At its most basic, a life settlement entails the trading of a life insurance policy under specific circumstances. Prior to the advent of this product, the insured who no longer wanted coverage could either surrender the policy or let it lapse. As an investment, the contract is akin to a bond with periodic coupon payments (dividends, if the policy is participating) and an indeterminate duration - a function of the life expectancy of the insured.

A third party with no insurable interest, purchases the contract for an amount greater than its cash surrender value, but less than its face value. The purchaser assumes responsibility for keeping the policy in force by making the premium payments. Upon the insured's death, the buyer receives the policy's face amount. As stated previously, the policy's internal rate of return, or performance, is a function of how long the insured lives, and, is for the most part, independent of financial events, save for the financial condition of the insurer(s). In this regard, it would appear to satisfy the requirement of risk diversification.

How it Came to Be
Life settlements are an example of financial innovation using an established product. One can make a case for settlements as a new asset class in view of their actuarial component; an outgrowth of viatical settlements from the 1980s, when terminally ill patients would sell their policy to a third party for much needed cash to pay for high end-of-life health expenses. The product and strategy has evolved considerably and continues to do so. Given its novelty, the body of regulation that defines it continues to develop.

As with any investment, one must consider the risk-return tradeoff. Buyers purchase the policy at a discount to its face value, generally from individuals who have no further need of the coverage, but could use cash up front. Other reasons for sale include a change in estate planning, onerous premiums that have become unaffordable, a change in beneficiary arrangements or the fact that the original rationale for purchasing the coverage no longer exists.

Typically, insureds in their mid-sixties to early- to mid-seventies are sellers with a life expectancy of at least several years. The mechanics of how a policy is priced are beyond the scope of this primer. As a general rule, the longer the insured individual's life expectancy, the lower the policy's value to the buyer who must pay the premiums to keep the policy in force, not to mention the broker fees and other fees to acquire the right to a death benefit. The longer the insured lives, the greater a drag these fees exert on policy returns. This occurrence is referred to as extension risk, whereby a policy remains in force at or beyond an individual's life expectancy.

How the Sale and Purchase of a Life Contract Works
The policy owner or insured may arrange a sale through their life insurance agent or financial advisor. These parties, in turn, typically engage the services of a life settlement broker, though the seller may occasionally work directly with the broker. It is the broker's job to obtain the consent to release medical records, which they forward to a number of life settlement providers. These companies evaluate the insured as an asset, and obtain the life expectancy estimates through an underwriter to gauge the mortality risk (in this context, a crude estimate of the policy's duration). The providers then bid on the life contract. If the seller accepts the bid, the provider purchases the contract.

If someone's selling, someone's buying. The providers may pool policies and transfer them to a financial institution that would securitize then into a life settlement bond. Hedge funds, pension funds, mutual funds and occasionally high net worth investors may purchase a piece of a securitized product, which attempts to arrive at an average duration, if it includes a sufficient number of policies that have been properly evaluated. The challenge to the "life settlement bond manager" would be the diversification of the health risks in the contracts purchased, as well as a thorough and ongoing evaluation of the insurers whose policies comprise the collateralized insurance obligation. One man's ceiling may be another man's floor. Good health may result in the insured living longer.

The investor, meanwhile, continues to pay for coverage in an illiquid investment of increasing duration and cost and diminished returns. In a sense, investors could find themselves in a confused mess, not unlike the one experienced by investors caught up in the snare of auction rate securities in the latter part of the 2000s.

Another potential risk, this to insurers, is of greater payouts leading to an overall higher cost of insurance. Whereas in the past, individuals saddled with unaffordable or unwanted coverage could either lapse or surrender a policy, investors in a securitized insurance product would be motivated by the potential return on their investment to pay into the policy longer. This phenomenon could ultimately result in a greater number of payouts over time.

The Bottom Line
The burgeoning life settlement industry, like its housing forbears, is opaque. Might this recent innovation be a boon to the baby boomers whose senectitude is afforded the security of additional cash, or another potential bust-up for financial institutions taking on actuarial risk with potentially flawed models that failed to conform to expectations? Perhaps models look best on the runway.

SEE: Making A Living On Death Bonds

Related Articles
  1. Insurance

    Who is a Beneficiary?

    A beneficiary is a person or entity that receives funds, assets, property or other benefits from a trust, will, or life insurance policy.
  2. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Insurance

    Learn about the SPDR S&P Insurance exchange-traded fund, which follows the S&P Insurance Select Industry Index by investing in equities of U.S. insurers.
  3. Retirement

    Strategies for a Worry-Free Retirement

    Worried about retirement? Here are several strategies to greatly reduce the chance your nest egg will end up depleted.
  4. Markets

    The 5 Biggest Canadian Insurance Companies

    Learn more about the insurance industry as a whole, how it functions in Canada, and the five largest Canada-based insurance companies.
  5. Insurance

    How to Shop for Home Insurance

    Tips for getting the best protection for your place and possessions.
  6. Stock Analysis

    How MetLife Became a Global Insurance Giant

    MetLife is the largest life insurer in the United States. Here's how it has managed to stay on top.
  7. Professionals

    The Top Insurance Needs of Retirees

    While health insurance is the primary insurance need for retirees, there are other types advisors need to consider for their retired clients.
  8. Professionals

    Life Insurers and Millennials: Strange Bedfellows?

    Life insurers are courting Millennials. Is this a strange fit? And how will they cater to this generation?
  9. Investing

    Advising FAs: Explaining Life Insurance to a Client

    Life insurance was initially designed to protect the income of families, particularly young families in the wealth accumulation phase, in the event of the head of household's death.
  10. Professionals

    How Advisors Can Help Expectant Couples

    Bringing a child into the world makes parents more acutely aware of their finances. Here's how advisors can help expectant couples prepare.
  1. Directors And Officers Liability ...

    Directors and officers liability insurance covers you if you're ...
  2. Automatic Premium Loan

    An insurance policy provision that allows the insurer to deduct ...
  3. Cestui Que Vie

    The individual who is the beneficiary of a trust or insurance ...
  4. Classified Insurance

    Insurance coverage provided to a policyholder that is considered ...
  5. Guideline Premium And Corridor ...

    A test used to determine whether an insurance product can be ...
  6. Cash Value Accumulation Test (CVAT)

    A test method used to determine whether a financial product can ...
  1. What are the main factors that impact share prices in the insurance sector?

    The main factors that impact share prices in the insurance sector are interest rates, earnings and actuarial risk. In the ... Read Full Answer >>
  2. Why do insurance policies have deductibles?

    Insurance policies have deductibles for behavioral and financial reasons. Moral Hazards Deductibles mitigate the behavioral ... Read Full Answer >>
  3. Which emerging markets are seeing the strongest growth in the insurance sector?

    The emerging market economies seeing the strongest growth for the insurance sector are primarily the main emerging market ... Read Full Answer >>
  4. How do insurance companies use a whistleblower?

    Fraudulent claims are among the most prevalent and serious business risks that insurance companies face. Many consumers have ... Read Full Answer >>
  5. How is maintenance of standard of living for survivors accomplished in estate planning?

    Estate planning is an integral component of comprehensive financial planning, as it allows individuals and couples to maintain ... Read Full Answer >>
  6. What options strategies are best suited for investing in the insurance sector?

    Three segments comprise the insurance sector. The largest, property and casualty insurance, exhibits significantly less volatility ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!