Liquidity is one of those funny words. Not long ago, the only people who used the word were financial professionals, and only then when they were talking among themselves.
Suddenly, however, “liquidity” has become an everyman term, what with the world suffering from a liquidity crisis and the feds injecting liquidity into the financial system so that banks can lend to corporations and other banks.
And now consumers, many scrambling for cash, are looking for liquidity, too. Thanks to the emergence of new secondary markets, some of this can be found in assets that have been historically thought of as illiquid. Counted among these are formerly illiquid items such as life insurance policies, annuities, and legal settlements.
While conceptually, the notion of illiquid financial assets may sound obscure, in fact, as Chart 1 indicates, it’s a huge market.
Interestingly, the smallest of these markets — structured legal settlements with $100 billion outstanding — gave impetus to the much larger investment annuity market, and to some degree, the massive $18 trillion life insurance market, which can now be accessed through life settlement transactions.
Structured legal settlements are payments made over time to accident victims or relatives in wrongful death cases. Many times, the thinking behind a structured settlement, rather than a lump sum payment, is to provide for the future financial needs of a plaintiff that might arise as a result of their injuries. In the case of the wrongful death of a child’s parent, payments might be timed to important life milestones such as entering college or getting married. In other cases, accident victims might receive payments into the future that contemplate further medical expenses from therapy or treatment of complications.
Despite the best intentions to anticipate future needs, plaintiffs often need cash immediately, and an entire industry of service providers came into existence to serve these needs.
Most owners of structured settlements are reasonably well-informed about their options. In a September 2008 survey of structured settlement owners, J.G. Wentworth found that approximately 45 percent claimed to be well-informed or very well-informed about their options. However, fully 25 percent reported they were not very well-informed. For these people, understanding their liquidity options might enable them to solve difficult financial circumstances now confronting them. While providing liquidity for structured legal settlements is a court-ordered process, it may nonetheless offer a good option, especially if it allows other assets to remain undisturbed.
From settlements to annuities
The financial instruments backing the periodic payments to plaintiffs are, in fact, annuities. Thus, the industry that was developed to meet the liquidity needs of structured settlement owners — underwriting standards, lines of credit, capital markets support — provided the infrastructure to make the large-scale purchase of investment annuities possible for individuals.
However, one of the most important advances in the structured settlement market that had an impact on the development of a secondary market for annuities was more legal than financial. Specifically, the anti-assignment language that is part of most annuity contracts provided a potent barrier to gaining liquidity for these assets. In the structured settlement market, however, this was overcome by assigning the right to receive payments rather than the annuity contract itself. Applying this principal to investment annuities helped open up the floodgates.
While the secondary market for annuities does not offer the immediacy of a stock exchange — it can take three to six weeks to complete a transaction — it does offer significant flexibility. That is, annuity owners can sell their entire annuity, all of their payments for a certain period of time, or just a portion of their payments for a certain period of time.
Here’s an example: A widow has an annuity paying $2,842 per month funded with a single premium immediate annuity for $600,000. She finds herself facing stiff college tuition bills for her two children. Rather than borrowing, her agent advises her to sell 10 years worth of payments for $244,844, enough to see her children through school without incurring any debt. And once her children are established, the widow can again begin receiving monthly payments of $2,842.
Some annuity buyers even found ways to enlarge the market by purchasing not just the guaranteed payment stream as in the case above, but also the non-guaranteed ones. These are the payments that continue after the guarantee period but cease upon the annuitant’s death.
From annuities to life settlements
Buying these payments represented an important advance, since it introduced the notion of annuity payments with mortality risk. It’s important to note that most of the annuities purchased in the secondary market are ultimately bundled and sold as bonds to institutional investors. Therefore, the kinds of annuities that that are purchased on the front end of the secondary market are strongly connected to the kind of assets that institutional investors want to own on the back end. Thus, a demand for payments with a mortality risk connected to them was one of the forces that gave rise to the development of a secondary market for life insurance policies, which are known as life settlement transactions.
The notion of life settlement transactions is not new. What are new are life settlements for smaller policies, with face values of less than $1 million, which has much more applicability for many more clients. For instance, a 72-year-old man with a $500,000 universal life policy recently sold it for $150,000 in cash.
The decision to purchase life insurance is often made very, very carefully; the decision to sell life insurance should also be made with equal care. In many instances, keeping the policy is the right option. But if your client’s circumstances have changed since they bought the policy, such as through the death of a spouse, the beneficiaries have outgrown the need for the proceeds, or your clients simply need the money now, a life settlement transaction is worth considering.
Even term policies with no cash value can have value in the secondary market. A client who took out a $250,000 term life insurance policy in 1984 found it was becoming more and more expensive to maintain. In 2008, the total cost of his premiums would be $7,800. Meanwhile, his credit card balances were going up and up, as were his utility and fuel bills. The client said, “It got to the point where my wife and I had to consider what had more value to us: freeing up cash that we could use today, or cash in the future, after I died.”
By converting his term life policy into a whole life policy, the client was able to immediately sell it for $14,000 in cash. The financial benefits of the transaction were magnified by the fact that not only did the client receive cash, he also got out from under $7,800 in annual premium expenses for a total impact of $22,000 in the first year.
Overall, the absence of liquidity in many assets owes its origins to the way in which the products are marketed. That is, annuities, life insurance, and legal settlements are positioned in such a way that their owners view them as sacrosanct — once purchased or accepted they can never be sold again. Increasingly, this is no longer true. However, what’s important for advisors to help clients recognize is that assets are just that, assets, to be used for the benefit of their owners and not their issuers.
John Zepeda is a senior sales representative for J.G. Wentworth. He can be reached at 866-386-3102.