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Peter Katt
Peter Katt
Updating the Life Settlement Market

Why your clients should not rent their life to be an insured only to try and sell it later or become an investor in another’s life insurance policy.

June 16, 2011
by Peter Katt, CFP, LIC

As the economy and financial markets have seen considerable turmoil so has the life settlement market with less funding available now for the purchase of policies. Nonetheless, the settlement market still bounces along with great enthusiasm. Recent experiences I have had suggest this is a good time to update CPAs on what to look out for in dealing with life settlements or pitches to invest in life insurance policies.

What Is Life Settlement?

A life settlement is the sale of a life insurance policy by the policy-owner to a third-party. The policyowner typically receives cash for the sale in an amount greater than the surrender value (or there would not be any reason to go through the life settlement process). The buyer assumes ownership and pays premiums s/he deems necessary to keep the policy solvent. In addition, they receive the death benefit upon the death of the insured.

Generally speaking, life settlements are an option for high-net-worth (HNW) policy-owners age 65 or older. Independent estimates report that among this group, one out of five (20%) of policies has a market value that exceeds the cash value offered by the carrier.

The market for the buying and selling of life insurance policies for investment purposes has a rational basis. The original life settlement business plan was to buy unwanted or unneeded policies as an institutional investment from insureds over 65 whose health had deteriorated more than just the passage of time. This provided mortality arbitrage needed to make the purchase price higher than the policies’ surrender value.

Should Your Clients Sell Their Policy?

In reality, it is likely that more than nine out of 10 (95%) potential policy sellers should retain them.

There are only two situations in which selling a policy is the best choice:

  • When cash is desired and a life settlement offer exceeds the policy’s surrender value.
  • When a policy has heavy surrender charges, poor pricing and the insured is still in good health to replace the offending policy. The settlement value will be substantially higher than the surrender value even when the insured’s health has not deteriorated. Prior to the sale, another policy with better pricing should be acquired to replace the policy to be sold. Obviously, this should only occur as long as the client’s net worth can justify both policies.

Should Your Clients Buy Life Insurance Settlements?

There are pitfalls for policyholders to consider before selling a policy. But what if your clients are on the other side? Do life settlements make good investments?

The appetite for doing life settlement transactions has become so great that the industry has convinced itself that life insurance is mispriced and the policies of insureds in the same health are attractive targets as well. Settlement brokers purchase policies and repackage them to sell to small institutional and individual investors.

Some in the industry refer to this as dumb money because the investors are too ignorant to know how to analyze the investment potential, mainly because they don’t understand that it is critical to have an accurate assessment of life expectancy. Life expectancy is often fudged by the settlement broker.

Creating Life Settlement Inventory

Settlement firms and agents have used seminars and dinners to convince wealthy seniors to rent their HNWs and lives to become insured for the sole purpose of then selling the life insurance policies in two years. These transactions often involve a third-party paying the premiums and providing the wealthy senior a bonus for renting his life.

There are two problems with this:

  1. Insureds do not know who will end up owning these policies.
  2. As dumb money dries up, there may be no market for the policy.

Having no market is not a problem if a non-recourse note has been used. However, if the insured is responsible for paying back the premium financing, they will face a huge debt that will have to be repaid if the policy is terminated because the premiums and/or loan interest is not affordable.

Premium Financing Followed by Life Settlement

A recent premium financing client is on the hook for $949,462. Betty is 84 and in good health for a smoker. If she dies within seven years this $4 million financed life insurance policy will provide a good financial return for her heirs. If not, the delayed repayment of the debt could nearly consume her estate. The family had no idea what they had gotten into and the agent did not understand it either. The family is literally in tears over the bad options they face.

The promised life-settlement fall-back position has failed to produce an offer much higher then the current cash value. Betty and her family have several years of agonizing moments deciding what to do.

Table 1 shows the value of this program upon Betty’s death. (The internal rate of return [IRR] is derived from what return (death benefit) Betty is getting for premiums paid. The IRR is 12% at 90, 2% at 91 and turns negative age 92.)

Table 2 shows the cost to terminate the policy if the loan-interest costs become too great with Betty remaining alive. I had to prepare these estimates because the firm that sold this wouldn’t provide it and the agent didn’t understand what to do.

If premium financing is continued, the return could be large, but the cost of Betty not dying in time (sic) is probably unacceptable. If this program is continued it turns negative at age 92, which is Betty’s life expectancy. If Betty lives to 92 and this policy is terminated, the cost is estimated to be $1.80 million (see Table 2).

The current $949,462 cost to terminate this program is really the delayed cost of providing life insurance coverage for the past six years that has had a net zero cost to date. Unfortunately Betty and her family had no realization of these enormous costs involved with what is essentially a loan for the life insurance policy. What they wanted was life insurance for nothing and the agents wanted to cash a huge commission check.

Conclusion

What started as a worthwhile secondary market for the very few situations when it makes sense to sell a life-insurance policy has gotten completely out of control because of huge hidden fees and commissions and the misplaced belief that policies are a great investment. Most insureds should not sell their policies until they are about to terminate. And none of your clients should ever become an investor in another’s life insurance policy.

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Peter Katt, CFP, LIC, is a fee-only life insurance advisor since 1983, he has written insurance columns for AAII Journal and Journal of Financial Planning since 1991.

* DISCLOSURE: Readers should assume that all investment advice mentioned in this column are the author’s and/or his firm’s unless otherwise noted and does not necessarily reflect the views of the AICPA or the AICPA Wealth Management Insider.

* Forefield Advisor, a PFP Section and PFS Credential benefit, has additional resources on the use of life insurance. The AICPA’s PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter, apply to become a PFS Credential holder.