The life settlement industry has seen its share of turmoil in the past few years. But growing pains are part of any new evolving industry. Here are seven reasons why the future of the life settlement industry looks bright.
1. No more “Wild, Wild West”
Forty-two of the 50 states now regulate life settlements, covering more than 90 percent of the United States’ population. This is good for both investors and consumers, who are now able to transact business in a more orderly, regulated marketplace. These laws provide rules and conduct standards for the industry and add significant protection for the participants in a life settlement transaction.
2. The return of investment capital
The financial crisis that began in 2008 landed a one-two punch on the life settlement industry.
First, investment capital dried up globally. For life settlements, this meant almost no money for new investment, and it severely hampered lending for premium payments to existing portfolios.
Second, life settlements are often touted as investments that are not correlated to the stock and bond markets and thus provide diversification to investors. But during the financial crisis, investors became concerned about the solvency and claims-paying ability of the insurers that issued the policies they were buying.
Having come through the crisis, investors have more confidence in life settlements as an alternative investment because it is primarily a mortality play, with little correlation to stocks and bonds. New investment sources, like pension plans, are entering the market. The long-term nature of life settlements and the very favorable returns compared to traditional investments are attracting the attention of pension fund managers. And traditional investing sources, such as banks and hedge funds, are getting back into the game as the improving economy begins to generate more capital for investment again.
3. Higher-quality life expectancy estimates
Another factor that shook up the industry in 2008 was the sudden change in mortality tables used by two of the major life expectancy companies, which increased life expectancies by some 25 to 30 percent. Although the immediate fallout from these changes was the stifling of business, life expectancies that more closely resemble insurance company underwriting can only add to investor confidence over the long term. Additionally, life expectancy companies, now having had many more years of experience in underwriting life expectancies for life settlements, have much more data upon which to base their estimates.
4. The demise of stranger-originated life insurance (STOLI)
Life settlements were intended to bring added value for a policy that was about to be lapsed or surrendered. But by the early 2000s, it became clear that there was a significant difference between the mortality tables that insurers used to price policies and the life expectancy reports that were used by the life settlement industry.
Life expectancies used by life settlement investors were generally considerably shorter than those of the insurance companies. While an insurance company might be pricing their policies to provide a 4 to 5 percent internal rate of return at death, the shorter life expectancies calculated in the life settlement industry could bring compounded yields in excess of 10 percent. As a result of this discrepancy, under certain circumstances, a newly issued policy could have immediate value on the life settlement market. Taking advantage of this difference in underwriting, the phenomenon known asstranger-originated life insurance, or STOLI, came into being.
STOLI was marketed to older insureds and frequently touted as “free insurance” with an upside potential. The general format required the insured (or a trust created by the insured) to own the policy for two years to get beyond contestability provisions and the “wet ink” laws of a number of states, which prohibited the sale of policies within two years of issue except under certain hardship provisions. STOLI became so popular that many producers and insurers confused it with legitimate life settlements, which are transacted on properly originated policies with valid insurable interest at issue.
The beginning of the end for STOLI came in December of 2005, when the New York State Insurance Department released a General Counsel Opinion that STOLI-type arrangements violated insurable interest laws. This ruling had significant impact on the STOLI industry. State legislatures began passing anti-STOLI legislation that would make it easier to enforce insurable interest laws. Insurers — many of whom either ignored, supported, or were oblivious to these transactions — “got religion.” That is, they implemented underwriting procedures intended to detect and prevent STOLI transactions.
Insurers also began to review previously issued policies for STOLI, and, as a result, a number of suits were filed to rescind such policies. In addition to insurable interest violations, many of these policies were thought to contain false statements, particularly with respect to the insureds’ net worth, which was overstated in order to qualify them for larger face amounts of insurance. Investors’ interest in STOLI policies waned as they realized that such policies contained considerable risk because they could be unenforceable and subject to rescission by the insurer.
The final death blow to STOLI came in the fall of 2008, when, as previously mentioned, two of the dominant life expectancy underwriters adopted new mortality tables and increased their life expectancies by some 25 to 30 percent. So now, adding to all the legal risks, there was the likelihood that these policies would not provide anything near the returns investors were seeking. As a result, the blight of STOLI on the life insurance industry and the life settlement marketplace has almost entirely disappeared.
With STOLI largely history, today’s life settlement industry is, once again, doing what it was originally intended to do — provide policy owners with an alternative to the lapse or surrender of a policy that maximizes the value of their contract.
5. The American Taxpayer Relief Act of 2012
Perhaps the most significant recent development to influence the life settlement industry is the American Taxpayer Relief Act of 2012 (ATRA), which increased the estate tax exclusion to $5.25 million for individuals and, with portability, $10.5 million for married couples. According to Urban-Brookings Tax Policy Center, this change in the estate tax law means that only a very small percentage of Americans, 0.14 percent, will be subject to federal estate taxes. Additionally, those who are subject to estate tax will see their average effective rate drop to only 16.6 percent, which is well below the estate tax rate of 40 percent set by ATRA. This means that even the small number of estates subject to the federal estate tax will see a significant reduction in their estate tax liability.
For many years, life insurance has been heavily marketed to affluent seniors as a way to offset the burden of federal estate taxes. With that burden declining significantly or disappearing entirely, many of these policies may now be redundant. This will inevitably cause a dramatic upswing in the number of policies that are lapsed or surrendered because they are no longer needed, which should mean a substantial increase in the number of seniors who could benefit from a life settlement.
6. Increased recognition from legislators and regulators
The National Conference of Insurance Legislators (NCOIL) has adopted a model disclosure law that requires insurers to notify senior insureds about to lapse or surrender a policy that alternatives like life settlements exist. The states of Kentucky, Maine, New Hampshire, Oregon, Washington and Wisconsin have already adopted similar laws, and others are sure to follow.
The newest trend on the legislative horizon is Medicaid life settlements. A number of states — Florida, Kentucky, Louisiana, Maine and Texas — are considering laws that would allow life settlement proceeds to be used to offset medical expenses provided under Medicaid. As an incentive, a portion of the proceeds would be reserved for their beneficiaries. Additionally, any proceeds that might remain after offsetting medical expenses would also go to the insureds’ beneficiaries. Medicaid life settlements would benefit both the government that has to foot the bill for Medicaid and the beneficiaries of the insured.
7. Growing public awareness of life settlements
Life settlements have now been around for about 15 years, and that means more and more consumers and financial advisors have heard of them. When consumers no longer need, want or can afford their insurance, it’s in their best interest to explore the benefits of a life settlement as an alternative to the lapse or surrender of a policy. Producers are now under increasing pressure to offer their clients the option of a life settlement as a way to maximize the value of their policies.
The life settlement industry has matured considerably since its beginnings. As life settlements increasingly become part of the mainstream, advisors who want to do the right thing for their clients should start learning about and getting involved with life settlements now.