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New Life for Old Insurance

Pro's and Con's

Life Settlements – Life Insurance Rescue

Seems like people will figure out how to make a buck out of anything. Lately, this includes death. Don't get me wrong: Since the dawn of man a lot of people have been making a lot of money on death. Death sells, for the reason that it is the big unavoidable. Morticians and those who sell burial plots are getting ready to go through their biggest up cycle ever as the baby boomers start cashing it in. And life insurance has always been a very lucrative business, though the trouble with life insurance is that you actually have to die to reap the benefit of it.

Not anymore. Seems like some very bright people have figured out a way for you to make money on your life insurance before you die. No, it does not involve being placed into a time machine and being teleported to some future date right after you've been lowered into the ground where you collect on your own policy and then get zapped back to the present where you can spend it. It doesn't involve you faking your death, either.

Nope, these very bright people have figured out a way for you to make money on your own death before you die, in a way that doesn't involve fraud or teleporting. To the contrary, they will show you how to create vast amounts of cash - hundreds of thousands of dollars if not more - seemingly out of thin air without you having to do much than take a medical, signs some forms, receive the check, and then of course at some future date die at your leisure.

The one sure thing about anything this good is that it is sure to get a bunch of other folks all riled up, and indeed this strategy has of late come under some serious scrutiny with some other very bright people claiming that there are some significant and hidden downsides to the strategy. What? You can't get something for nothing? If it is too good then it is not true?

Somewhere between the very bright people who claim that you can make money off your death before you die, and the very bright people who claim that you can't, lies the truth. To find that truth you must first understand the concept of a "life settlement", and to understand that, you must understand what its immediate predecessor, the "viatical settlement" are all about.

Viatical Settlements

Let's say that you are diagnosed with a terminal illness, such as serious cancer or AIDS, but you don't have sufficient money for treatment or even to keep yourself comfortable until you die. But let's say that you do have a life insurance policy, although in such a case you'll find that it does you pitiful little good until you do cash it in. So, you find somebody who will buy your insurance policy now at some reduced value, knowing that very shortly they will be able to cash it in. This gives you the money for treatments to hopefully slow the progress of your disease and also maybe keep you somewhat comfortable until you finally kick the bucket.

From the investors' perspective, they have examined your medical records and prognosis and know with some certainty (depending on what you have, and how bad it is) that you are going to die within a couple of years. When you die, the investors know that your life insurance policy will now pay them as the named beneficiaries, so they will get the money that they paid you for the policy plus some. It is then just a simple matter of taking their total profit on the policy, and dividing it by how many years you actually live, and that is their return on their investment.

So, let's say that you have a $300,000 life insurance policy, your oncologist tells you that at best you have two years to live, and so the investors pay you $200,000 for it and you name them the beneficiaries of the policy. If in fact you die in two years, the investors will have made a profit of $100,000 split over two years, or what amounts to a $50,000 per year return - although this will be a pre-tax profit and income taxes will be owed on it. Still, not bad for a $200,000 investment.

This type of investment in the life insurance owned by a person who is probably soon going to die (with "soon" being somewhat arbitrarily set as being within three years) is known as a "viatical settlement". In the 1980s, there was created almost overnight a multi-billion industry in investing in the life insurance policies of AIDS patients, and later this industry spread to cover terminal cancer patients and in fact nearly any other disease where sure death was a soon-to-be-realized certainty.

The fly in the ointment for investors is of course that you might outlive your physician's prognosis, meaning that when the Angel of Death came for you at the appointed time you told him to take a hike and don't come back until much later. This danger, from the investors' view, arises primarily from advances in medical technology. What might have been sure death a couple of years ago, might become defeatable or at least put into long term remission.

Such was the case with many of the AIDS patients. As medical technology progressed, some of the patients start living longer while with others the AIDS went into remission altogether and they are still alive. Doubtless, there are few investors out there who have been waiting a couple of decades now to cash in on the life insurance policies that they long-ago bought, and there probably are not just a few cases where the AIDS victims have now outlived the investors in their policies.

Eventually, the same thing started happening with cancer patients who also refused to cash in their chips at the appointed time, and investors were no longer willing to take anything but the very worst cases, where no advance in medical technology was going to make a difference. This selectivity started causing a lot of fraud in the viaticals market, as people who actually weren't very sick at all started portraying themselves at death's doorstop and repeatedly sold policies on their own lives. Then, some viatical fraudsters simply collected money from investors and never even invested in policies. This and similar fraud caused the viaticals market to be viewed as very sleazy (as if dealing in death wasn't sleazy enough in the first place), thus inviting state regulators in to further muck up the process with red tape, and driving would-be investors out.

Life Settlements

So the viaticals mess left a multi-billion dollar business with relatively few real victims of disease to buy policies from. But one of the great things about America is the ingenuity of our capital markets, and their ability to not just let money sit around but to put it to work. It was just about when the viaticals markets were starting to fall apart that some very bright person looked at the situation and said,

"Hey, what about people who aren't terminally ill, but whose health has gone down since they originally bought their policy? Since the insurance companies are prohibited from lowering benefits to reflect their poor health, their policies are worth a lot more than their surrender value."

Thus was born the concept of investing in the life insurance policies of the elderly, or what is known as "life settlements".

Assume that you have an old codger who is 65 and had a significant decline in health, such as a stroke or major heart attack (their medical records include physician's comments to the effect of "one foot in the grave" or "quite surprised to see him again"), but who once upon a time bought a $1 million life insurance policy. The old codger has since raided all the cash value out of the policy to fund his medical treatments and early retirement. Indeed, because of his age the cost of insurance is now rapidly increasing meaning that the old codger will either have to put more money into the policy or it will expire anyway. His problem is that he doesn't have any more money to put into the policy unless he borrows against the equity in his home or something, which he really doesn't want to do.

Keep in mind that by this time the old codger has forgotten what he bought the life insurance for initially, which was both for tax-free growth and to leave something for his kids. Because it no longer has cash value for him to access, and because he has forgotten that it will pay out a large amount of money to his kids if he keeps it up, it to him is a wasting asset that he would love to get rid of. The life insurance has basically become a "What have you done for me lately" sort of investment, and thus emotionally the old codger is much more willing to hold it than, say, stock in IBM which hasn't paid him much in the way of dividends but still has dramatically appreciated in value.

A quick glance at your handy pocket guide to Actuarial Tables & Life Expectancies reveals that the old codger is supposed to die, on average, within five years. So, you go to the old codger and say, "Hey, I'm willing to buy your life insurance policy from you for $500,000 paid immediately." From your viewpoint, this is a good investment. If he cashes it in by 70 as predicted, then you get paid $1 million on the policy, meaning that you've made $500,000 over 5 years (less any premiums you have to pay to keep the policy up). In round numbers, this is a $100,000 per year pre-tax profit on your original $500,000 investment. That 20% annual pretax return doesn't look too shabby against current interest rates, and the insurance company is arguably much more solvent than any bank. Gosh, even if the old codger lives to 75, it's still not a bad investment, since then you're still making 10% per year. And the odds of the old codger living past 75 (and giving your corporate bond like rates) are somewhat offset by your hope that he will cash it in before 70 meaning that you made a wonderfully nice profit.

As an aside, most of the investors in life settlements are large financial firms and hedge funds who are looking for something that has at least the safety of high-grade corporate bonds, but with a high return (since bond yields are still intolerably low). These firms buy many, many life settlements and pool them together. While these firms can not, of course, predict when a particular old codger will finally kick the bucket, they can employ the Law of Large Numbers to get a pretty good actuarial feel for when most of the policies will pay, thus allowing them to calculate their expected yield for the pool - and sell slices of the pool to investors looking for safe, higher yielding investments.

Who Loses With Life Settlements?

From the old codger's viewpoint, it is a great deal for him too. Since he couldn't afford to make current payments to keep the policy up anyway, in his mind the value of the policy was a precisely calculated "$0". And here you come along and give him $500,000 hard cash for it.

Wait, you say, how can this "win win" situation be? Not everybody can be a winner in a transaction, right?

Absolutely right. In this situation there is a loser, and a big loser too. It is the old codger's kids. Had the old codger kept the policy alive, his kids would have been big winners at his death - just like the investors will be, and even more so since unlike the investors the kids will not have to pay income taxes when the policy pays off (although the old codger's estate may have to pay federal estate taxes, depending on what happens with estate tax repeal).

To an extent, the insurance company is also a loser. The reason has to do with what is called a policy "lapse", meaning that the insurance company receives premiums but does not have to pay out on the policy. Anytime a policyholder doesn't keep a policy up, there is a lapse. Suppose the old codger did not sell his policy to the investor, but simply let it lapse. In that case, the insurance company would have collected premiums from the old codger for years, but in the end never paid out any death benefits to the old codger's estate.

Policy lapses are sweet money for life insurance companies, and do impact their profitability. A life insurance company can make a bunch of bad underwriting bets but still be profitable if lapse rates are high enough. Indeed, there are some industry analysts who suggest that some life insurance companies are only profitable because of their lapse rates.

Life settlements can theoretically work to reduce lapse rates, because the investors who buy the policy will always contribute just enough money to keep it paid up until it pays off. If enough people hear about life settlements and sell their policies before they lapse, the lapse rates would go to zero and the life insurance companies would be forced to raise rates. This would make life insurance less competitive against other investments, and probably lead to lower sales.

But if you think that any of this causes the life insurance companies to worry, you're wrong. Life insurance companies know that any loss of sales due to higher premium rates will probably be more than offset by the greater sales due to people who start buying life insurance policies as investments with the thought of later selling the policies to fund retirements. Life insurance companies had always been somewhat embarrassed by lapse rates anyway, since they tended to indicate that policies had been improperly sold in the first place. Also, life insurance actuaries already assume that a certain number of policyholder's will have health declines, and thus will hold their policies until their death. From an actuary's standpoint, the concept of life settlements in causing losses to the insurance companies isn't nearly as onerous as one might think. 

Finally, the life settlements markets are limited to a relatively small part of the market since they are only for people over 65 and who have had a dramatic health change. This group probably represents less than 0.5% of all life insurance policies, so life settlements probably are not going to impact life insurance profitability that much.

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