A characteristic of the life settlement market is that the life insurance company issuing a policy has almost no financial influence at the point of the settlement. Though the ultimate guarantor of the cash flows traded and an expected net loser in a life settlement transaction, the insurance company is almost always an unwilling party to the transaction.
It may be possible to change that situation. If insurers were to offer cash surrender values to policyholders in excess of contractually guaranteed amounts, the secondary market would be altered, perhaps to the advantage of both the insurance company and the policy owner. This article explores the viability of such offers.
Why would an insurance company want to make such an offer? The answer is to improve its own financial position and that of its insured. Just before a life settlement transaction, a policy has 2 potential future paths entirely under the control of the policy owner: The policy can be cash surrendered, or it can be maintained in force until the death of the insured. For policies that are viable candidates for life settlement, cash surrender would usually be a much more favorable outcome for the insurer. The company has money already set aside in the form of reserves to cover such surrenders.
Persistence of the policy under a life settlement is usually much less favorable for the insurance company. Insureds under policies that are viable candidates for life settlement are typically in worse-than-average health and therefore their remaining expected lifetimes are short enough that the discounted value of the death benefit, less future premiums, is larger than the insurer’s reserve for the policy. A life settlement essentially freezes in the resulting prospective loss. An insurer would likely be better off attempting to forestall the life settlement by offering the policyholder an extra-contractual cash surrender value between the contractual cash value and the discounted value of the future death claim, less premiums. If the after-tax value of that amount is greater than the after-tax value of the life settlement offer, the policy owner would also be better off. There is a good chance that could frequently be achieved.
To be clear, for policies that are viable candidates for life settlement, the relationship between cash amounts available to policy owners presumed in this article to be achievable is:
Contractual cash value < Life settlement < Extra-contractual cash value < Death benefit
Can life insurers actually pay cash values greater than contractual amounts? There are two aspects to this question. One is legal, the other financial. Life insurance cash values must be calculated in accordance with the Standard Nonforfeiture Law and associated regulations, guidelines and interpretations. Taken together, they establish minimum cash surrender values for all types of life insurance and policy circumstances. They do not require that all policies provide the same cash surrender values if similarly situated with respect to all parameters other than the health of the insured.
The issue, then, is fairness. Is it fair for insurers to pay greater than contractual cash surrender values to a relatively narrow segment of policyholders? The actual offer might be as follows: At the time of surrender, cash values for all policies will be the greater of the contractual value and a value determined by the insurer based on an underwriting assessment of the insured’s health, much like that for a life settlement. Policies covering insureds in average to good health would expect to receive the contractual value, while those in poor health may receive a higher cash value.
Companies would need to develop an assessment and computational process that is inexpensive and demonstrably reasonable and objective. A gatekeeper mechanism such as a pre-screen and refundable assessment fee could serve to minimize requests unlikely to result in extra-contractual cash surrender values.
It is worth noting that life insurers are already allowed to provide an enhanced benefit to insureds in poor health. Accelerated death benefits are commonly provided when covered insureds are certified as terminally ill within 12 or 24 months. It is not a great stretch conceptually to compare the underwritten benefit described above to the common accelerated benefit. Both are based on the discounted future death benefit and an assessment of the insured’s health at the time of the transaction. It is also notable that accelerated benefits were, in some cases, added to in-force policies years after issue.
If regulatory issues are excessive, a life insurer could presumably offer life settlements for its policies through a subsidiary, and thereby achieve approximately the same result as underwritten cash values. However, this approach has the potential to be less equitable to policyholders and seems unlikely to put more cash in policy owners’ hands.
The second aspect to the question leading off this section is financial. Is the insurer better off in aggregate by offering underwritten cash surrender values? The answer depends primarily on whether aggregate savings from underwritten surrenders that would otherwise have been life settlements is greater than the aggregate extra cost of underwritten surrenders that would otherwise have been contractual-basis surrenders. The net impact is very difficult to assess given current data. However, as life settlements grow in frequency, the potential for a positive answer also grows.
Underwritten surrenders would cost more to process than contractual-basis surrenders. Several factors would contribute: the cost of the longevity or mortality assessment, the computational cost of developing a proposed cash surrender value, an agent commission and additional administrative expenses. These are manageable expenses for a life insurer since the ability to provide or arrange for these tasks is already in place. Even assuming commission expenses are comparable to those for a life settlement, total underwritten surrender expenses should be less than current life settlement transaction costs.
Existing statutory and GAAP reserve levels are considered sufficient to mature an insurer’s future policy obligations. At the death of an insured, the claim amount is paid out of premium and investment cash flows and the release of the reserve being held. In most instances, the relationship between the original underwriting classification and the ultimate cause and timing of death goes unremarked. Surrender for an extra-contractual cash value calculated as described above would reduce an insurer’s cost relative to persistence of such policies until death. Such offers, then, should not require additional reserves, and might be handled no differently in financial statements from other types of benefit payments.
For insurance company tax purposes, extra-contractual cash value payments would logically be treated much like other benefit payments. For policy owner tax purposes, extra-contractual cash values would logically be treated like contractual cash values (no tax on the basis and personal rates on the excess) or like life settlement amounts (no tax on the basis, personal rates on the excess up to the contractual cash value and capital gains rates on the excess). However, the tax treatment of extra-contractual cash values is uncertain and an important element of their viability.
Insurers have several potential responses to the secondary market in life insurance policies. A company can ignore it, at least for now, as being too small to worry about. Although accurate numbers are not available, industry watchers estimate that life settlements were completed for $10 billion to $15 billion of face amount during 2005, less than 0.2% of the approximately $9 trillion of individual life in force at the time. A company can discourage life settlements of its own policies, improve its underwriting process to reduce premium financed life settlements or support organizations that broadly discourage the life settlement industry. A company can also participate in life settlements, buying life settlements as investments or mortality hedges.
Providing underwritten cash surrender values is a more direct and robust response. While there seems to be no serious obstacle, there are several critical components to successful implementation:
o Regulators must accept extra-contractual cash surrender values.
o Agents must be on board, presumably by way of sufficient compensation.
o Financial accounting must be reasonable.
o Income taxes must be consistent with contractual surrenders or life settlements.
If these issues can be settled favorably, an everyday process of determining extra-contractual cash values can be developed that is fair and routine and inexpensive.