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Why Life Settlements Are a Bad Idea.
What does life settlement mean?
A life settlement is the act of selling one's life insurance policy to a 3rd party, in exchange for an immediate lump-sum payment. The payment is much greater than the surrender amount offered by the life insurance company, but less than the face value of the policy.
It sounds great on the surface - sell your life insurance for immediate cash!
After all, it's not like you're going to get the death benefit while you're alive. But it's not quite as simple as that, and the person selling the policy must relinquish any control of determining the beneficiary.
Life settlements evolved from something called a viatical settlement. The viatical settlement industry grew in the 1980's out of the AIDS crisis. It was pitched as a way for AIDS patients to profit from their death before they died. Here's how...
Many AIDS patients had life insurance policies, but not enough money to pay for risky new treatments that could prolong their lives even a few months.
Enter a viatical settlement company. An agent for this company would offer to buy the patient's life insurance policy a fraction of the death benefit, say for 20-30%. In return, the patient gets a hefty chunk of money to pay for treatments, and the viatical settlement company gets the life insurance policy and the eventual death benefit when the patient died.
The viatical settlement industry essentially ended when new AIDS drugs were developed that extended a patient's life span by decades instead of months. Investors made much smaller returns, and patients didn't need the money for experimental treatments, so the investor money went elsewhere.
Growth of Life Settlement business.
Now there's a new demographic that needs to profit from their death before they die - the elderly. Many companies are preying on senior citizens with life insurance policies, high debt levels, and insufficient assets.
How a life settlement works.
Here's a very simple example to illustrate the concept of a life settlement.
Joe is 65 years old and in declining health. He has a $1 million life insurance policy that he bought when he was in good health. He's seen his retirement savings and net worth decimated by the decline in the housing market and the stock market crash of 2008. He needs money, and can't afford his premium payments.
Joe meets an agent from a life settlement company who offers to give him $300,000 today for his $1 million policy. That sounds pretty good to Joe, since the policy isn't doing him any good right now and selling it would solve his money problems.
Joe takes the money, and the agent takes the policy.
The life settlement company then resells the policy to another party, usually a pension fund or hedge fund. There, the wizards of Wall street work their magic and securitize (remember subprime loans?) them, i.e. package many individual policies together and sell shares of the total package to investors.
Flash forward 5 years and Joe passes away. At this point, the insurance company pays the beneficiary (i.e. the investors) the original death benefit of $1 million.
This leaves the investors with a profit of $700,000 (excluding taxes, and premium payments - simple example, remember?) over 5 years, or a return of about 46% per year.
That is a very simple example for illustration purposes, and it's one in which things worked out well for the investors. But there is a risk that Joe fares better than expected and lives longer. Simply put - the longer Joe lives, the less the investors earn.
Winners and losers.
Proponents in the industry, and salesmen say that life settlements are a A win-win situation for everyone, but is that really true?
- The insured (Joe in the example above). This is the original policy holder, and he actually does get to benefit from his life insurance policy before he dies. It costs him nothing, except perhaps taxes, and he gets an immediate payment.
- The investors. If Joe passes away in a timely fashion, the investors get big returns.
- The agents and brokers. All those life settlement agents and investment brokers get fees, and commissions regardless of the outcome.
- The insured (Joe in the example above). He's a loser if he ever wants life insurance again, because his original policy is still active but no longer owned by him. Maybe he marries a woman much younger than he is and wants to provide her with an income when he's dead and gone. He may not be able to do so. Technically he is still insured and may not be able buy another policy.
- Insurance companies. On the face of it, it looks like the insurance companies are losers in this deal. The policy holder who has made faithful premium payments for years and is suddenly not be able to afford those payments, has now just sold the policy to a group of investors who will make the remaining payments and receive the death benefit. So instead of a policy lapse where the insurer keeps the money, they have to pay out a death benefit because the policy holder is usually an investment bank, pension fund or hedge fund and is likely to be around long after the insured is deceased.
- Insurance consumers - You and I. The insurance companies don't actually lose too much because they pass the cost on to people like you and I who buy life insurance policies and don't sell them to a life settlement company. The insurance companies raise the premium costs, leaving everyone else to pay a little extra for those increased death benefits the insurers have to pay out.
- Family of the deceased. These are the true losers in this picture. In our example, if Joe had a wife or children who could have benefited from his insurance policy, they just lost it all to the investors.
Why it's a bad deal.
Life settlements can be beneficial for a small group of people - a person who has no beneficiaries or estate needs, no family and no charitable concerns. But such a person probably shouldn't have a life insurance policy anyway, since the purpose of life insurance is to replace one's income for those he leaves behind, or leave something for his estate.
It's also a bad deal for the general insurance buying public, as it contributes to added expenses for the insurance company and therefore increased premium costs for the buyer.
Another big reason life settlements are bad is that they encourage insurance fraud. They are unregulated, and hold the potential for very large returns. Because of this, it's given rise to something known as SOLI - "Stranger-Owned Life Insurance." SOLI is when a senior is encouraged by an unscrupulous broker to buy a life insurance policy with the sole intention of selling it.
This has led to much talk about investigation by attorneys general in many states.