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They Bet Your Life On It

I often receive phone calls that begin like this: “Hello, Mr. Elkin? I’m Bill Friendly. How are you today?”

I assume Mr. Friendly is just being polite, and that he is not interested in the details of my recent medical history. I make this assumption because, outside my immediate circle of family, friends, colleagues, clients and acquaintances, nobody has much reason to care about my health.

But suppose I let a stranger, or a group of strangers, buy a very large insurance policy on my life. From that point on, every cheerful “How’re you doing?” would, to my ears, sound more like an eager, “Are you going to die soon?”

Welcome to the world of “life settlements.” Proceed at your own risk.

In life settlement transactions, an individual typically sells an insurance policy on his own life or on the life of a loved one to a third-party investor. The investor becomes responsible for paying premiums and then pockets the proceeds when the insured person dies.

While the insurance company wants the insured individual to live longer than average, investors who hold insurance policies on strangers hope those strangers will die sooner rather than later. We usually assume that our spouses, children or other close relatives who might benefit from life insurance payouts are not going to actively root for our early demise. I would not take that for granted in the case of a stranger.

Investors who buy insurance policies on strangers take risks, too. One is that the insured stranger may live to an extremely old age. Another is that, due to insurer insolvency or some other future legal or financial development, the expected payout may never come to pass.

A pending case in New York shows how the rules of the game can abruptly change. Prior to his death, prominent attorney Arthur Kramer took out seven policies, totaling $56.2 million, on his own life. The policies were quickly sold to investors, bringing in large lump sums for Kramer. When Kramer died in January 2008, the investors were ready to collect their reward. But Alice Kramer, Arthur Kramer’s widow, sued, saying that in fact she should receive the money. The sale of the policies should never have been permitted, she said.

While New York allows life insurance policies that have already been issued to be sold to anyone, it prohibits third parties from taking out policies on strangers or casual acquaintances. To take out a policy on someone, you must have an “insurable interest” in that person’s life. Alice Kramer argued that, since the sale of her husband’s policies occurred so quickly after their purchase, the policies were, in effect, taken out by the investors, violating New York law.

Regardless of how the Kramer case is resolved, the high stakes will likely draw renewed attention to life settlements. Not many deals have been completed since the financial markets froze in late 2008, but that could change in the future. Life settlements are still being promoted, and they might come back into fashion.

The basic problem with life settlements is that, in theory, they should not work reliably to anyone’s benefit. Insurance companies do not have a magic printing press to produce money. They insure many lives, knowing that some will be very short, some will be very long, and most will be about average. An insurance company expects to earn a conservative return on invested premiums, and knows it will pay sales commissions and many other expenses. The death benefit is what is left after those expenses are paid from the premiums the insurance company invests. Death benefits are not necessarily a bad return, especially since in most cases the benefits aren’t subject to income tax, but the returns are not spectacular unless the insured dies at an early age.

Most life settlements trigger a “transfer for value” tax rule that makes the insurance death benefit taxable. That means, up front, the economics of an insurance policy are worse for the investor than for the policy’s original owner. Not a promising start for an investment.

Hedge funds or other investment pools that spread their risks by buying multiple policies should, therefore, expect sub-par returns. But hedge funds do not exist to generate sub-par returns, do they?

So life settlement transactions are an invitation to fraud, which is one reason why insurance companies detest them. Insured individuals who seek the quick sale of a policy, or agents who get big up-front commissions, have incentives to hide unfavorable details about the insured person’s health or finances while applying for coverage. (Insurance companies have noticed that people who are in financial trouble tend to die sooner than people who are not.) In most states, once a policy is more than two years old it is “incontestable,” which prevents the insurer from backing out if it finds it has been defrauded.

Investors who put money into these deals can be hoodwinked, too. They may be given misleading details about the insured individuals’ ages or health. In extreme cases, the premiums on the policies become so steep as the insured gets older that the policy is allowed to lapse, rendering the investment worthless.

Arthur Kramer may have been very happy with his life settlement, but that does not mean it was a good transaction. I find the entire business so distasteful that I doubt I would ever recommend that a client participate, on either end of the bargain.

When strangers ask me how I’m doing, I want to be able to assume that they are merely being polite.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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