As more baby boomers retire, opportunities are growing for registered reps to sell life insurance policies directly to life settlement companies, cutting out life insurance settlement brokerage firms. Financial advisors and brokers typically get a much nicer chunk of the enormous commissions on the products—which can go as high as 30 percent of the policy purchase price—when they act as the broker on these deals.
Sales in this industry have grown to $15 billion in 2007 from $5 billion in 2002, according to Douglas Head, executive director of the Orlando, Fla.-based Life Insurance Settlement Association. Head projects annual sales to grow even more over the next 10 years.
Why? Institutional investors and hedge funds are expected to aggressively invest in life settlement pools as cash-strapped baby boomers sell off their life insurance policies to fund retirement, say industry observers. “The life settlement transactions could grow to $100 billion annually as baby boomers seek to supplement their retirement income,” says Head, whose association represents 184 life settlement companies.
Life settlements grew out of the viatical settlement business, which launched in the 1980s when AIDS patients who were desperate for cash began selling their life insurance policies to investors for upfront payment. Both viatical and life settlements involve the sale of an insurance policy to a third party for more than the cash-surrender value of the policy, but less than the death benefit. But life settlements tend to be less predatory than viaticals. Life settlements typically involve policyholders who have 10 years to 15 years of life expectancy; viaticals tend to involve policyholders who are terminally ill and have less than two years to live.
Today, there are too many boomers out there with inadequate savings for a 30-year retirement. For some of them, a life insurance policy is their largest untapped asset. Or, perhaps their life insurance needs have changed, and the old policy is no longer adequate. For these clients, a life settlement might be the best bet.
Life settlements are particularly attractive for older clients who are short on funds. Say a 70-year-old male with a $1 million life insurance policy needs extra cash for retirement. You might sell his $1 million policy for a net $156,000 to a life insurance settlement brokerage firm, like Chesapeake Financial Settlements, for example. Or, you might broker a deal with a life settlement provider directly.
Already, over the past five years, life settlement companies have paid out more than $340 million to individuals, according to a study by Neil Doherty, finance professor at Wharton, University of Pennsylvania.
Of more than $30 billion in face amounts of life insurance that have been sold since 2002, nearly 90 percent represented underperforming universal life insurance policies. Universal life insurance pays current rates of interest and permits flexible premium payments. However, when interest rates decline, cash values don’t grow as much. So policyholders must kick in extra premiums to keep their policies in force.
“You rarely see whole life insurance or variable universal life insurance—which invests cash value in mutual funds—sold,” Head says. “The cash value growth in these policies is strong.”
Danger Zone: STOLI
The remaining 10 percent of life insurance sales involved viatical settlements or Stranger Owned Life Insurance Transactions (STOLI, for short), Head says. In STOLI transactions, an individual buys a life insurance policy for the purpose of selling the policy on the secondary market for a quick profit.
Viatical settlements and sales of insurance policies purchased in good faith for financial reasons are considered legitimate transactions in most states that have adopted the National Association of Insurance Commissioners Model Viatical Settlement laws. However, more states are adopting stiff legislation to prevent abuses in Stranger Originated Life Insurance.
With STOLI, a senior purchases a life insurance policy and sells it to a third party or settlement company, which typically pays the premiums. The third party investor in the life insurance policy profits by collecting the death benefit once the elderly policyholder dies.
STOLI arrangements typically involve premium financing and/or deceptive trust arrangements, often used to cover up the future sale of the policy to a third party. For example, last Jan. 22, a New York-based U.S. District Court judge denied a settlement company a $10 million death benefit on grounds that the company was essentially “wagering” on a 77-year-old man’s life.
The retiree had set up a trust naming himself as the initial beneficiary. The next day, he applied for a $10 million life insurance policy and designated the trust as the sole beneficiary. Six days later, the retiree sold his interest in the trust and the rights to the insurance proceeds upon his death to a settlement company for $300,000. Five days later, he died.
California adopted legislation last August to prohibit STOLI transactions. Florida’s insurance department has been conducting hearings on the improper use of life settlements, while New York is expecting to adopt legislation the first of next year.
Twelve states this year adopted laws based on model regulations of the NAIC and National Conference of Insurance Legislators (NCOIL). Some states are using a combination of both models to limit STOLIs.
“STOLI schemes are a violation of the law and insurance companies are against it,” warns Steve Brostoff, spokesperson for the American Council of Life Insurers, Washington, D.C. “There is a lot of litigation going on involving STOLI schemes.”
STOLI transactions are problematic for both the insurance companies and state insurance regulators. Insurance companies, in part, determine policyholder premiums, based on about a 6-percent-policy lapse rate. Because third-party investors hold on to policies to collect the death benefits, lapse rates decline. This increases insurance company costs. The costs are passed on to new policyholders in the form of higher premiums.
Regulators and insurers also agree that STOLI transactions violate “insurable interest” laws, which typically prohibit the purchase of insurance if the buyer has no risk of loss.
California Insurance Commissioner Steve Poizner says life insurance settlements can be a favorable way for a senior to access the death benefit of a policy for which he or she no longer has a good economic need. “The problem,” he says, “lies in STOLIs, which involve investors soliciting the original purchaser of life insurance for the sole purpose of an eventual sale.”
The majority of states—including Arizona, Oklahoma, Ohio, Maine, Connecticut and Hawaii—use the National Conference of Insurance Legislators Life Settlement Model Act, which focuses on STOLI sales abuses. The New York insurance department says its legislation likely will have more disclosure requirements than the NCOIL rules.
Meanwhile, recent amendments to the NAIC Viatical Settlement Model Act prohibit the sale of a life insurance policy until five years after its purchase—except in the case of terminal illness. West Virginia and Nebraska have already adopted this rule.
NCOIL rules require a two-year moratorium on life settlements—the same as the contestability period required by insurance companies.
NCOIL rules define a STOLI and limit marketing and advertising. They also make engaging in STOLI schemes such as masked trust arrangements and premium financed loans, fraudulent activities.
Under the rules, life settlement providers must report STOLI data annually to state insurance regulators, so that it can be determined if providers are initiating policies for the purpose of settling them.
The NCOIL STOLI act provides that a person who commits a fraudulent life settlement act is guilty of committing insurance fraud, and subject to civil and criminal penalties.
In situations involving premium financing, insurers must advise applicants of the adverse consequences that might result from the later settlement of the policy. Insurance companies are also permitted to require the applicant to certify that he or she has not entered into any agreement or arrangement providing for the future sale of the life insurance policy.
Third parties are prohibited from receiving any proceeds or consideration from the policy or policy owner that are in addition to the amounts required to pay the principal, interest and service charges pursuant to the premium finance agreement.
Steven Weisbart, Ph.D., insurance specialist with the Insurance Information Institute, New York, warns that life settlements can create problems for individuals who go into a nursing home. If they run out of money to pay for nursing home coverage, they could be denied Medicaid because they assigned their insurance policy to a third party.
It’s important to advise a client that the cash received from a life settlement is taxable income, he stresses. So a financial advisor should first check to see if there are other less costly alternatives than a life settlement.
A policyholder may be able to borrow against the cash value of the policy. Or, he or she might be eligible for accelerated death benefits for serious illnesses. Many of today’s policies come with long-term care riders. Weisbart says a client also needs to be reassured that his or her personal information is confidential and protected.