Most people buy life insurance for those who will be left behind when the insured person dies. The proceeds of a life insurance policy are generally intended to provide for family members in the event of the death of the insured person, to pay estate taxes, or to benefit a favored charity. Life insurance benefits typically grow over time through interest rate earnings that are tax deferred, and all the proceeds are generally tax-free to the beneficiary. For many people life insurance is an ideal investment that will benefit their families or their estate years later. Families, heirs, trusts, and charities are said to have an “insurable interest” in the life of the individual, and while they benefit from the insured person’s death are presumed to have a greater interest in the continuation of their life than the death benefits they will receive.
In recent years a secondary market has sprung up to buy and then sell the life insurance policies of older individuals by offering the insured person a certain percentage of their death benefit as an immediate cash payment in return for their death benefits. This business arrangement is known as a “life settlement” when an unrelated person with no insurable interest in the life of another buys the life insurance policy of that person. Life insurance policies purchased from individuals are generally bundled and sold to investors in the secondary market. Investors then become the beneficiary of the policy, paying the premiums until the insured person dies. By some estimates, more than $10 billion of these death benefits were traded in 2005 through this secondary market (Ziser, 2006).
How the practice of ‘life settlements’ began
This type of purchase arrangement first appeared in the 1980’s when investors began buying the life insurance policies of people with AIDS. These transactions are known as Viatical Settlements; the word ‘viatical’ comes from the Latin word meaning literally traveling money. Buyers sought out people with AIDS, paid them a portion of their death benefits, and then sold an interest in those benefits to investors. The price of shares sold to investors were, in part, based on the life expectancy of the insured person, often measured by their T-Cell count and their calculated short life expectancy.
As better treatments were developed for AIDS and survival rates increased, investors often failed to meet the investment objectives they had been promised – often earnings of 40 percent or more on their original investment. As a result of improved life expectancy of the insured, investors were forced to pay more money to finance the premiums and keep policies in force longer than expected, sometimes much longer. As a result purchasers and investors looked for new investment opportunities and discovered the life insurance policies held by people 65 and older.
Viatical settlements today are defined as life insurance policies purchased from someone who has a catastrophic or terminal illness expected to result in their death within 24 months. Life settlements on the other hand are generally the purchase of a life insurance policy from someone 65 or older with a life expectancy of two to twelve years (Skar, 2004).
While the California Department of Insurance does regulate viatical settlements to some extent, it does not regulate life settlements.
Selling a death benefit
Today a significant number of older people own life insurance policies they purchased earlier in life for the benefit of their families or their estate. In later life they may be approached to sell their policy for a portion of the value of its eventual benefits. This is especially true for older people with high net worth and life insurance policies with large death benefits. The prospect of receiving immediate cash is sometimes very appealing or even irresistible, especially when ill and faced with high medical bills or other unexpected expenses. In other cases the original purpose of a life insurance policy may no longer exist, for example for the support of minor children who have grown to adulthood, or the premiums may become unaffordable as life circumstances change after retirement.
When selling life insurance policies, benefits that would have gone to family members, paid estate taxes, or benefited a charitable organization will be realized instead by these life settlement investors, many of them large foreign institutional investors. The percentage of a death benefit that purchasers of these polices are willing to pay a person depends not just on the amount of the death benefit but the age and health of the insured person and their calculated life expectancy. The older and sicker someone is the more likely they are to get a higher offer. In most cases they will be offered more than the cash value their policy provides if they stop paying premiums and cash out their policy. In cases of a term life policy where there is no cash value in the policy if they stop paying premiums and the policy lapses, a cash offer may be even more attractive.
No state regulation of life settlements
A life settlement is often considered an investment, not an insurance product and therefore its sales usually do not fall under state insurance regulation. Many state laws that apply to insurance product sales may not apply to life settlements, depending on the laws a state has enacted. California has no laws regulating these transactions. For instance, there is no free look or ‘cooling off’ period once a person has signed a contract for the sale of their policy, nor is there a requirement that the commission a person receives when buying and selling one of these policies be revealed to the insured person. The individual who has sold their life insurance policy continues to be insured, but is often unaware that investors have the right to inspect their personal medical records and to contact them periodically to inquire about their health.
Careful consideration should be given to all of these issues, and consultation with an accountant and tax advisor is strongly advised for anyone contemplating the sale of their life insurance policy. The sale of a person’s death benefits affects not just the insured person but their family members, their estate, and potentially their tax obligations as well.
Concerns with investor driven purchases
In general, when people buy life insurance they have an “insurable interest” in their own lives. Families are presumed to have an insurable interest in the family member who is insured, balancing out their interest as beneficiaries of the death benefits that will be paid with their interest in the life of their loved one.
The concept of an insurable interest was intended to prevent gambling on human life, and has been embedded in U.S. law for more than a century (Bourland and Schultz, 2005; see p.8 Warnock v. Davis). Indeed an extreme example of what ‘insurable interest’ is intending to prevent is a case in L.A. last year involving two women who befriended homeless individuals, took out life insurance policies in their names and killed them after the two-year contestability period expired (see knbc.com/news/9603698/detail.html). While this is an extreme and rare case, in recent years seniors are increasingly being approached to buy a life insurance policy, not by an agent of an insurance company, but by the agent of investors who proposes to pay them to apply for a policy and then sell it to them later. Investors will buy the policy from them in two years, once the contestability period has expired, and will pay the insured person a large percentage of the death benefit for their trouble.
The individual proposing this scheme may even offer to finance the premiums during the two-year period before investors buy the policy from the insured person. This seems too good to be true when people hear this proposal, and in fact it usually is. This scheme is known as investor driven life insurance but more recently has become known as stranger owned life insurance (SOLI). An investor, a stranger, has no insurable interest in the life of the insured person whose benefits they buy. In fact, just the opposite is true. Investors only benefit upon the death of the insured person when death benefits are finally paid, and premiums are no longer due.
California, like many states, requires the owner of a life insurance policy to have an insurable interest in the life of the insured person when the policy is issued, a standard that is not met when a policy is purchased for the express purpose of selling it later. In addition, an insurance company issuing the policy may have the right to void the policy from the beginning, or to cancel it later alleging the lack of an insurable interest by an investor driven sale. If a policy is successfully canceled by the life insurance company, the person who applied for coverage may have a large financial obligation to the investor for the amount loaned to finance the premiums during the initial two year period before the transfer to investors has taken place. If the person had been paid the agreed upon amount for their life insurance policy as part of the transfer, they might also owe that amount to the investors in the event the company cancels the policy after discovering the sale to investors.
In other cases individuals have been convinced to sell an existing policy to investors and use the proceeds to buy another one that promises a better return. However, there is a limit to the amount of life insurance a single person can have in force at one time, usually based upon their total net worth, age and health. When a life insurance policy has been sold to investors it may reduce or eliminate the amount of additional life insurance companies are willing to issue. Much to his surprise, the talk cable television host Larry King was persuaded to engage in “highly complex life insurance transactions” involving the purchase and resale of life insurance policies and is now suing the Meltzer Group Inc., in Bethesda, MD (Brady, 2007). Among the issues involved in this case is the fact that Mr. King was unaware he would have difficulty buying additional life insurance because of his age and health and because of the amount of death benefits he already bought and then sold to investors.
The market for these transactions also focuses on older people who need to increase their income or assets. While life settlements may benefit some people who no longer need the benefits they originally purchased and need the cash they will be paid for those benefits, stranger owned life insurance, or SOLI, turns the concept of life insurance on its head, becoming nothing more than an investment in the death of a complete stranger.
The premium that life insurance companies charge an individual for life insurance is predicated on the normal life span of the insured person. The contestability period and the exclusions in a policy are meant to discourage the purchase of life insurance when an insured person knows, and the company does not, that they will die in a short period of time, and to preclude an unhealthy interest in the shortened life span of an insured person. Because these investor induced transactions are relatively new, the impact on the cost of life insurance products remains to be seen since at least part of the cost of a life insurance policy is predicated on a certain number of those polices lapsing before benefits are ever paid out. In the meantime, older Californians who are approached to participate in one of these transactions should consult a trusted accountant, financial advisor or elder law attorney before entering into one of these arrangements.