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5.1 Impact on Net Income

The rapid growth of the life settlements market will have consequences for multiple stakeholders. Life insurers, consumers and regulators will all be affected in some way or the other. Life insurers could potentially lose $1.3 billion or more every year. This is approximately 13% of the profits earned from all life policies. According to IBIS World Industry Report, the total industry revenue of life/health companies was $800 billion in 2008.32 Of these, life policies accounted for 19.9% while the rest of the revenue came from other segments like annuities, health etc. Therefore the total revenue of life policies was approximately $160 billion. The same industry report mentions that the average profit margin from 2002-2007 was 6.3% of revenues. However, the challenging market conditions in 2008 lead to a net income margin of only 0.9%. Assuming a 6.3% net income margin, the $160 billion revenue from life policies would yield $10 billion in profits, while 2008 net income would be approximately $1.6 billion.

In perspective, the $1.3 billion potential loss due to life settlements is 13% of average life profits of $10 billion. Using 2008 net income, the $1.3 billion loss translates to 80% of 2008 profits. This analysis shows us that the financial impact of life settlements on life insurers is not just marginal but quite significant. A 13% impact on net income year after year is difficult for

any industry to sustain. As a result the life insurance industry will have to adapt to the growing life settlements market in some form or the other. Life settlements implications may not be a priority for life insurers in the current economic environment, as they are more worried about their assets and shrinking capital, but in the next few years as life settlements expands and grows to take advantage of more insurance policies the financial impact on life insurers will call for major changes to how they price and write the policies.

5.2 Risk of Insolvency

One argument put forward is that losses imposed by life settlements will cause some life insurance firms to become insolvent. This will lead to a negative effect on society as there will be less choices and supply of life insurance. It is certain that life insurers lose out on profitable impaired lapses, however there is no evidence to suggest that they will become insolvent because of life settlements. This is because most of the products like whole life and universal life policies targeted by life settlements are generally not lapse supported. This means that by regulation, lapses cannot be priced as a source of profit. Therefore lower impaired lapses should

theoretically cause no underlying change in the base profitability of the product given that all other pricing assumptions hold. Firms, therefore, cannot become insolvent.

However, firms may now have a higher probability of become insolvent. In the past, impaired lapses provided significant bonus profits to firms. Now, life settlements firms take away this source of bonus profits. Life insurers therefore, have less margin of safety to sustain further losses. If for example, the pricing assumptions for whole life insurance are not correct, the losses incurred from this error will no longer have the margin of safety from the bonus profits of impaired lapses. Life insurers would now have to be more careful about their pricing

assumptions and have a higher probability of overall losses if pricing assumptions are misestimated.

5.3 Pricing and Underwriting Implications

In terms of pricing, the life insurers will probably be forced to increase premiums for policyholders. This would seem to hurt current and future policyholders as life insurance would be more expensive. However, it is also important to realize that higher dollar premiums will be matched by an increase in payouts expected by the policyholders. Therefore, consumers do not necessarily lose out. Consumers were previously buying an inferior product at a lower premium, where as now they would be buying a superior liquid product and hence expect to pay higher dollar premiums. The life settlements market eliminates the downside risk of receiving only surrender value if the policyholder becomes impaired. Therefore, as long as the dollar premiums increase proportionately to the higher expected payouts, consumers will benefit as they have enhanced liquidity for a product for which they are still paying the same spread, which is premiums over expected payouts.

As a result of life settlements, insurance companies should also recognize the need to enforce stricter underwriting standards for new policies. Enhanced liquidity on life policies encourages prospective policyholders to lie on their health status in order to get underpriced policies. If an unhealthy policy applicant lies on his application and suggests that he is much healthier than he actually is, he will qualify for lower premiums and therefore his policy will be underpriced. After he qualifies for life settlements, the policyholder will then sell his policy in the secondary market for significant profit. To prevent such opportunistic frauds, insurance companies need to re- evaluate and improve underwriting standards.

5.4 Future of Life Settlements Market

As to the future of life settlements, many argue that if the life settlements market continues to grow and profit, it would seem that the life insurance companies would face a tough time making money. Therefore a large life settlements market and a profitable life insurance industry would not be able to co-exist. In the end, the money losing life insurers would lobby for protection from Congress. Congress will act to help the insurance industry and impose restrictions on life

settlements market since consumers need an insurance industry rather than a life settlements market.

This argument may not be necessarily true. The life settlements market and life insurance industry may be able to thrive side by side but then consumers will have to lose out. The

profitability of life settlements firms is not driven exclusively by losses of life insurers. The life settlements firms do gain from life insurance companies by buying impaired policies that were going to lapse (Type 1 transactions). Further, they also gain from impaired policyholders who are driven into selling their policies but would have not lapsed had the life settlements market been non-existent (Type 2 transactions). These policyholders would regard the life settlement price as much more than cash surrender value and thus think of it as a good deal for them. However, if they hold their policy until death, the intrinsic economic value of the policy is much greater than the life settlement value. By selling their policy when they were not required to, they lose out on value.

On the other hand, the life settlements firms profit from impaired policyholders who were not going to lapse. The life insurers would be unaffected in such a transaction because they have to pay the death benefit irrespective. Without life settlements market, the policyholder would have

kept his policy in-force until the death benefit is paid. With the life settlements option, the policyholder chooses to sell because of the perceived higher value and the life settlement firm holds it with the life insurer still paying the death benefit at the time of death. Therefore the gain by life Settlements can be seen as a sum of gain from life insurers from Type 1 transactions and consumers from Type 2 transactions.

As for Type 1 transactions, the growth should be limited. This is because only 3-8% of senior policies lapse every year according to historical lapse data. This puts a cap on the upper bound of transactions possible every year. If the total face value of life insurance policies held by impaired senior citizens is close to $100 billion, then assuming a higher bound of 10% yearly lapse rate would mean $10 billion impaired policy lapses every year33. Therefore the upper bound of growth for new life settlements transaction every year is around $10 billion. So there is no way life settlements can keep growing for an extended period of time on Type 1 transactions. The double digit growth would have to come from pursuing policyholders to sell through Type 2 transactions. The Type 2 transactions however, are not in the best interest of consumers. Policyholders lose out significant amounts by selling their life policies when other alternatives would have yielded greater returns.

One thing seems certain, a bigger than necessary life settlements market is not beneficial to society, it harms life insurers, it harms consumers more than benefiting them. Therefore if the life settlements market keeps on growing it may hurt society more than helping it. It would reduce consumer surplus. Therefore asserting that a dynamic life settlements market is in the best interest of consumers, as Doherty and Singer (2003) imply, does not seem justified.

5.5 Need for Regulatory Oversight and Action

It is therefore important for the regulatory agencies to make sure that policy holders are fully knowledgeable of a life settlement transaction. They need to regulate the life settlements market in terms of requiring full, accurate disclosure to current policyholders. This will limit Type 2 transactions where a lot of consumers are losing out because they are not aware of life

settlements and are talked into the life settlements sale by life settlements brokers who do not act in the best interests of policyholders.

One interesting real-life example of a policyholder being misled into selling (a Type 2 transaction) is Larry King. In 2004, Larry King sold his $5 million life insurance policy for $850,000 in a life settlement transaction.34 He then came to realize that the transaction was not done in his best interests. Rather, his insurance broker Meltzer drove him into deals that were against his financial interests. In 2007, Larry King filed a lawsuit against Meltzer Group Insurance Brokerage saying he was underpaid and had little understanding of the complex transaction. The deal benefited Meltzer through large commission and was not in his financial interest. The lawsuit was then settled out of court.

This example suggests that even well-informed seniors can be misled into life settlements. Therefore, type 2 transactions are quite prevalent and need to be reduced. The projected life settlements market size of $21 billion in face value by 2012 should not be achieved.35 This is because as mentioned previously if $100 billion of impaired lapses are thought to be outstanding and further assuming a rather high normal lapse rate of 10%, would give $10 billion market of Type 1 transaction. Therefore the rest seems to be primarily Type 2 transactions and this needs to be reduced in the interest of policyholders.

Even more urgent task of regulators should be to stop abuses of life insurance brought about by the life settlements market. A practice called stranger-originated life insurance (STOLI) is one example of potentially worrying consequences of life settlements. Also known as speculator- initiated life insurance (SPIN-LIFE), this arrangement is initiated by strangers or investors who want to gamble on lives of people they are not related to. Instead of the policy applicant buying the policy with an initial intent to protect and benefit those with an insurable interest, it is initiated by strangers who want to benefit for their own investment purposes.

In a typical STOLI situation, an investment firm induces a particular wealthy senior to obtain life insurance. The investment firm would offer incentives to the insurance applicant such as free payments of premiums by the investment firm on the senior’s policy and additional cash

payment to the senior once the life insurance is initiated. Therefore the new senior policyholder has nothing to lose. His premium payments will be made by the investment firm plus he will get additional cash payment upfront, which is some percentage of the face value.

The investment firm fully finances the policy and pays the premiums. Two years into the contract, the investment firms would officially purchase the policy like life settlements and stand to profit from the death benefit of the senior when he dies. So why does the investment firm wait for two years to officially purchase the policy even though he makes all the payments? This is because state laws prevent life settlements transaction on policies less than two years old to prevent speculation and misuse of life insurance. However, the investment firms get around this law in various ways and initiate several STOLI polices.

STOLI presents several moral issues and questions the issue of insurable interest. Society is diminished when life insurance is used as a vehicle for gambling on human life rather than for social insurable purpose. There have been widespread reports of several STOLI originations by

investors and this should be worrying to society. State regulators and lawmakers should enact strong legislation that prevents such behavior. Several states have already taken action to prevent STOLI. However, more needs to be done to prevent such questionable behavior not only in some states but all states. The American Council of Life Insurers (ACLI), the Association for

Advanced Life Underwriting (AALU) and the National Association of Insurance and Financial Advisors (NAIFA) have all asked for stronger restrictions on STOLI like behavior.36 Strong legislation by lawmakers needs to be enacted sooner rather than later in all states.

But which agency should regulate? Is it the State Insurance Regulator, Attorney General of State, or the Consumer Protection Agencies? It seems that the insurance regulators in various states have started to look into the possibility of STOLI/SPIN-LIFE regulation but a lot needs to be achieved. In terms of education for policyholders and financial advisors to prevent Type 2 transactions, consumer protection agencies may be able to best address this situation. They need to make sure that marketing materials and life settlements brokers have strict disclosure

requirements. All the regulatory agencies need to sit down together and decide on how the responsibilities for regulating different issues with life settlements will be shared. In this way, there will be no gaps in regulation.

On the other hand, legitimate life settlements should not be restricted. They offer value to life policy owners who bought life insurance with an insurable interest, to benefit individuals,

families, businesses and employees, and whose circumstances may have changed such that they need to explore a life settlements transaction.

You may ask why don’t the life insurers out-compete the life settlements market by providing health dependent surrender values rather than fixed amounts? Such action would effectively put the life settlements firms at great financial risk. The life insurers would not do so

because of liquidity reasons and to prevent a run on life insurance companies. Life insurance firms invest premiums and hold assets that have long durations. If surrender values are increased to reflect the market value of the policy by providing health dependent surrender values, it would effectively make insurance companies like a bank, where you can withdraw at any time without significant penalties. In recessionary economic conditions like now, if the life insurers bought lapsed policies at market value, it may have caused a “run” on some of the life insurers as people would rush to get cash given rumors about the stability of some life insurers. It is therefore understandable as to why life insurance companies do not want and probably will not compete with life settlements firms.

Since insurance products have a long term horizon, life insurers may not feel the full impact of life settlements on their results any time soon. However, they need to start thinking and planning about possible long term implications to them. In this way, they can adjust pricing or underwriting standards for new policies, before it is too late. Therefore this paper analyzes the life settlements market and goes further to quantify the potential financial impact on life insurers.