, there simply is no guarantee who will end up owning the policy, and that might disturb some.

Indeed, the historical background of the insurable interest laws goes back to what were known as the "death pools" of Victorian England. Then, bettors would speculate on when a particular person would die, and later started taking life insurance out on their lives without them knowing about it or giving their permission. When later the "accidental" death rates of such persons started to rise, the English Parliament basically forbid SOLI by requiring that the purchaser of a life insurance policy have a recognizable interest in the person being insured. By waiting the two years before buying the policy, the investors in life settlements skirt these rules but the underlying concerns are still there.

Congress and Life Insurance

Some of the life insurance companies are concerned about life settlements. This concern has nothing to do with lapse rates or death pools, and everything to do with Congress. Their concern is that if Congress realizes that life insurance policies are really just investments, Congress will start taxing them the same way as other investments.

Life insurance has a huge tax advantage over most other investments insofar as its value is allowed to build up tax deferred and no income or capital gains taxes are due when the life insurance policy pays off at death. This special treatment is due to the historical use of life insurance to take care of families after the death of the breadwinner, but today it makes little sense where many life insurance policies are just ordinary investments with only the thinnest sliver of death benefit being given to get the tax-free buildup.

Congress, which is once again running huge deficits, has been eyeing the cash buildup in life insurance policies and wondering exactly why that buildup is not taxed. Some in the life insurance industry are concerned that this whole life settlements business may precipitate the taxing of this buildup.

Some Final Thoughts

So what do you do if you have already been talked into a life settlement and then were talked into buying replacement insurance? You should talk with an attorney to determine whether the original sale made sense, and whether your life insurance agent fully explained to you that it might have made more financial sense to continue to fund the policy than to sell it. You should also talk to your attorney about whether your life insurance agent explained to you that the cost of insurance might be higher with a replacement policy because you have aged. And if you are being approached to do this transaction, you should find an attorney who is knowledgeable about it to help you to review whether it is right for you.

Life settlements are now being pitched as "free money" for wealthy people, but in reality they should only be used by people who no longer have the liquidity to keep their policies in effect. For everybody else, the sale of the policy is probably unsuitable and the advice to sell it will often be wrong. Those considering entering into a transaction to "grow" a life insurance policy for later sale should consider their risks of later liability to investors if the policy is successfully challenged, and demand indemnification and hold harmless agreements from the investors. Also, they should carefully consider who might end up holding their policies, and perhaps attempt to limit the investors in their policies to strictly institutional investors.

We expect that regulators will soon jump into the life settlements markets, as the National Association of Insurance Commissioners (NAIC) and various state securities regulators have started looking into the issue. As noted, the NASD has stated that it already considers life settlements to be a security and thus subject to suitability analysis. Eventually, too, interests rates will rise thus making the rates of return on life settlements less attractive to investors. All this will cause an eventual shake-out of the life settlements business, thus hopefully returning it to its meaningful core function which is to provide an alternative method for seniors who cannot afford to keep their policies up to gets some additional cash out of them.

In the meantime, seniors should be wary of deals that offer them quick profits for simply allowing life insurance to be placed on their lives. They should not allow themselves to be rushed into such arrangements, but instead should take the time to carefully analyze what it is they are doing, and whether they would be better off simply buying the life insurance themselves and holding it, instead of committing themselves to selling it off after two years.

Insurance agents and financial planners should also be wary of these deals, and the potential for later being subject to discipline for advocating an arrangement which was unsuitable for their clients and subjected them to lost opportunity when their client later discovers that he would have been better off holding on to the life insurance as his estate's own best investment. Particularly where replacement insurance will be used, insurance agents and planners should be very careful that they explain that the true cost of insurance for the new policy will likely be higher than if their client had simply continued to fund the original policy. It is not too difficult to envision lawsuits after the death of the senior where the family finds out that the senior had a huge amount of life insurance, but they were not beneficiaries.

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