In the 21st century, no one disputes the economic value of working men and women. A primary purpose of life insurance is to protect families and businesses against lost economic value due to premature death. In addition, permanent life insurance is an extremely valuable and flexible financial asset that has a wide variety of uses in estate and business planning, regardless of when the insured dies.
Nevertheless, some policy owners discontinue insurance policies for a variety of reasons including: (1) a change in economics–either the policy owner can no longer afford the policy or income replacement coverage is no longer required; (2) a key employee has retired, so key person insurance is no longer needed; (3) a change from first-to-die protection to second-to-die coverage for estate planning purposes and, (4) lifetime purchase of a co-owner’s business interest eliminates the need for buy-sell insurance.
If the purpose for which the insurance was purchased no longer exists, or if the owner of the life insurance policy merely wants to discontinue premium payments, various contractual options are provided in the policy. For term insurance, the contract simply lapses or terminates. For a cash value policy, the contractual options include: (1) surrender the policy to the insurance company for its cash value; (2) exercise the extended term option to maintain the original death benefit for fixed period of time (3) exercise the paid-up insurance option to maintain a reduced death benefit to age 100 or lifetime, and (4) exercise an annuity settlement option by exchanging the cash value for a monthly income that would be guaranteed for a certain number of years or for the lifetime of the annuitant, with the guarantees based on the claims paying ability of the issuing company.
To the mix of contractual guarantees listed above, a non-contractual alternative may exist for some policies: the life settlement. Sophisticated investors, including hedge funds, may offer to buy an eligible policy and take over the premium payments in exchange for receiving the eventual death benefit. The target market for these investors are insured people over age 65 with relatively large policies, where the insured has suffered a negative health event since the policy was first issued. In order to qualify for a life settlement, the insured must submit current medical information for evaluation. The investors take advantage of what the insurance companies by law cannot do-determine policy values based on the insured’s current health status.
Life settlements are contractually the same as viatical settlements (viaticals), the original term used for policies being bought and sold in the 1980s and 90s when AIDS was epidemic and its victims needed money quickly for medical expenses. Viaticals typically involved individuals who had life expectancies of 2 years or less and the policies generally were small face amounts. A number of regulatory issues associated with viaticals, including widespread instances of investor fraud, arose.
On the positive side, viaticals were the impetus for regulators allowing life insurance companies to add “living benefit” or “accelerated benefit” riders to policies, which allow policy owners to withdraw 25%-50% of a policy’s amount if the insured has a terminal illness with fewer than 12 months to live.
Some consumer advocates are concerned that the owners of these policies may not be aware of the transaction costs and the lost opportunity cost involved in selling a policy. A recent study by the University of Connecticut and Deloitte Consulting estimated that transaction costs are 50% or more of the intrinsic economic value of these policies. Their study concluded that where an estate need exists, some estate asset other than the insurance policy should be liquidated to avoid these high costs.
State insurance commissioners and securities commissioners are also concerned about a relatively new phenomenon involving a series of complex financial transactions in which promoters encourage high net worth senior citizens to buy very large amounts of life insurance at virtually no cost using non-recourse premium loans. In some cases, an upfront fee is paid to the insured. After a holding period to avoid contestability, the loans are repaid through funds received by an investor group and the policies move seamlessly into the life settlement market. However, both the insurance industry and state regulators are concerned that this development may threaten the foundation of insurable interest on which the life insurance industry rests.
Nonetheless, the life settlements market continues to grow and financial and insurance advisors need to be informed about all sides of the issue. The issue will be addressed in detail during the featured presentation “The Great Debate: Life Settlements” at the 2006 Financial Service Forum in Palm Springs this October, hosted by the Society of Financial Service Professionals.
Because of changes in needs, personal circumstances or policy improvements, policy owners may benefit by using a life settlement. Such arrangements are not without risks, however, and today’s professional will need to learn everything there is to know about life settlements and their client’s situation before making a recommendation on what to do with a policy that may qualify for the life settlement market.