With life settlements getting a lot of industry and media attention, it’s no wonder that your clients are asking questions like, “What if the insured lives longer than expected?” and “What kind of risks do future premium payments create?” While these are good questions, they do not address the most important questions that need to be asked when considering this type of investment.
Economic feasibility is the true test. To evaluate an investment in a life settlement policy, you need to understand the difference between economic feasibility and the amount escrowed for future premium payments. This can be somewhat complicated. A quick study of how this works can make the difference between a successful investment strategy and an uncertain and possibly disastrous outcome. In these uncertain times, with investors even more cautious than ever, we, as trusted advisors, need to fully understand these concepts.
Life expectancy is a key feature of any life settlement investment, but it should not be the only basis for making your decision. In 2008, the Society of Actuaries Valuation Basic Table team updated the mortality tables to reflect the fact that seniors are living longer. Many life settlement investments, which relied solely on the insured passing away by the projected life expectancy or shortly thereafter, were found to be under water and unprofitable for the investor. When properly underwritten, this does not have to be the case. The answer lies in the premium illustration for each policy.
There is a tremendous risk of losing your investment if you rely solely on life expectancy calculations when analyzing the economic viability of a life settlement policy. Determining economic feasibility in a stressed situation is vastly different than determining the amount of money escrowed to pay future premiums (for example, when an insured lives beyond the projected life expectancy). When properly underwritten, a life settlement provider obtains a premium illustration that shows a level premium that will carry the policy far beyond the insured’s life expectancy (usually 15 to 20 years or to age 100). When a proper policy analysis is done, the economic feasibility is considered strongly. For example, the purchaser still has a positive return even if the insured lives a long time and premiums have to be paid the whole time.
You should request and get this kind of illustration for every investment policy under consideration. You can also run a return-on-investment calculation to determine, for yourself, that the return on each such policy is still economically feasible well past the insured’s life expectancy. You must include the payment of premiums beyond the amount escrowed with the initial investment. A reputable life settlement provider will be able to give you a return-on-investment calculator and policy illustrations. If these are not readily available, beware; your investment dollars may be headed for disaster.
Consider what would happen if you did an economic feasibility analysis that only showed level policy premiums for the life expectancy plus two years. You would have substantially lower premium costs, so a life settlement provider could afford to pay more in commissions to agents, ignoring the precarious position that the purchasers have been placed in. The problem with life settlements is that your initial premium calculations are completely off if the insured lives beyond the life expectancy by three or more years. The premiums go way up and the policy becomes economically unfeasible. This is similar to the problems that arise with an adjustable rate mortgage. It works, but only if you can get out of the property before the interest rates go up. If not, you’re under water.
So, when presented with a life settlement investment opportunity, the first question you must ask is not how much is placed in escrow to pay premiums but how many years will the estimated level premiums carry the policy. If the term for positive economic viability is only the life expectancy plus two years, your clients are at substantial risk of losing their entire investment if the insured lives longer than the escrow.
Other important considerations: In the unfortunate age of Madoff and Stanford, you cannot be too careful about whom you do business with. The following is a short review of must-have traits for your life settlement investment provider:
1. Valid policy illustrations
The number of years that premiums will carry a policy in a profitable situation is much more important than simply the number of years escrowed.
2. Investment funds in escrow
Make sure that your client’s investment dollars will be in a true escrow account. How can you tell? Funds placed in a true escrow account can only be withdrawn when a life insurance policy is actually closed and transferred into the purchaser’s name. This happens at a policy closing conducted by a qualified escrow agent when 100 percent of the policy is transferred to the new owners and all details of the transaction are overseen by the escrow agent. Beware of a progressive policy closing in which bits and pieces of a policy are transferred to purchasers over time. The ability to oversell a policy is present in this case. How would you know if more than 100 percent of a policy was being sold?
3. Policies must be underwritten firsthand
Any reputable provider of life settlement investments will analyze and qualify every policy that they offer to investors. If they don’t, how would you know who performed the initial policy analysis and what their criteria were? A quality provider always does its own extensive underwriting of each policy it offers. As seen above, in the economic feasibility discussion, if a current level policy illustration is not an integral part of the initial purchase decision, a disastrous outcome could occur including loss of profit and principal.
4. Regulatory credibility
Has the provider’s business model been tested and upheld in state and federal courts? If not, it may be shut down at a moment’s notice for regulatory violations.
5. Actual asset purchased
Is the asset a discrete ownership interest in a life insurance policy or is it a note issued to the company so it can buy life insurance policies with your money? Discrete fractional ownership is essential!
6. Complete transparency of operations and financials
A publicly traded company will offer you the highest degree of transparency. If not publicly traded, what audited financials are available? How many years has it achieved its reported results? How much money does the provider have in the bank to sustain its operations?
7. Reasonable commissions
As any fraud investigator will tell you, a classic characteristic of fraudulent schemes is the payment of substantially higher commissions than industry standards. Make sure you are not being enticed into a fraudulent investment scheme by high commissions.