Betting on Death: Life Settlements Flourish on Wall Street

When Wall Street first began securitizing mortgages--that is, packaging them together and trading them like so many pork belly futures--it seemed like a really good idea.

And for a while it was -- until recently, when folks got greedy and things went awry. Call it the law of unintended consequences.

The same law might be applied to life settlements, newly popular financial instruments created by the sale of life insurance policies to packagers who then bundle the policies into securities that are sold like any other investment product.

Click here to read In English, Please: The History Behind Betting on Life

In the 1980s, life settlements, then referred to as viatical settlements, emerged as a way of allowing terminally ill patients--often those suffering from AIDS -- to cash in on their life insurance policies. The money obtained by selling a policy was frequently used to pay health care bills.

Smelling a profit, Wall Street in recent years has jumped into the game in a big way. The explosive growth following Wall Street’s entrance has given rise to what critics view as unseemly practices by third party investors who -- quite literally -- benefit when people die.

Given that awkward fact, life settlements are often referred to as death bonds.

A number of state regulators have heard the criticism and are taking a closer look at the practice. Specifically, regulators are looking at what's known in the business as stranger-originated life insurance, or STOLI, settlements. Here’s why:

As life settlements have grown more popular and more profitable, aggressive promoters have begun trolling senior citizen complexes in search of clients, namely elderly residents who might be convinced to purchase life insurance, and then to sell their policies for a one-time cash payout.

Ostensibly, everyone wins. The policy buyer gets a nice windfall; the promoter sells the policy to investors at a profit; and the investor cashes in when the person named on the policy dies.  

This business model, however, suggests an obvious--if perhaps extreme--worst-case scenario.

Since investors in life settlements get their payoff when an insured person dies, it’s only a matter of time before a policy holder is killed so that investors can reap their profits sooner.

“Should strangers be allowed to make investments in the lives of others?” asked attorney R. Mark Keenan of New York firm Anderson Kill & Olick.

“In the old days, that was considered a no-no. There shouldn’t be incentives for people to machine gun other people,” Keenan observed bluntly.

The attorney explained that just as investors in mortgage-backed securities fear defaults on the mortgages in which they’ve invested, so investors in life settlements fear that the insured whose policies they've purchased will live long lives and thus cut into their profits.

“The down side of mortgages is that people default. The downside on these life settlements is that people live too damn long,” said Keenan, who has written extensively on the topic.

Here’s how STOLIs work: Promoters approach seniors (usually affluent ones) and offer to lend them money so that the seniors can buy a large life insurance policy. Sometimes a bonus such as a trip or a car is offered to sweeten the deal.

In two years, the seniors sell their policies to the promoter, who package and resell them to institutional investors such as hedge funds, pension funds and investment banks.

The investors pay the premiums on the policies, then receive the payouts when the original purchasers die.

Life insurance policies are viewed by investors as a solid bet because the returns are not tied to the broader economy. Unlike the stock and commodities markets, dying is not cyclical.

The market for these securities is projected to grow to $20 billion by the end of 2008.

To meet that growth, a number of companies that deal exclusively in the purchasing and reselling of life settlements have emerged.

Scott Kirby, president of Advanced Settlements Inc., one of the largest U.S. life settlement companies, said the financial products serve a valuable purpose.

“It’s a marketplace that policy owners deserve to have. It provides incredible value for people who own life insurance. People should have the right to sell their policies,” Kirby said.

Prior to the advent of life settlements, the only options policy holders had for an unwanted policy was to either stop paying the premium and lose whatever money had already been paid, Kirby explained, or sell it back to the insurance company at a value determined by the company.

Now there exists a “very well-established, regulated structured marketplace” into which policy holders can shop their unwanted policies.

Kirby said Advanced Settlement pays its customers, mostly wealthy seniors, “two to three times” the value they’d get from their insurer.

“If faced with the option of just letting the policy go because you couldn’t afford the premium or no longer need the coverage, there now exists a huge market that will buy the policy from you versus simply surrendering it to the insurance company,” he said.

Kirby takes issue with the STOLI acronym, saying the "stranger-originated" phrase is misleading. "The debate needs a lot more attention. People need to hear both sides of the argument." 

But it's the "stranger-originated" aspect of life settlements that has caught the attention of regulators who are uneasy with the idea of third parties initiating financial relationships in which investors hold a financial stake in people’s lives -- or more specifically their deaths.

“These people are running around with targets on their backs. The first case where someone gets killed is going to reverberate around the world,” said Brad Tibbitts, director of the life and property casualty division for the Utah Department of Insurance.

Utah is one of several states looking to strengthen regulations covering life settlements.

Tibbitts said a negative upshot of the growth of life settlements is that insurance companies are now charging higher premiums to cover their losses from policies now being paid to their full term.

Insurance companies have traditionally profited by canceling a certain number of life insurance policies after the policy holders for whatever reasons stop paying their premiums. In those cases, the company pockets the premiums already paid and pays no benefits when the person dies.

But when the policy is purchased by an investor the premium always gets paid and the insurance company is required to pay out when the person who originally purchased the policy dies.

Not surprisingly, the insurance industry opposes these STOLI arrangements.

Life insurance, said Jack Dolan, a spokesman for trade group the American Council of Life Insurers, plays an important social role. In the traditional model, the beneficiary, usually a family member, “wants the continued good health of the insured,” he said.

STOLI arrangements, however, are “contrived arrangements where, right from the get go, the plan is for the third party to be in a position to profit from the death of the insured.”

Dolan’s groups is seeking a requirement that life insurance policies be held for at least five years before they can be sold to a third party.