Selling your life insurance policy is right up there with taking out a reverse mortgage when it comes to retirement income sources that most people would be better off not tapping. But folks do it anyway, while paying little attention to the costs and, as a new novel points out, the risks of a policy landing in the wrong hands.
Selling a life policy for a relatively large sum—known as a life settlement—has gotten easier over the last decade. Hedge funds, private equity funds, insurers and pension funds dominate the market, which totals around $35 billion, up from $2 billion in 2002. Individuals are investing in them too, through securities that represent a fraction of a bundle of life settlements, sometimes called death bonds.
How Life Settlements Work
Those most likely to be offered a life settlement, formerly known as a viatical, are individuals with a universal life insurance policy they no longer need or can’t afford—or who simply don’t want to pay the premiums. A term life policy that converts to a universal policy may also have value. Policyholders sell their insurance for more than they’d get by surrendering the policy to their insurer. If you have a death benefit of $1 million, you might have $100,000 cash surrender value but manage to get $250,000 from a third-party investor. The investor assumes future premium payments and collects $1 million at your death.
Not a bad deal, assuming you're comfortable with the fact that someone out there has a financial interest in your demise. You get a bigger payout for a policy you were going to give up anyway. Life policies with total face value in the tens of billions of dollars lapse every year, according to industry estimates. Many of those policies have value in the secondary market.
As part of their ad campaign, the life settlement industry has enlisted actress Betty White, who pitches these deals for “savvy senior citizens needing cash.” Heck, she’s more persuasive than Fred Thompson is about reverse mortgages. But don’t be easily swayed. Aging celebrities from Henry Winkler to Sally Field are pitching all sorts of elder products these days in what amounts to an encore career—not a genuine endorsement.
The Privacy Risk
Okay, so what are the downsides to life settlements? For policyholders seeking to raise money, the creepiest risk by far is that you sell your policy to Tony Soprano, who understands that the quicker you die, the greater his rate of return. This is the extreme case explored in a new novel by Ben Lieberman, The Carnage Account. The lead character is a Wall Street high roller who buys up life settlements and dispatches the people with the biggest policies. “Very few products on Wall Street have been immune to exploitation,” says Lieberman, noting the wave of subprime mortgages that blew up in the financial crisis. “The abuse can now hurt more than your property. Instead of losing your house you can lose your life.”
Of course, Lieberman is a novelist with an active imagination. Life settlements have been around since the AIDS crisis, and there has never been a known case of murder for quick payoff, says Darwin Bayston, CEO and president of the Life Insurance Settlement Association. There have been only three formal complaints of any kind about life settlements to national regulators in the last three years, he says.
Yet Lieberman, who has a long Wall Street background, finds the entry of cutthroat hedge fund managers more than a little unsettling. Policies with insurers or held by pension funds remain largely anonymous inside huge portfolios. Institutions base their settlement offers on average life expectancies, knowing some policies will pay early and some will pay late.
But in smaller and more actively managed pools investors may pick and choose life policies that promise a quicker payoff, based on things like depression and mental illness, or clues from medical staff as to the most “valuable” policies. Life settlement investors are also targeting an estimated $40 billion of death benefits that policyholders might sell to fund long-term care needs, spinning it as socially conscious investing. How else will these seniors pay for end-of-life care? “Instead of credit risk or prepayment risk we now evaluate longevity risk,” Lieberman says. “This began as a way to help terminally ill patients. Now it incorporates perfectly healthy people and presents a way to bet against human life.”
One former life settlements investor told me he has seen third-party portfolios of life policies fully disclosing the names of the insured parties, which is the basis for the success of Lieberman’s fictional Carnage Account. In his novel, a murderous hedge fund manager gets this information and speeds up the whole process. Again, that’s fiction. But even Bayston concedes that a determined life settlements investor could get the identities of the insured people whose long lives are bad for investment returns.
The Financial Risks
Now, let’s look at the non-fiction risks with life settlements. For sellers, they are considerable, and include giving up your policy too cheaply and paying dearly for the transaction, and possibly becoming ineligible to buy another policy. Always check the cash surrender value first. Do not be swayed by brokers putting on a hard sale. They stand to collect commissions of up to 30% of the settlement. If you are determined to quit paying premiums, rather than sell the policy consider letting the cash value fund future premiums until the cash is exhausted. That’s a much better deal for heirs if you pass away in the interim. You can sell the policy when the cash value has been depleted—and get more for it then.
For buyers, settlements are complex and illiquid, and they may not pay out for many years. Given these hidden risks, they generally do not make sense for individual investors. Wall Street, meanwhile, benefits from their huge fees and expected long-run annual returns of 12% or more. Perhaps more important, settlements offer returns with no correlation to the financial market, which can be attractive to sophisticated investors and institutions, such as pension funds.
The life settlements industry has leveled off since the financial crisis, in large part because policies are taking longer to pay, thanks to increasing longevity. That drives down returns. Underscoring this risk to investors: the Society of Actuaries recently published revised mortality rates showing that a 65-year-old can now expect to live two years longer than someone that age just 14 years ago. But investors have been edging back into the market the last couple years, drawn by more realistic return assumptions and an anticipated flood of life policies held by boomers who will need cash to pay for assisted living.
Only in a novel do life settlements investors manage longevity risk with a hit man. But there are good reasons to be careful nonetheless.