I have received several questions in recent weeks asking for my opinion on a life settlements. Rather than continuing to answer these questions piecemeal, it seems to make more sense to put the whole thing in writing so I can point people to a more thorough treatment of the subject than I can sometimes give on the radio or in a Q&A session.
The topic is a big one, so I will tackle it in several parts. To begin with, what exactly is a life settlement? What are the risks? - There must be some because we know there is no such thing as a risk free return in excess of what U.S. Treasuries will pay. They are not obvious but they are significant. Finally, do I like them as an investment?
What is a life settlement?
A life settlement is when the owner of a life insurance policy sells the policy for more than the surrender value but significantly less than the death benefit because they no longer need the policy, can't afford the premiums, or need the cash. The purchaser pays the premiums and becomes the beneficiary of the policy. When the insured dies, the new policy owner gets the proceeds rather then the insured's heirs.
Typically, the policy is bought by a viatical settlement provider. That company may hold the policies as an asset in their investment portfolio. More often, they securitize a group of policies and sell an interest in the pool of policies to investors - much like the mortgages that were pooled into collateralized mortgage obligations and all those other various acronyms you read about in the paper these days. In this case, they are a broker-dealer of life settlements.
A policyholder sells a policy with a $100,000 death benefit for $50,000. The settlement provider or broker-dealer would take $50,000 of the money raised from investors and use it to pay the policyholder. When the policy holder dies, the settlement company receives the $100,000.
On the other side of the transaction, the company sells an interest in the policy to investors at some discount greater than the discount offered to the insured. For example, the broker-dealer offers the interest to investors at a 28% discount. The broker-dealer collects $72,000 from the investor and uses $50K to pay the seller of the policy, pocketing the difference. Some of that is paid as commission to the sales agent and the rest goes into company coffers.
When the insured dies, the insurance company pays money to the settlement provider, who then distributes the $100,000 proceeds to the investors. If the insured had a two year life expectancy and died on schedule, the investor would receive the full 28% return indicated by the discount. If the insured lives beyond the two year life expectancy, for six years say, the investor still receives the 28% holding period return, but because of the increased number of years to earn the return, the annualized return is reduced to 3.5%.
Life settlements sprang up in the 1980s in the form of viatical settlements - the sale of a life insurance policy by a terminally ill policy holder. The price paid for the policy was/is discounted from face value based on the anticipated life expectancy of the person selling the policy - the longer the life expectancy, the steeper the discount.
Viaticals became big business - and big news - in the 1990s because of the AIDS epidemic. The industry was largely unregulated and rife with fraud.
Advances in AIDS treatments eventually undermined the viatical industry, which was based on the certain and imminent death of the insured. Advances in medical technology soon had AIDS victims living longer and some went into remission altogether. The same thing started happening with cancer patients. Seeking greener pastures, the industry moved on to life settlements, also sometimes known as senior settlements.
The difference between viaticals and life settlements
A search of the web finds the term viatical settlement is defined, in conventional usage, as the sale of a policy where the insured is terminally ill and anticipates death within 24 to 36 months. A life settlement is the sale of a policy on an insured who is generally over the age of 65, not terminally ill, but whose mortality is predictable based on standard actuarial methods.
What returns can an investor expect?
It is hard to find any marketer of life settlements promising less than double digit returns. In a report by the Conference for Advanced Life Underwriting, the author notes, "Presumably, high current returns reflect an immature market, where uncertain regulation, doubtful liquidity and high risk of deception or outright fraud require a premium on the investment yield, and will revert to more conservative norms as the market matures."
Risks of investing in viaticals or life settlements
Federal and state regulators consider life settlements to be securities. That means the person selling them must be licensed to sell securities. It also means they must provide you with a full and fair disclosure of all material facts, including a discussion of the risks, in the form of a prospectus or other similar document.
Liquidity risk - unlike stocks, bonds or other highly liquid securities, you probably cannot readily convert a life settlement into cash if you need it. This means you may not get any money from the investment until the insured dies and the claim is paid. It is possible the insured could live much longer than expected, or even outlive you. There are plenty of cases where that has happened. Can you afford to lock your money up until the insured dies?
Longevity risk - "There's an old saying, `The only sure things in life are death and taxes' and viatical salesmen play on that," said Denise Voigt Crawford, Texas securities commissioner. "They tell investors that because death is a sure thing, viaticals are too. But the only sure thing with viaticals are the large commissions some brokers get, making it even tougher for investors to get the returns they're promised."
The Florida Department of Financial Services, which regulates securities in the state of Florida, says in their pamphlet on life settlements, "Be cautious of any person that represents these investments as guaranteed or low risk." The life expectancy of the insured is just a guess. Those stubborn insureds and their doctors aren't in any hurry to make your investment pay off. They can and do live longer than the life expectancy estimate.
Longevity risk is particularly relevant in IRAs and other retirement savings vehicles because they produce no income and are not liquid. This is a serious problem if the insured outlives the life expectancy estimate and you need retirement income. It is exacerbated if you reach the age of required minimum distributions and can't make them.
Variability of return - If the insured dies within the estimated timeframe, your return will be high. If they don't, your return will be low. Beyond the ghoulishness of waiting around for some poor soul to die so you can profit from their demise, the variability of returns is a risk. It isn't the slam dunk the salesperson often portrays.
Quality of life expectancy estimate - The life expectancy estimate is the key to return. If the company or its consultants improperly evaluate life expectancy, or worse, misrepresent the life expectancy, promised returns go out the window. Like all pooled investments, there is no transparency. It is difficult for the investor to really know what they own and the reputation of the parties involved. Considering the dodgy history of the industry, this lack of transparency is particularly troubling.
Credit risk - There are significant activities and associated costs incurred while the policy is outstanding. These include paying the premiums, tracking the insured, monitoring the health of the insured, filing a claim when the insured dies, and distributing the proceeds to investors. The credit worthiness of the life settlement issuer is a major issue. Who will pay these costs if the broker-dealer goes out of business of is otherwise unable to pay these costs?
There is also credit risk in the insurer as well. Viatical investment promoters commonly assure investors that issuing life companies have a high credit rating and are unlikely to fail. That is not necessarily true. Regulators seized Confederation Life in 1994, when it was rated B++ and had been rated A+ (superior) only the year before. For those unfamiliar with the company, it was the single largest life insurance company to fail in North America, with total losses in the billions.
Legal risk - Because the heirs lost out on whatever return the investors and issuer made, they can and often do challenge the change of ownership in the policy, tying up the proceeds in legal proceedings and incurring additional legal fees.
Again, transparency is an issue insofar as you could lose the entire investment if the settlement provider, issuer, broker-dealer, agent or others involved encounter financial trouble or are involved in fraud. Life insurance companies have two years to investigate and rescind policies obtained using fraudulent information. They may also sue for damages.
Many applications, for example, ask the applicant whether they intend to sell the policy. If the insured says no, at the time, and then later sells the policy, there is potential grounds for rescission. Other potential pitfalls involve policies that contain intentionally misleading information from the insured, known as "cleansheeting." This is when an insured or agent deliberately leaves relevant information off the application. If you think this doesn't happen, think of all the fraudulent mortgage applications that were filed in the last few years.
Another scheme that could cause you to lose money is known as "wet ink." This is where the policyholder obtains a life insurance policy for the specific purpose of immediately reselling it. Some are even encouraged by unscrupulous life settlement providers to repeat the practice over and over again.
Regulatory risk - Given that the SEC, FINRA and state regulators have deemed life settlements to be securities, the question of suitability comes into play. In the case of a life settlement, it is not just suitability of the investment for the buyer, but in this case, also for the seller. If the seller was allowed to sell a policy when it was not in his or her best interest, or the best interest of the heirs, as is often the case, regulators could take action.
The SEC recently filed their first case involving life settlements, going after a hedge fund for improper disclosure. This firmly establishes the SEC's intent to claim regulatory jurisdiction over life settlements, something they had not done until now.
Legislative risk - Life insurance is tax advantaged in that the value is allowed to build up tax deferred and no income or capital gains is due on the death benefit. This special treatment was due to the role life insurance is supposed to play in caring for a family after the death of the breadwinner.
Congress, which is faced with large budget deficits, has been licking their chops over the cash buildup in life insurance policies for quite awhile now. Life settlements, which threaten to turn life insurance policies into nothing more than an investment, may be the excuse Congress has been looking for to tax life insurance policies.
What is my opinion on life settlements?
I have covered the risks at length. Personally, I am much more comfortable with market risk. There is also just the general idea, which I find repugnant. I don't care how much they pay.
"The psychology of investing in viaticals is different than investing in other types of instruments, and people need to consider that going in," said Bradley Skolnik, Indiana securities commissioner and chair of NASAA's enforcement section. "The risk is high with viaticals, and investors need to ask themselves if the potential reward is worth the burden of hoping someone will die quickly so they can maximize their return."
Beyond those two things, I am a cash flow investor. I believe that today's investor has to be most concerned with matching up cash outflows to cash inflows. Life settlements offer no cash flow and no liquidity. Combining them with a traditional cash flow investment, like bonds or an immediate annuity, drops the return to an unacceptable level for the person who has to make a bare minimum of 10% a year (.04 + .04)/(1-.25) to cover a 4% withdrawal rate, minimum of 4% inflation and an assumed 25% marginal tax rate.
My take is life settlements are another great product for the commissioned salesman selling them but a bad idea for you. You can do better.
1. Rothberg, Ed, Viatical and Life Settlements: Investing Without a Safety Net. CALU Report (Conference for Advanced Life Underwriting, 2005) http://www.calu.ca/publicationDetails.asp?x=&y=EHQ-7142005-3382&i=308&d=1&z= (accessed April 9, 2008,).
2. “NASD Warns on Viaticals,” Financial & Tax Fraud Associates, Inc. http://www.quatloos.com/viaticals.htm (accessed April 9, 2008,).
3. Viaticals and Life Settlements, (Florida Department of Financial Services: Office of Financial Regulation) http://www.fldfs.com/Consumers/literature/Viaticals2.pdf (accessed April 10, 2008,).
Kim Snider is the President and Founder of Snider Advisors, a SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.
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