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A Time and Place for Life Settlements
Sales of existing life insurance policies to third parties —
often referred to as "life settlements" — have
grown exponentially in recent years, and that trend appears
likely to continue, according to the NASD.
The NASD recently issued a notice to brokerage firms and
associated persons that life settlements involving variable
insurance policies are securities transactions, and firms and
associated persons involved in such transactions are subject to
applicable NASD rules.
But what are life settlements? Until recently, the NASD
reports that the owner of a life insurance policy who no longer
wanted or could not afford it had two options: to let it lapse
or surrender it to the issuer for its cash surrender value. But
now, the emergence of a secondary market for existing life
insurance policies provides a third alternative: to sell the
policy to a third party for less than the net death benefit, but
more than the cash surrender value. Such transactions, the NASD
says, are typically referred to as life settlements. The value
of a particular life settlement depends on a variety of factors,
including the insured's life expectancy and the nature and terms
of the policy.
According to the NASD, the life settlement market emerged as
an offshoot of the viatical settlement industry that developed
in the 1980s as a source of liquidity for AIDS patients and
other terminally ill policyholders with life expectancies of
less than two years. Unlike viaticals, however, the NASD says
that life settlements involve policyholders who are not
terminally ill, but generally have a life expectancy of between
two and 10 years. Life settlements also tend to involve policies
when the insured is older and there has been a change in health
since the policy was issued. Policies with lower cash values and
higher net death benefits seem to draw more interest from
investors.
The life settlement market has expanded rapidly in recent
years. One recent study, for instance, estimates that existing
policies with a collective face value of $5.5 billion were sold
by policyholders to investors in 2005, while others suggest that
the potential market exceeds $100 billion. Although business
models vary, in a typical scenario, an insured sells an existing
policy to a life settlement provider, which either holds it to
maturity and collects the net death benefit, or sells the policy
or interests in multiple, bundled policies to hedge funds or
other investors. The insured may contact the life settlement
provider directly, or through a financial adviser, or may use a
life settlement broker, which solicits bids from multiple life
settlement providers on behalf of the insured. It is not
uncommon to hold out for a higher bid by not accepting the first
bid or by letting the providers bid against each other.
In most states, both life settlement providers and life
settlement brokers are subject to licensing and other
requirements, the NASD says.
According to the NASD, most life settlement providers claim
to target only those policyholders who have already made the
decision to surrender a policy or allow it to lapse, either
because the policy is no longer wanted or needed, or because the
policyholder can no longer afford to pay the premiums. However,
as more providers enter the life settlement industry, the NASD
reports that there is increasing competition to find
policyholders who fall into that relatively narrow category. And
this, says the NASD, has led some life settlement providers to
aggressively encourage financial service providers, including
broker-dealers, to canvass their books of business for seniors
or other eligible customers who may be interested in selling
their life insurance policies in the secondary market, even if
they do not need to or had not previously considered
surrendering or allowing their policies to lapse.
Significantly, the commissions paid in connection with life
settlements are typically quite high — in some cases, up to 30
percent or more of the purchase price.
Accordingly, the NASD is concerned that aggressive marketing
tactics, fueled by high commissions, may lead to inappropriate
sales practices in connection with these transactions.
By way of background, the NASD reports that a variable life
insurance policy is a security, and the sale of such a product
in the secondary market is a securities transaction subject to
NASD rules. What's more, those involved in selling or buying a
variable life settlement should understand fully the issues
related to suitability, due diligence, best execution,
supervision and training, and compensation in connection with
variable insurance contracts.
Generally, the NASD requires that, before recommending the
purchase, sale or exchange of a security, members must have a
reasonable basis for believing that the transaction is suitable
for the customer.
The NASD reports being concerned that some of the marketing
materials prepared by life settlement companies to encourage
financial service providers to recommend life settlements to
their customers do not present a fair and balanced view of life
settlements, and may encourage broker-dealers to recommend
unsuitable transactions.
A variable life settlement may be a valuable option for
insured's who otherwise would surrender their policies or allow
them to lapse, the NASD says. But variable life settlements are
not for everyone. There can be significant costs associated with
such transactions, and NASD cautions firms that a variable life
settlement is not necessarily suitable for a customer simply
because the settlement price offered exceeds the policy's
surrender value. Other relevant factors may include the
customer's continued need for coverage, and, if the customer
plans to replace the existing policy with another policy, the
availability, adequacy, the underwriting, and cost of comparable
coverage. Depending on the circumstances, including the
customer's stated financial needs and investment objectives,
firms also may need to consider the basic tax and other relevant
implications of selling a variable policy. Settlements paid in
excess of the cumulative premiums paid on the policy constitute
ordinary income to the policy owner, compared to the death
benefit which is tax-free. In order for the settlement provider
or investment group to receive the death benefit, they must file
a claim with the insurance company which requires an original
copy of the death certificate.
October 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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