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Be Wary Of ‘Life Settlement’ Transactions

Q:

My two partners and I built a successful business. The business held a large insurance policy on each partner’s life to buy out his interest in case of premature death. We recently sold the firm. Each partner took over the policy on his own life. I am in good health. I don’t need the coverage, and I don’t want to pay the premiums. I have been told that I can sell the policy to an investor for more than the policy’s cash surrender value. Should I consider this?

A:

It depends on many factors, but the biggest is this: Do you want a total stranger to be in a position to profit if you die prematurely? That is what will happen if you enter into a “life settlement,” as these transactions are called.

This is a fast-growing but controversial corner of the financial planning world. Insurance companies dislike these transactions because they have high potential for fraud (for example, a sick person is induced to hide her condition and apply for coverage that is then quickly transferred to an investor, who pays the premiums until the insured person dies) and for wagering on the lives of strangers. Insurance companies may also be financially vulnerable if they aggressively priced some products on the assumption that many policies would lapse before the insured persons died. Lapses would become unlikely if outside investors assumed responsibility for paying premiums.

Yet these transactions are being pitched relentlessly to lawyers, accountants and financial planners as being in clients’ best interest. Some speakers at professional conferences have even cautioned that it might be professional malpractice for an advisor not to tell a client who is considering surrendering a policy that he or she could consider a life settlement instead. I see so many potential problems with these transactions from both the insured person’s and the investor’s points of view that situations in which I would consider a life settlement will be very few and far between, particularly if the insured is in good health for his or her age.

For the insured, the deal-breaker (in my view) is that the sooner you die, the bigger the profit someone else stands to make. About three-quarters of the states regulate insurance policy sales in one form or another, but those laws don’t make me feel any better about this economic fact. Even if the initial purchaser is carefully screened, how do you prevent a policy from being resold to a person affiliated with domestic organized crime? Or to some “speculator” with an address in Belarus? This is a financial planning neighborhood I do not want to venture into.

Apart from any heightened risk of sudden “accidental” death, there are privacy considerations. No investor will buy a policy without looking over your health records. The investor is, after all, betting against the insurance company that you will die sooner rather than later. After the sale, the investor must keep tabs on you for the rest of your life, in order to know when to file a claim for death benefits. And if the investor wants to resell the policy, you will be asked to disclose your medical records all over again, though it is unclear under what circumstances you can be required to do so. If these reasons aren’t enough, numerous tax issues could give a prospective policy-seller pause. Still, I cannot say I would absolutely never consider a life settlement. There are some situations, particularly if the policy is new and has a low cash value, and the insured discovers a serious illness and needs cash, where it might make sense at least to evaluate the life settlement option.

I don’t like the economics of life settlements for investors, either. In the aggregate, buying insurance policies on healthy individuals is a zero-sum game. Some will die early, but others will have long lives. For an investor to reliably make abovemarket returns, the investor must be able to choose insureds who are going to die, on average, earlier than their normal life expectancies — preferably those who have recently bought policies and therefore have not accumulated large cash values. This is a risky undertaking. Imagine an investor who bought a policy on someone who had recently developed symptoms of HIV-AIDS in 1995. At that time, such a person might have been expected to live only a few more years at best. But in 1996 new cocktails of anti-HIV drugs hit the market. Life expectancy among HIV patients with access to these advanced treatments has increased rapidly since then. Great news for the patient who might have been able to afford these treatments after selling his life insurance policy. Bad news for the investor who bought it.

Answered by

Larry M. Elkin, CPA, CFP® December 2006

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