What regulations are appropriate for the life settlement market and which bodies should do the regulating? Should transaction costs and fees be disclosed to consumers? Are life settlements a good deal for clients?
These questions, among others, were debated by 3 experts brought together by the Society of Financial Services Professionals at its annual conference, Financial Service Forum. The panel discussion kicked off 3 days of educational sessions held here, Oct.15-17.
Regulatory controls appropriate to the industry garnered a significant part of the debate. Brian Smith, co-founder, president and CEO of Life Equity, Hudson, Ohio, said that draft legislation to restrict the use of settlements, including a proposed excise tax on the transfer of ownership of a policy within 5 years of issuance as well as extending a prohibition on policy sales from the current 2 years to 5 years, undermine “consumer choice and property rights.”
Gregory Serio, a managing director of Park Strategies, Albany, N.Y, and the former superintendent of insurance for New York, echoed Smith’s view.
“People are still operating under the notion that [life settlements] are something that we need to protect the public against,” he said. “The fact of the matter is that we may actually be restricting consumers’ rights to dispose of policies as they choose.
“[This debate] is not about consumers but about a high-stakes game of poker between the insurance community and Wall Street,” he added. “There is going to be a showdown between all of the big players.”
Whether more or less restrictive, Serio said the rules governing life settlements ultimately will be more uniform than they are today. That is because the investment banks, hedge funds and other financial institutions that fund settlements favor federal oversight over the current state regulatory process. The shift to a national regime, he observed, will parallel the evolution of the annuities market.
John Skar, a senior vice president at MassMutual Financial, said that future legislation should mandate full disclosure of transactions costs and fees, which he noted can be substantial–and ultimately detrimental to estate planning objectives. Skar illustrated his point with a hypothetical example involving a $1.5 million universal life insurance contract issued to an individual at age 55, but who is now 65 and is expected to live to 72.
Assuming the life settlement company offers $280,000 for the policy and continues to pay premiums on the contract for 7 years (until life expectancy), the annual internal rate of return to the client is 10%. This compares to an IRR of 20% if the client’s estate purchases the policy, pays the premiums and collects the death benefit.
The difference in rates, Skar said, can be attributed to $490,000 in costs that are loaded into the settlement transaction. According to a Deloitte/UCONN 2005 study that Skar cited, the loss in economic value to the client includes risk profit (29% of costs), taxes (25%), selling commission (15%), brokerage fee (12%), servicing and provider costs (7% each) and expense profit (6%).
“The bottom line is that if you have a policy that’s eligible for a life settlement and you have a current or future estate need, then retaining the policy is usually superior to selling it,” said Skar. “The transaction costs associated with settlements are simply too high compared to the alternatives, i.e., selling some other estate asset and keeping the policy. In only a small percentage of cases does selling a policy make financial sense, specifically instances where there is no asset to sell or where the settlement offer itself is a mistake.”
Smith disagreed on this last point, observing that life insurance is frequently sold to facilitate objectives beyond estate planning. He noted, for instance, that advisors will often recommend replacing an old policy with a new one (using the proceeds from the old contract to fund the new policy) that yields a better investment performance.
Smith also counseled against disclosure of transaction costs and fees, noting the suggestion would meet with resistance from advisors. And, concurring with Serio, he said that such detailed disclosure would be at odds with less stringent disclosure requirements on the purchase of insurance products.
Responding to Skar’s suggestion that clients seek an independent appraisal of the value of their policy before pursuing a sale, Smith also pointed out that advisors who engage in settlements act as brokers representing their clients, rather than as agents representing the settlement providers.
“Advisors have a responsibility to get the best deal they can for the client,” said Smith. “This responsibility, which entails gaining a good understanding of secondary market values for policies, effectively substitutes [for the need to disclose] transaction costs and fees.”
The topic of investor-initiated life insurance found greater agreement among the panelists. Smith described as “inappropriate” premium finance programs that induce individuals to purchase a policy for the purpose of facilitating its sale; contracts that prevent insureds from controlling and retaining their policies (e.g., because of prohibitive financing costs); and programs wherein lenders secure a portion of a policy’s death benefit to fulfill repayment of a loan.
Skar concurred, noting also that premium financing only causes problems when a third-party that’s funding the solution is looking to make a gain on the death benefit. And, invoking Smith’s examples of schemes to be questioned, he added his own: those that can’t withstand media scrutiny.
“I call this the New York Times or Wall Street Journal test,” said Skar. “Consider this headline: ‘Wall Street invests billions of dollars in newly issued life insurance policies of which 8-year old beneficiaries are paid $50,000 each in cash.’
“I’m worried about the headline risk and where Congress might run with it,” he added. “The tax benefits of life insurance can all go way because of such abuses.”