A Short Primer on Life Settlements for TOLI Trustees

Back when I was still in the life insurance brokerage world I got my first introduction to life settlements.  I will never forget the first words uttered by the salesman who was presenting that day…”Think of me as a used car salesman, but instead of selling cars I am selling used life insurance policies”.

I may not be the best marketer around, but I am savvy enough to understand that was probably not the best introduction he could have given.  According to Gallup polls I have seen, used car sales run neck and neck with being a member of Congress as the lowest rated professions when it comes to honesty and ethical standards.  But maybe his analogy made sense, because back then the bourgeoning life settlement industry was rife with fraud. Luckily for those who have to deal in this marketplace now, that has all changed.  In 2014, the life settlement industry is one of the most regulated markets around.

The life settlement industry in the United States had its roots in the viatical marketplace of the 1980s that grew out of the AIDS epidemic.  A viatical settlement allows a person with an extremely short life span (less than two years) to sell their life insurance policy to a third party.

In a life settlement transaction, the insured is not terminally ill, but is usually at least age 65 with a shortened lifespan.  As with a viatical settlement, the policy is sold to a “third person” for an amount greater than the current cash value.  The new owner maintains the policy until the death of the insured and collects a profit based on the purchase cost of the policy, including all transaction fees, and the life expectancy of the insured.  All other things equal, the shorter the life expectancy, the higher the buyer’s profit.  Life expectancy companies have sprung up that provide Life Expectancy (LE) Reports based on a review of the health records of the insured.

The life settlement business mushroomed from 2000 to 2008 as money flowed into the industry from a number of sources including hedge funds looking for “uncorrelated assets”.  Brand names like Goldman Sachs and Credit Suisse dipped their toes into the business.  Stranger Owned Life Insurance (STOLI), where older aged individuals were solicited to purchase life insurance utilizing non-recourse loans, flourished.  The pitch was that after purchasing the “free” life insurance, the insured could participate in the profits from the sale of the life insurance policy in two years, after the contestability period as over.  As with many life insurance schemes, the STOLI concept ended with a thud, with many disgruntled clients and the Attorneys called in to clean up the mess.

The “manufactured” STOLI business did as much to create the boom and bust nature of the industry as anything.  But other problems arose that hurt the business, including life expectancy projections that turned out to be incorrect, constant industry battles with insurance carriers and the real killer, the financial upheaval and credit crunch of 2008.  That dried up a lot of the funding that had been pouring in and what funding that was available for “alternative investments” went to more secure assets.

An August 2013 report by Harvard Business School Professor Lauren Cohen pegged the annual volume of new business in life settlement sales in 2002 at $2 billion, jumping to $11.77 billion in annual volume in 2008, before plunging to $1.25 billion in annual volume in 2011.  Business in 2012 rose slightly to $1.26 billion.  The U.S. General Accountability Office 2010 survey of life insurance settlement providers reported a 40-50% decrease in settlements from 2008 to 2009.

The value of all policies in force (life insurance policies owned by third parties that have not yet paid out) stands at approximately $35 billion today, according to Mr. Cohen.  But Conning, an insurance research firm, projects that that amount will drop to $10 billion within the next 8 years.  The industry itself is more optimistic citing growth potential in small face policies ($500,000 and down) as one possible growth area.

One thing that seems to be true is that the remaining players in the industry appear to be the best of breed and with the layers of regulations that have been forced on the industry it is a far cry for the early “Wild West” days.  It is a secure place to transact business.

So, when should you as a Trustee consider a Life Settlement as a policy option?  The simple fact is that a life settlement offer is usually not the best economic option for a policy. For one thing you are taking an asset that is income and estate tax (assuming held in an ILIT) free and converting it into a taxable asset. Life insurance sales proceeds are possibly taxable to the seller and the life insurance death benefit is partially taxable to the buyer. In addition, you are adding into the financial equation transaction fees and commissions that add to the costs.

In order to qualify for a life settlement it is typical that the insured would have suffered a health impairment since the purchase of the policy that shortened his or her life span. That impairment creates the arbitrage between the actual life expectancy of the insured and the underwriting classification of the policy. It is for this reason a life settlement will work for the buyer, and perhaps a reason for you, as Trustee, to keep the policy.

A 2005 Deloite study reviewed the “values” of a life insurance policy, including the Life Settlements Value and the Cash Surrender Value. In addition, they “quantified the value of a third option: retaining the policy until death”. They referred to the third option as “the Intrinsic Economic Value”. Their study “focused on comparing the Intrinsic Economic Value with the Life Settlements Value”. In the conclusion of their study they stated: “The policyholder with impaired health could maximize her estate value if other assets are liquidated and the life insurance policy is maintained until death. The potential yield of a life insurance contract when the policyholder’s health has deteriorated is so great that other creative options to preserve the contract should be explored before making any decision to sell a contract.  The Beneficiary, who has a vested benefit in maintaining the life insurance contract, can help preserve a high-yielding, tax-free asset by securing funds to satisfy the liquidity needs of the policyholder or by assuming the premium payments on the life insurance policy. The return on the Beneficiary’s investments to preserve the life insurance contract is likely to exceed any other investment option.”

I could not state this any better. There is no doubt that there are times when a life settlement makes sense.  No life insurance policy should be surrendered for a cash value payout that is less than can be netted from a life settlement, and if a policy is going to be allowed to lapse for no value, a settlement is the prudent step.  In fact, not exploring a life settlement option in those situations may be possible grounds for litigation.  And there are a multitude of different options in the marketplace today, including ones that offer interim policy funding so that at least a partial death benefit can be paid in the future. The entire settlement marketplace should be explored.

However, it should be pointed out that a life settlement is rarely the best use of the asset you are entrusted with and if a life settlement is done, the trust file should clearly document the exploration of every other conceivable option. The same beneficiaries that might welcome a $500,000 (possibly taxable) settlement offer may be meeting you in court next year if the insured dies soon after the sale and a $2,000,000 non-taxable benefit could have been paid.

One last note. Explore every option with the carrier for the policy, especially if the insured is in poor health. Earlier this year we were exploring a life settlement option for an insured in very poor health. No ongoing monies were available to the trust and the policy was in lapse mode.  While the policy contract did not include an accelerated death benefit option, after extensive conversations with the carrier we found that the benefit was actually available because of state requirements enacted after the policy was issued. The bottom line, as always…you as Trustee are an advocate for the Beneficiary and must make sure you provide maximum benefit to the trust on behalf of your client, the Beneficiary.

3 thoughts on “A Short Primer on Life Settlements for TOLI Trustees

  1. Pingback: 2014 – A TOLI Update for Trustees | youritm

  2. Terrific perspective. We’ve seen a 25% increase in policy valuations to uncover the life settlement value by trustees to ensure they’re making the most appropriate recommendations for the trust. They’re also concerned that thinly funded policies could be surrendered or lapse that are worth 6-7 figures in the regulated Secondary Market for Life Insurance. We expect this to continue in 2015.

  3. Projecting a life expectancy of somebody is not an exact science. There are a lot of factors involved. Face it, it is not as secure as many other investments out there, but the returns would make up to it for a long time to come. Risk needs to be calculated and not avoid it. By the way, moral values still needs to be taken above anything else. And that counts policyholders as they are the one who need money the most and expect a good enough cover for what they have paid for right?

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