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Signs of a new leaf: the life settlement market shows signs of rebounding, but headwinds abound.

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Comparing the amount of life insurance policies that found their way into the secondary market in 2014 versus those sold in 2008 might lead one to conclude the life settlement industry has fallen on hard times.

In 2014--the last year that data was available--investors purchased approximately $1.7 billion worth of U.S. life insurance face values, considerably less than the $11.7 billion purchased during the 2008 heyday of the life settlement industry, according to Conning. After the financial crisis, a number of large institutional investors abandoned the market and the industry has struggled since then to find its footing.

But recently there have been signs that the secondary life market is rebounding, as investors increasingly see it as an uncorrelated asset class that delivers better than average returns in a low interest environment. In its recent report, Life Settlements and Secondary Market Annuities: Opportunities and Challenges, Conning forecasted that the average annual gross market potential for life settlements over the period of 2015 through 2024 will be approximately $182 billion.

What works in the industry's favor are demographic trends, an improved regulatory environment and recent legislative actions that facilitate the possibility of life insurance policy sales to third-party brokers.

The main demographic trend--that baby boomers are aging--complements the industry's value proposition that selling an unwanted life insurance policy is a better option than lapsing or surrendering the policy.

"Life settlements are one option for the number of baby boomers who are moving into older ages and are looking to generate some form of retirement income. As you have more people entering the potential secondary market, they'll be exposed to the concept and be thinking about it," said Scott Hawkins, director, insurance research at Conning.

The target market for life settlements are those who own life insurance policies they no longer need or would rather replace with an infusion of cash.

"Policy lapses in this group are very significant," said Darwin Bayston, president and CEO of the Life Insurance Settlement Association (LISA). "People over the age of 65 have about $2.5 trillion in face value policies or somewhere in the neighborhood of 42 million policies. Of that group, about $112 billion in face value policies, representing a little over a million policies, lapse each year."

The regulatory and legislative climate for life settlements has improved.

As of 2014,42 states and the territory of Puerto Rico regulate life settlements, affording approximately 90% of the United States population protection under comprehensive life settlement laws and regulations. Five states now require life insurers to disclose the life settlement option to policyholders. And Texas and Kentucky have passed Medicaid Life Settlement bills, allowing individuals to use life settlement proceeds to fund Medicaid fund long-term expenses, according to LISA.

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Despite these favorable developments, there are a number of reasons that the market may not grow beyond its current size. These include relatively low levels of capital investment, reputational risk, lack of market transparency and lack of consumer awareness.

"Despite this positive environment, the inability to re-attract capital to pre-2009 levels remains a persistent challenge for the life settlement industry. Unless investors commit higher levels of capital, annual volumes are likely to remain well below pre-crisis highs.

As a result, new settlements will not be sufficient to offset the decrease of in force life settlements as the large block of older policies files death claims," according to the Conning report on the industry.

"Supply is quite limited," said Emmanuel Modu, managing director and global head of insurance-linked securities at A.M.Best. "Research I've seen shows that at one point the annual origination of life settlements was about $12 billion in face value. But I think right now life settlement origination is probably below $3 billion a year. And I think part of that change was because prior to 2009, there was a boom in premium financed policies where insureds borrowed money to pay their insurance premiums. The supply of policies was artificially boosted by this phenomenon, which some people pejoratively called STOLI (stranger-originated life insurance). For the most part, such policies are no longer being sold in the secondary market."

The STOLI phenomena is linked to another obstacle that might inhibit widespread expansion of the life settlement industry: reputational risk. The industry still suffers from effects of the profusion of bad actors that were present in its early days, when some investors enticed some elderly consumers to buy and then sell them their policies.

"The reputational risk factor exists for two reasons. Some people find it unseemly to buy a life insurance policy and certainly some of the media in the early days fed into that reputation, calling them 'death bonds,'" Hawkins said.

Litigation Matters

"At the same time, the industry did itself no good favor by being targeted by Ponzi schemes or other fraudulent groups that created funds and took investor money and then disappeared. There were several of those over the course of the industry's history that were very noticeable and attracted press and regulatory attention and that added to a perception among investors that this is a less desirable asset class," Hawkins said.

There's also been a profusion of litigation involving the life settlement industry, basically falling within two categories: lawsuits between insurance companies and investors over settlements or claims, and lawsuits by investors in a particular life settlement fund against fund organizers over misrepresentation or fraud.

"This goes back to the headwind around reputational risk. If you were a new investor and you were looking at this, seeing these lawsuits might raise some level of concern and may discourage you or may lead you to dive into it more and decide, hey," I understand what's going on here and I will continue to pursue this asset class.' But it's a reputational headwind that they face," Hawkins said.

Two recent lawsuits are illustrative:

Earlier this year, American International Group Inc. reached a settlement resolving a $2 billion lawsuit in which it accused Coventry First LLC, a Philadelphia-area life settlement firm, of "an egregious criminal scheme" aimed at defrauding it out of hundreds of millions of dollars by overcharging it for life insurance policies acquired from the elderly. As part of the deal, AIG's Lavastone Capital affiliate can transfer Coventry's servicing of AIG's life settlements portfolio to another party. The deal also allows AIG's unit to freely sell policies that were originated by Coventry.

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Also this year, long-running litigation involving Life Partners, Inc. which billed itself as "the oldest life settlement company in the world," showed signs of nearing conclusion. In that case, life settlement investors alleged they were defrauded about the value of life settlement policies they purchased through the Waco, Texas-based company.

Life Partners "bought large policies and chopped them into pieces to be able to sell them to mom and pop investors," said Jim Orr, a partner of the Irving, Texas-based law firm Heygood, Orr & Pearson, which represents allegedly defrauded investors. The U.S. Securities and Exchange Commission also filed a suit against the company, alleging it had misled investors by underestimating the life expectancies of those insured.

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"What happened was that they would buy the policies based on life expectancy reports issued by major, regularly used life expectancy companies. And then they would get a new life expectancy from a doctor in Nevada that basically only worked for them. And the new life expectancies would be shorter. If the life expectancy is shorter, the person is going to die sooner and you're not going to pay as much in premiums and that would make the policy appear more valuable to investors," Orr explained.

After a federal judge imposed a $46 million judgment against the company, Life Partners Holdings Inc. and its subsidiaries Life Partners Inc. and LPI Financial Services Inc. filed for bankruptcy protection early last year. The court appointed a bankruptcy trustee who filed a series of plans for reorganization and last April a range of lawsuits aimed at recovering money for investors. "The Life Partners fraud deserves a place in Texas history as one of the largest and longest-standing fraud schemes ever perpetrated in this state," the trustee said.

In addition to fraud, Orr believes the high incidence of life settlement litigation is caused by inconsistent state laws and regulations and the fact that some parties have much greater knowledge of the industry than others. And the parties with greater knowledge may be able to take advantage of the parties with lesser knowledge.

"Any time, there's a lot of money involved that can produce lawsuits. You also have inconsistent regulation, and to some extent lack of regulation. And the regulations and laws differ from state to State and that can produce litigation because it makes it more difficult to comply with applicable laws," he said.

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Model acts propagated by the National Conference of Insurance Legislators and the National Association of Insurance Commissioners are used by states to draft regional laws.

"Most states have a law covering life settlements, but there is a great deal of variance in their provisions," Orr said.

"For example, in New York, a policy cannot be sold except through a licensed life settlement provider. But if someone didn't know that, and they purchased or sold a policy in New York without going through a licensed life settlement provider, that could potentially produce litigation. As another example, in Minnesota, you have to wait four years after applying for a policy before you can sell it as a life settlement."

Much the same situation exists for the handful of state laws that require states to inform policyholders of the life settlement option. The laws differ in how they define what triggers the insurance carrier's duty to notify the policyholder of his or her right to sell, according to Orr.

"For example, I know of at least one state where if the insured reaches the age of 60, they need to be notified of their right to sell their policy as a life settlement. Other laws say that if the insured has a terminal illness they must be notified. Other laws say that if the insurance company receives a notice of a request to surrender the policy for the cash value, that triggers the insurance company's duty to notify the policyholder of their right," he said.

Even the most questionable transactions that occurred during the era when STOLI transactions were prevalent can be valid under the law of some states, but invalid in other states.

"I think in the time period of roughly 2005 to 2008, there were probably a lot of policies that were taken out with the intent of selling them as a life settlement," Orr said. "Now in some states, a policy is void for lack of insurable interest if there was no intent to keep the policy. In other states, that would not void the policy. In other states, the carrier cannot attack the policy after two years for any reason, including lack of insurable interest. In other states, even if you had no intent to keep the policy for legitimate life insurance purposes, as long as there was no third party investor who had already agreed to buy the policy and who was paying the premiums on the policy, then the policy is still good."

"I think today there are much, much fewer policies being applied solely for the purpose of selling them as life settlements. Now, does it happen? I'm sure it does, but I think it's much less prevalent than it used to be," Orr said.

Bayston believes that these egregious incidents of fraud are largely a thing of the past.

"I think during what would be 2006-2008, when we had all these premium finance policies going on and the whole STOLI thing occurred, there were just an awful lot of lawsuits that came out. But in terms of actual consumer complaints by the NAIC, there have been hardly any in the last three or four years. The lawsuits that are out there are something of a carryover from any number of years before. Those are just going to drag on and they are going to be clouds until they aren't there anymore. But I think there's less of that kind of activity now than there has been for quite some time," he said.

Lauren Cohen, a Harvard Business School professor of finance who has studied the life settlement industry, believes that one of main challenges confronting the industry is lack of transparency.

"Transparency is not great in this market and so it's difficult to determine the price of these transactions, the actual returns that investors are going to receive, and the returns that an end policy owner receives as opposed to what's received by the brokers or life settlement providers or investors. So it's a very intermediated market and I think an inefficiently intermediated market right now.

"Although this is a sizable problem, the good news is that we can solve it and create better incentives that will align the end users or investors and policyholders. With more transparency, maybe we don't need as much intermediation," he said.

Bayston believes the main thing holding the industry back is lack of consumer familiarity.

"More than half of seniors have lapsed a policy at some point in time and 90% of them say,' if I'd have known about life settlements, at least I would have explored it.' Nearly 80% of them feel that their financial adviser should have informed them about it. But then on the other side of it, nearly half of the financial advisers say 'the reason we don't inform them is because we don't understand them either. 'There's a huge education need.

"I think the headwinds are probably of our own making. Our biggest challenges are getting the word out and educating legislators and regulators on the value of this for consumers."

Key Points

The Overview: The life settlement industry is showing signs of rebounding as investors increasingly see it as an uncorrelated asset class that delivers better than average returns in a low interest rate environment.

The Tailwinds: Demographic trends, an improved regulatory environment and recent legislative actions make selling a life insurance policy an easier process.

The Headwinds: Relatively low levels of capital investment, reputational risk, lack of market transparency and lack of consumer awareness stem growth in the life settlement market.

Angelo John Lewis is a senior associate editor. He can be reached at angelo.lewis@ambest.com.
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Title Annotation:Life Insurance
Author:Lewis, Angelo John
Publication:Best's Review
Date:Jun 1, 2016
Words:2417
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