Policy for sale: the growth of life settlement sales is beginning to impact life insurance actuarial assumptions.

The growth in the life insurance secondary market, namely life settlements, is causing concern for life insurers, with experts saying life settlement transactions "distort" years of pricing assumptions life insurers have made on policies.

But one life settlement company's chief executive officer says that concern, and others, aren't warranted. A slow-moving insurance industry must recognize life settlements offer increased options for consumers with changing financial needs in an ever-evolving financial services market, he said.

A life settlement, as defined by A.M. Best Co., is an insurance policy sold by its owner--typically the insured or a trust--for an amount greater than the surrender value of the policy but lower than the face amount of the policy. The purchaser of the life settlement becomes the new owner and beneficiary of the life insurance policy and is responsible for making future premium payments and collecting the death benefits of the insured.

The life settlement market is an outgrowth of the viatical settlement market in which policies of the terminally ill are bought and sold. In the life-settlement market, however, insureds are enerally 65 years or older, with medical impairments resulting in shortened life expectancies, according to A.M. Best.

The life settlement market has experienced "enormous growth," said Alan Buerger, chief executive officer of Coventry First, a Fort Washington, Pa.-based life settlement company that caters to institutional, not individual, investors. Coventry First bought about $1.9 billion in face value of life insurance in 2004, he said. "No company prior to two years ago ... had ever purchased more than $1 billion in a year," he said.

The total life settlement market in 2004 was about $6 billion of face value, Buerger estimates. "The market is growing ... there are so many new companies coming in," he said.

One skeptic, though, on the size of the market is Joseph M. Belth, professor emeritus of insurance at Indiana University and editor of Insurance Forum. "All of the promoters seem to think this is a huge market," he said. "But I don't know anything about the size of the market until I see sworn statements from state regulators or some regulator. There are none."

According to Buerger, those who may benefit from life settlements are an insured whose beneficiary has died; a policyholder whose premiums have become unaffordable; a policyholder with a poorly performing policy; and those with decreased estate values. Those who have divorced or entered bankruptcy also may benefit.

However, among the big concerns the life insurance industry has with life settlements is the lack of "insurable interest," which lends itself to fraud, said Belth. "The person who transfers his policy to a life settlement firm, transfers his policy to an entity that does not have an insurable interest in the life of the insured," he said. "In fact, they have just the opposite. They have a financial interest in the death of the insured--the sooner the better."

Coventry First's Buerger took issue with that statement. "Let's say a life insurance company sold an annuity where the annuitant receives an income for the balance of their life," Buerger said. "The life insurance company makes more profit the sooner the annuitant dies because the insurance company stops making payments."

But the bottom line is that life settlements have provided additional options for consumers, Buerger said.

"The insurance industry is frequently slow to embrace new ideas," he said. "For example, when I started in my career ... if a life insurance agent got licensed to sell mutual funds, they were considered unethical and were immediately terminated by the life company.

"It's hard to imagine today, given that they all own mutual fund groups, that they are all in the equities business for their producers," Buerger said.

Another major concern for life insurers, say some--but not all--is that life settlements are cutting into the industry's profits.

A mid-2003 study by Conning Research & Consulting Inc. showed that while it is beneficial to policyholders to have the option that life settlements present, the life settlement industry produced double-digit growth rates that began to impact the bottom line for life insurers, which hadn't planned for the impact on their profits.

Manfred Nowacki, group vice president of the life/health division at A.M. Best Co., said life insurers make certain assumptions when they sell policies. "The industry assumes that so many policies will lapse each year and so many policyholders will die each year," he said. "And when ... these settlement companies get involved, it distorts all of a life company's assumptions, and it could impact the results of the insurer if enough policies are involved."

Life settlements threaten the life industry in several ways, said Stephen C. Baker, an attorney who represents life insurers and who leads the insurance practice at Drinker Biddle in Philadelphia. "It turns a lot of the financial assumptions about life insurance on their head," he said, noting that life settlements cause policies that otherwise would lapse, not to lapse.

For example, a 70-year-old, with the children grown and college paid for, may reach a point at which "a big term life policy" no longer is needed. "That's the point at which classically, these policies go out of force," Baker said, adding that many life settlements don't involve people who are ill. "The pricing for this insured, and all the other insureds, takes into account that there is going to be a lot of policies that don't ever pay death benefits--not for any other reason other than the fact that these insureds live, and don't die with the policy in force.

"It is entirely possible that decades worth of actuarial assumptions will turn out to have been wrong," Baker said.

But the concern has "nothing to do with threatening our price assumptions," said John Skar, senior vice president and chief actuary with Massachusetts Mutual Life Insurance Co. Rather, "consumers are unaware of how much estate value is being lost" through life settlement transactions, he said.

The life settlement industry always contends that the consumer/policyholder often can get much more than the policy's cash value by selling the contract, noted Skar. "They say that selling the policy is better than lapsing it. This is true, but that misses the real point," he said.

"The important point is that the real, economic value of these policies is much higher than that life settlement value," Skar said. His opinion is that life companies want policyholders to retain their policies, not lapse them.

The life insurance policy is a financial asset, like a house, or stocks or bonds, he said. When they are sold, there are transaction costs, Skar said. With a house, for example, the transaction cost may be 4% to 6%, while transaction costs for stocks and bonds may be 1% to 2%, he said.

With life settlements, the cost exceeds 50% of the "true economic value" of the policy, Skar said. "Let's say that you were planning to leave your house to your children at your death," Skar said. "Someone comes along and says, 'I will offer to buy your house for 50% of its true value. You won't have to pay the mortgage costs anymore.'

"You might call your children up and ask them to take over the mortgage payments, rather than sell it to a stranger for 50% of value," Skar said.

Tax Treatment

Another concern for life insurers is that currently, life insurance receives "favorable tax treatment" as an investment and financial product because Congress and state legislatures believe that it's based on the legitimate purpose of protecting an insurable interest, Baker said.

"If life insurance can be traded like some commodity, disconnected from an insurable interest, if people aren't careful, they are going to find that they've killed the goose that lays the golden eggs," Baker said. Put another way, "if Congress or state legislatures would begin to feel that life insurance was being misused for financial gain, and not being used as a technique to protect people with insurable interests, I think you would find that Congress might move in the direction of eliminating some of the favorable tax treatment of life insurance," he warned.

Jack Dolan, a spokesman for the American Council of Life Insurers, said his group believes that before you "relinquish interest in your life insurance policy, talk to your life insurance agent or insurance company; see if the policy has options that can address your financial needs," Dolan said. "Also ensure you are prepared for any potential tax consequences associated with selling your policy."

Meanwhile, David Woods, chief executive officer of the National Association of Insurance and Financial Advisors, said NAIFA doesn't oppose life settlements but favors a specific license for agents who engage in life-settlement transactions. Agents must be licensed to sell life insurance, he said. "That same license in most states gives them the opportunity to also engage in a life settlement transaction. We think there should be an additional license required."

Finally, Belth noted the "rather extensive record of fraud engaged in by people in the secondary market" as another concern, but he added that life settlement and viatical companies, the latter of which are "drying up," have worked to address the once-rampant fraud, but more needs to be done.

Fraud "is not dissimilar to bad actors in any business," Buerger said. And Coventry First is "aggressively pursuing" efforts to see that the secondary market is regulated in every state, he said, noting that about 20 states currently regulate the industry.

Learn More

Massachusetts Mutual Life Insurance Co.

(Member of MassMutual Financial Group)

A.M. Best Company # 06695

Distribution: Career agents, banks, broker/dealers, banks and wirehouses

For ratings and other financial strength information about this company, visit www.ambest.com.

Key Points

* The life settlement industry is producing double-digit growth rates that are beginning to impact life insurers' bottom lines.

* In the life-settlement market, insureds are generally 65 years or older, with medical impairments resulting in shortened life expectancies.

* Life insurers are concerned that because of life policies sales, legislators may begin to view life insurance as a commodity and it will lose its favorable tax treatment.

The Life Insurance Secondary Market

Among the 28 states, plus Washington, D.C., that responded to NCOIL'S 2003 market survey, 19 had some law in place governing life settlements or viaticals.

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Reasons to Sell an Insurance Policy

* Premiums paid by the policyholder have become unaffordable and the policy is in danger of lapsing;

* Estate planning needs of the insured have changed significantly;

* Funds are needed for long-term health care;

* Beneficiary has changed because of death or divorce;

* Disposal of unneeded "key-man" insurance or other business-owned insurance;

* Fund new annuities, life insurance or investments;

* Satisfy the need for cash in a forced liquidation due to bankruptcy or financial difficulties;

* Liquidate policies donated to not-for-profits; or

* Dispose of policies that no longer are needed or wanted for a variety of other reasons.

Source: A.M. Best Rating Methodology, "Life Settlement Securitization"