As consumers come to grips with the reality of life settlements, a growing number of large institutional investors are realizing the huge potential for returns and are jumping into the multi-billion dollar industry. But where does the small investor fit in?
In spite of what the corporate landscape may suggest, there are ways a small investor can capitalize on the newly regarded asset class. Investors should proceed with caution, however, as the speculative quality of life settlements remains a topic of heated debate.
Taking another look at life insurance
With the decision by the Financial Accounting Standards Board (FASB) a few years ago to recognize the true market value of a life insurance policy, life insurance is now considered a legitimate asset as well as insurance, Doug Head, executive director for the Life Insurance Settlement Association, said. Still, “a lot of people have not looked at it that way,” he said.
As word gets out about life settlements as an alternative to surrendering or lapsing a life insurance policy, consumers are catching on to the fact that their human life value–or the maximum amount of life insurance they can obtain, based on income and assets–can be realized in the life settlements marketplace.
Source: Conning Research report 2007 Data provided by the Conning Reseach Report “Before this marketplace opened up, [a person’s human life value] was just a mere statement of fact, maybe interesting at a cocktail party, but really meant nothing to the individual who had that ability,” David Kane, president of the benefits division at York International, said. “Now that ability has become an asset and many people will say ‘well let me buy four million dollars worth of insurance, and [after the contestability period], I’ll sell it.’”
Thus, the life settlement marketplace presents consumers with an intriguing opportunity to invest in their own life insurance. In other words, the fact that life insurance is an asset that can be bought and sold like other types of property might encourage consumers to purchase more life insurance coverage once they know there is liquidity for that asset in the future.
Life insurance companies adjust, react
Life settlements only capture a sliver of the market, at 0.1 percent of the total face value of insurance policies issued in 2006, according to research by Conning. However, life insurance companies are anticipating the effect that a growing number of life settlements will have on their business operations. This is because life insurance companies traditionally price their products based on an anticipated amount of lapses, some of which may not happen as consumers conduct life settlements as an alternative to surrendering their policy, Kane said.
“The insurance industry as a whole is in a bit of an uproar, because they have some fear about…[having] adequate reserves to pay all these claims [they hadn’t expected to pay],” Kane said.
As a result, insurance companies may re-price their products in order to accumulate adequate reserves to pay off these claims. Consumers may need to brace themselves for higher premiums, but those may not come to pass.
“We feel that the insurance companies…will start playing an active role in the industry [and buy] policies essentially as a hedge to the change in lapse rates, rather than [raise] prices,” Zohar Elhanani, chief operating officer at Legacy Benefits, LLC, said. “If [insurance companies] raise their prices to a point that [is] not economical or [is] prohibitive, [they] will lose their clientele.”
AIG, Phoenix Life and Genworth are among the life insurance companies that are entering the industry space, Elhanani said.
Some states, such as Maine, are taking strict stances against STOLI deals| alt=|The capitol of Maine in Augusta|]The life insurance industry, however, appears to be concerned with a more pressing issue: the regulation and restriction of certain types of life settlement transactions. Specifically, life insurance companies are trying to influence policies meant to crack down on arrangements that have become known as stranger-originated life insurance (STOLI) schemes.
Last March the AALU, ACLI and NAIFA released their first issue of the newsletter STOLI Alert, which describes STOLI as an arrangement in which outside investors initiate the purchase of life insurance on strangers, often offering individuals cash compensation or large amounts of life insurance for “free.” A number of state legislatures have found such arrangements to be in violation of insurable interest laws, or laws that forbid individuals from taking an insurance policy out on someone else’s life, unless they have insurable interest in that life.
STOLI schemes vary in shape and form. A typical example of STOLI involves “non-recourse” premium financing, in which outside investors induce consumers to buy life insurance with cash incentives and promises to finance the premiums during the initial contestability period of two years; after the contestability period, ownership of the policy is often sold on the secondary market or transferred to the investor so that the consumer can either pay off or walk away from the debt. In some deals, consumers are required to commit to selling their policies once the contestability period is over.
While some states have taken a firm stance against these transactions, other states interpret insurable interest laws more loosely and non-recourse premium financing schemes are consequently able to slip through legal cracks. Life settlement firms also remain divided regarding the viability of such arrangements; Legacy Benefits, for instance, chooses not to purchase policies that are manufactured and owned through non-recourse premium financing, Elhanani said.
STOLI versus legitimate life settlements
Constituents of the life settlements industry are concerned that regulations meant to crack down on STOLI schemes will negatively affect legitimate life settlement transactions. For example, the NAIC has proposed a five-year moratorium on life settlements once an insurance policy has been purchased.
“We’re hoping there won’t be a snowball effect [as far as] any prohibition on reselling an asset within the first five years,” Elhanani said. “We hope that doesn’t affect the legitimate life settlement business.”
The proposal for the five-year moratorium would allow life settlements after two years if the policy premiums have been funded exclusively by the insured. Although such a provision could act as a deterrent for non-recourse premium financing schemes, the policy would also limit settlements for consumers who have paid for premiums through legitimate financing programs, which Elhanani says have “been available for the past 30 years.”
Head presented a fierce rebuttal to STOLI Alert in a LISA press release last October, asserting that “the truth about STOLI Alert is, quite simply, that it isn’t about STOLI. The publication is about attacking the secondary market, which competes with carriers and provides value for consumers.”
Investors should exercise their own discretion in determining the appropriate structures and rationale that should be in place for purchasing life insurance. Last October, talk show host Larry King filed a lawsuit against a Maryland insurance brokerage in which he admitted to taking out a $10 million dollar policy with the express purpose of immediately selling the policy in a life settlement but later concluded he had gotten a raw deal.
The high profile battle in court should serve as a cautionary tale to consumers and investors alike in terms of exercising proper due diligence before making the decision to invest in their life insurance.
Consumers may also wish to make sure their interest is adequately represented in the legislative process, which is defining the extent to which life settlement transactions should be regulated.
Unlike market-dependent investments, life settlements are low-risk| Risk in life settlement investments is inherently low for both parties|]The future: asset-backed securities
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While life insurance companies and life settlement firms battle for the general public, investments in the new asset class are expected to go public in just a matter of years.
“It’s our belief that as the market matures there will be securitizations that will allow for individuals to invest in a block of policies, [similar to] a municipal bond or something like that,” Head said. “[So far] the industry has not matured and the ratings agencies are not yet satisfied that they understand enough about the business to be able to get to that point….There have been some successful securitizations already, although they have been pretty small.”
Life settlements are a very attractive asset class for a number of reasons, the most prominent being a near elimination of risk. Unlike payouts for most other types of investments, the payout of a death benefit is—by nature—a certainty.
“At the end of the day, [investors] are not going to lose [their] money,” Kane said. “[They] might get a worse rate of return than [they hoped] for, but unlike other investments where [they] could literally lose all [their] money, people must die.”
Life settlement-backed securities are estimated to yield a rate of return of 8 percent per year and attract attention as “uncorrelated investments,” meaning their performance isn’t tied to what’s happening in other markets, according to an article in Business Week published last July.
Furthermore, the investments will likely yield increasingly favorable returns as the industry numbers continue to climb at an exponential rate. Experts predict explosive growth in life settlements over the next decade as a result of increasing amounts of institutional capital being pumped into the system as well as a growing demographic of elderly, well-off individuals to ensure a generous supply of life insurance policies.
Buying into a pool of life settlements also offers customary advantages such as diversification and sophisticated due diligence measures provided by large institutions.
In conclusion, the life settlements industry has been growing and fighting its way through the courts, Wall Street and juiced up media headlines. Ultimately, an informed investor and consumer base will hold the most sway in influencing the future of the life settlements market, and their ability to be educated about the advantages and risks of any new investment is the very factor that both life settlement and life insurance industries are counting on.
This is the second of a two-part article series that examines the controversies surrounding the life settlements industry. This article addresses the specific issues that affect investors, whereas the first article, Life Settlements: Beyond the Hype, provides a more general breakdown of life settlements for consumers.
