Did you now that you can sell your insurance policy to a 3rd party and receive an immediate lump sum?
I never knew this existed until I came across The Trade-offs of Selling Your Life Insurance in SmartMoney magazine.
The process is called “life settlement”, and it works like this…
Would you take cash for your life (insurance)?
For example: Meet Bob, a 68 year old retiree with a million dollar life insurance policy. Bob has some health issues, and not enough money to pay for the care he needs to stay a live a few more years to see his grand kids grow up a little more. Enter a life settlement agent, we’ll call him agent Smith.
Agent Smith offers Bob $400,000 for his life insurance policy. For Bob, it looks like a win-win scenario: he gets the money he needs today, in exchange for a policy that he may not even be able to pay the premium on and that wouldn’t help him anyway since he’d have to be dead to get the money, and his wife has already passed away.
If Bob lives another 5 years, then the investors get their $1 million, which works out to be $120,000 per year (before taxes and premiums are subtracted). For those of you playing at home, that’s a 30% annual return!
So, who owns Bob’s life?
At this stage in the game you may be wondering (as I was): That sounds great, but who owns Bob’s life?
The short answer is: whoever holds Bob’s life insurance policy has become the beneficiary.
So, most likely it’s the investment bank, pension fund or hedge fund since wall street is packaging multiple life settlement policies together into single bonds.
What’s the risk?
For Bob, there is no risk. The risk is assumed by the investors, and the risk is that Bob will live longer than expected. The longer Bob lives, the less return the investors make.
Who wins?
The earlier Bob passes away, the better the monetary result for the investors. So, if Bob dies early, the investors win.
The brokers and agents for the life settlement companies win because they make a commission and earn a fee for the transactions.
Who loses?
The direct losers here are Bob’s children, since they will now not see a dime from the insurance upon his death.
But what if Bob had no children or family to leave behind?
Fair enough. In that case, the insurance company loses since there is now no chance of Bob defaulting on his premium and since the hedge fund, pension fund or investment bank that now owns his life insurance policy will likely outlast Bob, the insurance company is guaranteed to have to pay the original death benefit of $1 million.
In a less direct way, the rest of life insurance customer lose out because to cover the increase in death claim payouts, the insurance companies have to raise premium prices.
Why it’s a bad deal.
I think life settlements are a bad deal because they target the elderly and seriously ill, they potentially increase the cost of life insurance for everyone and they are entirely unregulated which makes this a breading ground for fraudulent and unscrupulous life settlement companies to prey on the hopes and fears of the elderly.
Consider this statement from a NYT article on the subject:
the industry has been plagued by fraud complaints. State insurance regulators, hamstrung by a patchwork of laws and regulations, have criticized life settlement brokers for coercing the ill and elderly to take out policies with the sole purpose of selling them back to the brokers, called “stranger-owned life insurance.”
Besides, it’s a relatively small portion of the population that can really benefit from this. After all, unless you have a large estate or a significantly younger spouse, it rarely makes sense to even carry a life insurance policy this late in life.
The kids may lose out if their financial plan was based on getting life insurance from their father–but if that is there level of financial engineering I’d bet they have other serious problems.
Personally, I don’t have a problem with life insurance settlements. It lets people enjoy the rest of their life instead of living cheaply and giving their heirs a windfall.
As far as driving insurance rates up, it would only do this if people with life insurance were planning on ending the policy at the precise moment it looks like it actually might benefit them. In the example you gave, his kids should offer to pay the policy if he doesn’t have the means to do so.
@Debt Free Dude,
You have a definite point about the kids having deeper financial problems if they’re plan is based on the parent’s life insurance policy!
Whereas I’m new to this space, there are numerous faults in this person’s posting:
1)A life insurance policy is an asset. It certainly benefits the senior since he needed the money for himself (think Madoff victims). You said in the article that the senior likely couldn’t afford to continue making the premium payments so the beneficiaries are NOT getting shortchanged since the senior was going to stop paying the premiums anyway
2)The lapse rate among seniors on paying their premiums is over 50%. This means that most elderlies stop making their payments so it’s a win-win for the carrier
3)Furthermore, the “surrender value” of the policy is miniscule compared to the value of the policy in the secondary market
4)As far as premium raising by the carriers, yes, that may occur someday, many years from now when the lapse rate
deteriorates. But this business is less than 2% of the carrier’s business so I doubt this will happen in the near future
5) I read where a lot of this business was done in the 80s when AIDs was an epidemic. This market help soothe the last years of the victims’ lives as they were able to afford to spend the last one or two years of their lives traveling and indulging in other favored activities
6)And it isn’t the Wall Street instittutions that necessarily benefit; it’s the investors; you and me. It’s a win-win situation.
7)Yes, it does need more regualtion to protect the investor. Like any good new product, there will always be people trying to ben the rules to make a profit. That will eventually get taken care of.
In 1911, the Supreme Court ruled that a Life Insurance policy was an asset that can be sold. Don’t try to take this privilege away from people who need it.
@William,
I want to thank you for not only stopping by, but for writing a thoughtful and respectful comment.
Here’s my response to your points..
1. A life insurance policy is an asset that the policy holder is (and should be allowed) to sell, but it doesn’t always make sense to do so. In the case where the senior is not likely to afford continued payments, then it’s probably the Insurance company that really loses out since they will end up paying the death benefit to the investors for a policy that would otherwise have lapsed. If there are beneficiaries in the mix, then you’re right they probably wouldn’t have seen the death benefit anyway if the senior could keep up the payments.
2. If the lapse rate for premiums is over 50%, then it is a loss for the carrier because they would end up paying the full death benefit for a policy that would otherwise have been canceled. It would be a definite win for the senior though.
3. True. That’s why it’s such a big win for the senior and a big selling point for the Life Settlement Company.
4. I have to disagree with your premise that it will take many years for rates to rise. Many insurance companies have already taken a hit due to the economic meltdown in 2008. And all companies pass rising costs on to the consumers, so I don’t think it will take much for insurers to increase rates to compensate for the risk that the policy will be sold and they will have to pay the benefit. Remember, premiums are essentially based on the likelihood that the insurer will have to pay the benefit. That’s why rates are higher for older individuals in the first place. An increase in policies being sold as life settlements increases the likelihood the insurer will have to pay the benefit.
5. Yes, that is very true. And that’s also one of the selling points of life settlements – it helps the current policy holder today, which is something the insurance wouldn’t otherwise be able to do.
6. I agree whole heartedly. And I have nothing against investors big and small making a profit, but there are other concerns involved such as the effect on insurance rates for others, and the effect on the family or beneficiaries of the policy holder. I was just trying to bring some of that to light.
7. I believe some serious regulation is going to have to be involved in how life settlements are offered, if only to limit fraudulent companies taking advantage of seniors. But I am by no means in favor of taking away a person’s right to sell their policy. I am only trying to outline the pros and cons.
Thanks again for adding to this debate!
Winning or losing depends on whether or not the transaction meets the client’s objectives. People usually buy life insurance because they are concerned they won’t live long enough to accomplish certain financial objectives. When they get older, their concerns often shift from not living long enough to living too long and outliving their income. A life settlement allows seniors to utilize their policy to meet an entirely different objective than was originally intended.