Are Life Settlements the $170 Billion Elephant in the Room?

Are Life Settlements the $170 Billion Elephant in the Room?
As much as the life insurance industry tries to ignore them, life settlements are here to stay and poised to grow.
By Steven A. Morelli
insurancenewsnetmagazine.com

Life settlements have long lived in the shadow of the insurance industry they depend on, variously described as a lifesaver for cash-strapped seniors and a blight on the sanctity of life insurance.

Despite all the bad publicity settlements have gotten over the decades, in the past year in particular, the industry still has enormous potential. About $10 billion in insurance face value is settled annually, but analysts say more than $170 billion in policies qualify for settling. That means the ceiling for sales is much higher than many might realize.

One of the keys is unlocking that $170 billion in potential, and that is starting to happen because of the recession. Seniors need cash—now. As they watch their devastated investments and real estate values slowly creep out of their holes, retirees have gotten another whack from a freeze in Social Security income. The life policies that seniors expected to either surrender for low cash value or let lapse became one of the few assets they can profit from.

That need has more regulators and commentators starting to appreciate life settlements. Stories in mainstream media such as the Dallas Morning News and Newsday are encouraging seniors to consider the worth of their policies above their cash value. Settlements typically pay three to four times the cash value, usually 15 to 20 percent of the policy’s face amount.

While that recognition grows, another movement is sprouting in state legislatures that could rip the market wide open. Just this year, first Washington State and then Maine passed laws requiring carriers to present the life settlements option to insureds who might be susceptible to cashing in or dropping their policies. At least three other states are reportedly considering similar regulations.

This represents a significant about-face for states, some of which make settlements difficult enough that companies have pulled out. Legislators and regulators have traditionally looked at settlements as inherently unseemly and as stranger-originated life insurance (STOLI) waiting to happen.

Why this change? Long-term care. The huge generation that rocked its way through the ’60s soon will be rocking on the porches of assisted-living centers, a short stop on the baby boomers’ way to the beds of nursing homes. Boomers’ bank accounts and investments will be no match for the enormous costs of extended care. LTC insurance still has not made a significant dent in this market. So, a large part of this population will spend down into Medicaid, which is shared by federal and state governments already struggling with the entitlement expense.

But Washington State and Maine did not invent this strategy. Some companies are already tying life settlements and LTC. In fact, the American Health Care Association, which represents care providers, offered a webinar in 2008 on how to use life settlements as a way for seniors to avoid selling their home and other assets to pay for LTC.
In the report, “Life Settlements: A Buyers’ Market for Now,” Conning Research & Consulting called it an “emerging convergence” and a key to salvaging the settlements market, which it said suffers from a bad image and is approaching saturation.

“This new source of policies represents a potential alignment of life settlements with the long-term care industry and state governments,” Conning said. “Should this alignment emerge, it could counterbalance some of the negative perceptions about life settlements.”

Capital Crunch
One thing the convergence would not counterbalance is a tighter capital market. The same economy that drove seniors to sell their insurance also drained the money to pay for them. Buyers, also known as providers, are offering less for the settlements, if they can offer anything at all. The credit shortage shut off the dollars for the initial purchase and the premium financing to support the policies that are not paid up.

That has helped depress what could be a thriving market. Conning Research estimated that the face value of settled life insurance lost 4 percent in 2008, dropping to $11.7 billion, down from $12 billion in 2007.
Doug Head, executive director of the Life Insurance Settlement Association (LISA), said the policy supply is finally showing up—just when investor demand is dropping.

“Unfortunately for consumers, they’re just not getting the prices they would get in 2008, which I think leads some of them to back off of the deal,” Head said, adding that sellers saw the value of their policies drop. “People who were getting 20 percent of face value last year are now being offered 12 percent.”

The lack of capital hurts the life settlement company, known as providers, but also investors who pump the money into the market. Some of the sophisticated investors who underwrite large bundles of settlements no longer have the cash or, in some cases, the confidence. During the economic turmoil, some venerable life insurance companies looked vulnerable for the first time in their histories. That left settlement investors wondering not only about failing carriers but also how the state guaranty funds would treat them. Would they get the same protection as the initial insured? It is still an unanswered question, although the life insurance industry has said no claim has ever gone unpaid.
A reader would be excused for thinking that the previous paragraph described something that has been vilified by legislators and regulators lately—life settlement securitizations.

A New York Times story on Sept. 5, “Wall Street Pursues Profit in Bundles of Life Insurance,” said bankers were casting their avaricious eyes toward life settlements, bundling them up and selling them as bonds just like they did with the economy-jamming mortgage-backed securities.

“In the aftermath of the financial meltdown, exotic investments dreamed up up by Wall Street got much of the blame,” reporter Jenny Anderson wrote. “Even as Washington debates increased financial regulation, bankers are scurrying to concoct new products.”

Many in the life insurance industry agreed with regulators that the new financial instruments merited caution. Then Congress got in the act by quickly conducting a hearing on the subject. Rep. Paul Kanjorski, D-Pa., chairman of the Capital Markets Subcommittee, started with an expression of disgust.

“The idea of institutional investors profiting from a person’s death also seems, to say the least, unsettling and immoral,” Kanjorski said.

But the congressman did not realize that it has been commonly done for years. The difference is the new version of the investments are credit-rated. The rated bundles are still rare and probably will stay that way not only because of the bad publicity but also because Standard & Poor’s Rating Services said in October that it refuses to rate the investments, according to National Underwriter. S&P said the risk pool is usually too small, with fewer than 100 policies; the actual mortality rate might not match the projected rate; and “the question of whether one can legally own a policy on a life in which one has no insurable interest remains an open issue.” That last reason would puzzle most people familiar with the U.S. Supreme Court’s Grigsby v. Russell decision of 1911, which stated, “To deny the right to sell except to persons having such an [insurable] interest is to diminish appreciably the value of the contract in the owner’s hands.”

Not only has it been accepted for nearly 100 years, but investors have long looked to life-settlement bundles for safe, respectable returns.

“The smooth, predictable returns of 8 percent to 10 percent a year, which traded life policy funds can produce, make them a very attractive option in giving stability to portfolios, “ said Jeremy Leach, Managing Partners Limited, which specializes in large life settlement investments.

Nevertheless, Since The New York Times story, the Securities and Exchange Commission launched an agency-wide task force to look into life settlement securitization.

The Taxing Issues

Another factor with the potential to depress the market is taxation.

A U.S. Senate Special Committee on Aging report broached the issue in April when it said that settlement brokers and providers are not telling seniors about the tax implications of their life insurance sales.
It is generally accepted that life settlements are treated the same as annuities—the proceeds are taxed once they exceed both the premiums the original owner paid and the costs of the settlement sale. But seniors usually are just told to consult a tax advisor, because providers said that the tax consequences are “extremely murky,” the Senate committee staff reported.

Treasury Secretary Tim Geithner responded by having the IRS issue guidance, which it did a few days after the committee’s April 29 hearing. The two IRS clarifications generally upheld the treatment for sellers and laid out new rules for investors. Although some people hailed the clarification, Conning found some problems for settlements.
Conning said that the first statement, Revenue Rule 2009-13, “clarified the treatment of income earned from the sale of a policy, rather than from its surrender. It raised the tax for those who sold their policies, creating a new disincentive for owners to life settle their policies.” The ruling used illustrations that indicate policyholders would pay more tax by selling their policies rather than surrendering them, Conning reported. The ruling also said the death benefit itself, which is ordinarily not taxed, would be taxed for an investor, minus the purchase price, premiums and costs. (See www.insurancenewsnet.com/IRS200913.)

The second clarification, Revenue Rule 2009-14, appeared to target the offshoring of investors by instituting a withholding tax (likely 30 percent) on investors who were citizens of countries that don’t have tax treaties with the United States. (See www.insurancenewsnet.com/IRS200914.)

“This ruling may have had the greater impact on life settlements,” Conning said. “Life settlement funds altered their organizational structure to mitigate the tax impact on investors by relocating their businesses. Together, both revenue rulings created challenges that could inhibit the return of capital to life settlements.”
The move to tax the death benefit for investors also treads close to the life insurance industry’s fear about settlements’  impact on what have been called the “three thin threads”—the inside buildup, tax-free death benefits and the ability to remove life insurance from a taxable estate.

Insurers have been concerned that the more life insurance is treated as a commodity, the more likely it is to be taxed like a commodity. Stephan R. Leimberg, an attorney whose research has helped guide Congress and other policymakers, echoed those concerns.

Longevity is another challenge, both of policyholders and policies themselves.

Claims are paid eventually and dependably, as Head said, but that is also one of the problems insurance companies have with settlements—policy longevity. Carriers figure a certain number of lapsed policies into companies’ profits, reserves and the products’ pricing. Insurers have said that life settlements could upset that balance.

James O. Mitchel, vice president of developmental research at LIMRA, said that is a long-standing concern.

“The notion was that with life settlements there would be no lapsation,” Mitchel said, “but if you look at what the percentage of total in-force life settlements could be, that argument becomes a little hard to accept. Even some of the most outlandish projections aren’t talking more than 4 percent of in-force policies, at best.”

Just how big is the life settlement market? It only can be estimated because no one keeps track. Most guesses peg the market at $2 billion in 2002, growing to less than $12 billion in 2008. Before sales slumped this year, some had projected the market to grow to $21 billion by 2012. Conning Research put the potential market of all the policies that could be settled at about $177 billion annually over the 10 years.

Even the Conning projection is a sliver of the $3 trillion of life insurance sold each year to join about $20 trillion of in-force policies, according to the American Council of Life Insurers. ACLI declined to comment on the impact of settlements on life insurance for this article, instead referring to Leimberg, an attorney who has written on life settlements and had testified before the U.S. Senate Special Committee on Aging earlier this year. (See the committee staff’s report at
www.insurancenewsnet.com/congressLSreport.)

Although insurers often benefit from the lengthening life expectancies of insureds, it is damaging to life settlement investors.

Edward Graves, an American College associate professor of insurance, said not only is it the longer lifespans themselves but also that some investors were surprised by inaccurate data when they bought the policies.
“Investors were getting these life expectancy quotes that were going on data pools that have no correlation with the individual lives they’re dealing with in buying these policies,” Graves said. “They were given an overly optimistic view of a very short life expectancy so that the pay back would be instantaneous and would be a great return.”
The life expectancies quoted to investors have been raised in recent years, Graves said. 

But that is not enough for some investors, reported Conning, which said life expectancy is one of the major reasons the settlements market has difficulty expanding. It did not help that major underwriters increased life expectancy estimates in 2007 and 2008.

The Market’s Future

The life settlements market faces significant challenges. With regulators investigating, tax treatments changing, investors recoiling at lengthening lifespans and capital only creeping back into the economy, the market will limp along for the rest of the year. Conning Research predicts the industry even has room for growth for the next few years but warns that the market could saturate with fewer policies sold.

The keys are awareness on the part of policy holders and a larger pool of policies coming to the market. Awareness is increasingly positive as the tone in media reports starts to change. In a recent Newsday column for example, seniors were told they should consider the option to help with retirement needs.

“If you need the policy’s worth in your lifetime and your heirs don’t need the money, a life settlement could be a life saver,” Saul Friedman wrote in his October column.

That advice is appearing more often, at the same time states are starting to require greater disclosure of the life settlement option. Not only is the older population living longer and needing long-term care more frequently, but they are also the beginning of a very long line. The first boomer turns 65 in 2011 and will usher into seniorhood a huge generation of more than 75 million people willing to try something different and find a new way. That will be an explosion of opportunity for the life settlements industry.

That can also mean greater acceptance for an industry that has been vilified since its beginning. States are establishing standards and even endorsing settlements, drawing life settlements out from the shadow of life insurance and onto their own stage—just in time for a whole new audience.

insurancenewsnetmagazine.com
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Steven A. Morelli is senior editor for InsuranceNewsNet Magazine. He has more than 20 years of experience as a reporter and editor for newspapers, magazines and insurance periodicals. He was also vice president of communications for an insurance agents’ association. Steve can be reached at [email protected].

Steven A. Morelli is a contributing editor for InsuranceNewsNet. He has more than 25 years of experience as a reporter and editor for newspapers and magazines. He was also vice president of communications for an insurance agents’ association. Steve can be reached at [email protected].