Selling a life insurance policy to generate current income has historically been a controversial practice. Investors who buy the policies do not make money until the selling policyholder dies, creating a death-watch dynamic that is morally repugnant to critics. The life settlements industry, as it's now called, accurately notes that such settlements have long been an acceptable estate planning tool. Now, with rising numbers of aging seniors, companies and brokers involved in life settlements are seeking acceptance of selling a life insurance policy as a mainstream retirement tool alongside annuities, long-term care, and other age-related financial products.
"A life settlement, in our view, is a legitimate transaction made in the financial interest of the policyholder," says Michael McRaith, the commissioner of insurance in Illinois and an active regulator in national life settlements issues. There can be valid estate considerations or a change in family circumstances that support the need to sell a life insurance policy, he notes. For example, he said, parents who have had life insurance policies for decades may no longer need or desire to leave death benefits to their grown children. "It might be better for the parents to have access to a cash settlement for that policy," he said.
"The most important concern for a consumer in any insurance transaction is that the consumer make an informed and educated decision," McRaith says. And that decision, he emphasizes, "should be in the best interests of their families and not necessarily in the best interest of the person [or firm] who is involved in the commercial aspect of a life insurance transaction."
Life settlements emerged from obscurity in the wake of the AIDS epidemic. Known then as the viatical settlements business, it layered a money-making objective with a compassionate twist for terminally ill AIDS victims, who could receive income before they died by selling life insurance policies. The investors who became the new beneficiaries of those policies would continue making any premium payments and then collect on the policy when the patient died.
Questions arose about the propriety of inducing AIDS victims to buy life insurance, and there were ghoulish odds posted on the correlation between a patient's blood cell counts and their expected time of death. Later, as improved drug therapies began commuting what had once been an AIDS death sentence, the viaticals business became less attractive to investors as life spans stretched from months into years, and then decades.
More recently, the image of life settlements was hurt by its association with what came to be called "stranger originated life insurance," or STOLI for short. In STOLI transactions, brokers often aggressively hustled older seniors into agreeing, for a fee, to have insurance on their lives purchased by third parties, who would pay the premiums and collect the death benefits. "These abusive STOLI practices essentially promote the wagering on human life, negating the good, social purpose upon which life insurance is based," the American Council of Life Insurers says in explaining its opposition to such "manufactured transaction."
In Illinois, McRaith recalled a full-page ad in The Chicago Tribune inviting people between the ages of 55 and 85 to meet a celebrity and learn about free insurance. Once in the meeting, they were encouraged to participate in a STOLI transaction. While the fee income was appealing to many seniors, McRaith said, there often were adverse financial consequences that were not disclosed, including income tax obligations and the loss of public benefits due to the extra income from their STOLI fees. Life insurers also object to selling policies with a 100-percent certainty of having to pay death benefits. Traditionally, many life insurance policies are dropped before the covered person dies, and life insurance premiums reflect these lapse rates.
Many states have adopted new rules to sharply limit if not end STOLI, McRaith says, including imposing a multi-year holding period before life insurance death benefits can be assigned to a third party. "Most states have some law that would prohibit stranger originated life insurance," he says. "If we knew of it happening in Illinois, it would be a violation of the law."
As the life settlements industry works to position itself as a mainstream option for seniors, the industry's largest and only publicly traded company, Life Partners Holdings, has been drawing unwelcome attention. The Wall Street Journal reported last month that Life Partners consistently understates the remaining life spans of the policyholders, whose policies are being sold to investors. If an investor experiences an extended wait to collect a death benefit, the costs of paying premiums and other expenses erode expected profits. The problem wouldn't affect consumers unless it reduced investor interest, which could reduce demand for policies and cut the prices that consumers receive for selling their policies into the life settlements market. The company reportedly confirmed this week that it is under investigation by the U.S. Securities and Exchange Commission, and the Journal reported that the investigation was linked to the issue of life expectancy calculations.
Beyond individual company business practices, by far the larger issue for life settlements has been the economy. "When the economic meltdown happened, everyone's lines of credit were cancelled, not just in our industry," recalls Scott Page, founder and head of The Lifeline Program, a life settlements company based in suburban Atlanta. "I think the industry is reinventing itself after a very tough 18 months."
Instead of relying on credit, Page says his company and others are using their own funds to purchase policies. "The industry just started recovering in 2010" and is not back to prerecession business levels. But Page says demographics are on his side. "Life settlements are just going to be one more option for seniors considering how they are going to survive in retirement."
For seniors considering selling their life insurance policy into the settlements market, Page offers this advice:
• These are complex transactions. Either use a financial adviser or work with the insurance agent who sold you the policy in the first place.
• You can work directly with a settlements company or through a broker. In either case, insist on total transparency and get several bids for what your policy might fetch. Payments can range from a few percent of a policy's face value to upwards of 30 percent. The key variables are your age and health, the kind of policy you have, the accumulated cash surrender value built up in the policy, and the ongoing premiums due on the policy.
• Transparency should apply to your considerations as well. Talk to all family members who might be affected by the decision. Make sure everyone understands and supports the decision. "We also require any of the current beneficiaries to sign notarized releases," says Page, attesting to their acceptance of a life settlements transaction.
• Understand, or make sure your adviser understands, your state's licensing rules for life settlements providers and how long the provider has been in business. Also, what is the source of funds being used to buy your policy, and who controls those funds? "It is not unreasonable to ask for proof of funds prior to signing an agreement," Page says.
• Policies ranging from $250,000 and higher in death benefits can be of interest to life settlements companies, but the more attractive policies to the industry are the larger ones. Universal life and other whole life policies are normally used. But Page says there is a growing "term to perm" effort to alert consumers that term policies that can be converted into whole life policies may be of interest to life settlements companies.
• A life settlements transaction should take several weeks, at least. Insurance and medical records must be obtained and verified. The process can take longer if a trust or estate is involved, if the consumer is involved in any divorce proceedings, or there are other legal considerations. Consumers' physicians must provide a "sound mind" statement that the consumer is mentally competent to enter into a life settlements transaction, which is especially relevant for older seniors.
• Payment for a life settlements sale should occur in a lump sum. "Be wary of companies that might want to offer you a payment stream," Page says. The gain on the sale—the difference between the payment and the total premiums paid on the policy—is taxed as ordinary income and should generate an IRS Form 1099.