An Emerging Market  

The important points addressed in this lesson are:

Major benefits of a life insurance policy
Historical development of the insurance industry
The concept of cash values and endowment at age 100
Factors leading to a distortion between a policy's cash value and its true market value
Emergence of a new market in life insurance


Traditionally, life insurance buying decisions are built around two basic benefits. The first is protection against the adverse financial consequences of death. The second driving force lies in the tax advantages of life insurance that make it such a powerful tool to achieve specific personal and business financial planning goals.

Nevertheless, circumstances can change that reduce the need for the death protection, the value of the tax advantages of a life insurance policy, or both. What happens then?  Until recently, policyholders had few options.  Since life insurance is fundamentally designed as a buy-and-hold financial instrument, terminating a policy does not favor a policyholder from a financial point of view.   In the case of term coverage -- the policyholder could simply let the policy lapse, terminating future premium payments and any potential death benefit.  In the case of permanent insurance -- the policyholder could surrender the policy in return for a pre-determined cash value (less any surrender charges).  Policyholders who surrender a policy, in effect, sell back the policy to the insurer for that pre-determined amount.  Economists refer to this type of situation as a monopsony:  a market with only one buyer -- in this case, the insurance company.   And as with any constrained market,  monopolies and  monopsonies produce less-than-optimum economic results.

With all that has changed in the past couple of decades, a true secondary market  for life insurance policies has finally emerged -- a market  governed by competitive economic forces.  Initially spurred by the AIDS outbreak in the 1980's -- and  driven by the need for cash to pay for costly treatments -- life insurance policies have become a marketable financial asset, much like stocks, bonds , real estate, etc.   The old buy-and-hold mindset gave way to a new, more flexible way to think about life insurance.   This course explores this new market and new frame of mind.

Development of Insurance

Before exploring this new life insurance market -- let's quickly review how insurance came into existence in the first place.  Since Biblical times, there have been arrangements for the transfer of risk.  Merchants, in ancient times, who sought financing for their overseas trading expeditions, obtained loans from investors. If a ship and its merchandise were lost, the owners were not responsible for paying back the loans. Since many ships returned safely, the interest paid by numerous successful merchants covered the risk to the lenders for the few that did not.  Fast forward to 1688, Edward Lloyd was running a coffeehouse where London merchants and bankers met informally to do business. At that coffeehouse, financiers who offered insurance contracts to seafarers wrote their names under the specific amount of risk that they would accept in exchange for a certain payment, or premium. These insurers came to be known as underwriters. Less than 100 years later, Lloyd's of London had become a formal syndicate of underwriters -- one that has since grown into the foremost market for marine risks.

As the saying goes, "success breeds success".  The success of transferring risk in the maritime industry was extended to property/casualty risks, sickness, accident and life insurance.  Today, it is hard to imagine life without insurance.   Starting with those informal roots in Lloyd's coffee shop, the insurance industry has grown into an indispensable part of the modern economy.  

As the industry grew and became more formalized, governments imposed regulations designed to foster solvent insurers and fair treatment of the insurance buying public.  In 1774, the British Parliament passed the Gambling Act, which outlawed policyholders from insuring the lives of those whom they had no documented connection.  This law turned life insurance from a simple wager (whether somebody -- for example, a member of the royal family -- would live or die) into a far more respectable tool with legitimate financial purposes.   

Life insurance -- which started out as simple term policies -- eventually evolved into "permanent" insurance.    Permanent life insurance allowed for a lifetime of coverage at a level annual lifetime premiums.  Permanent life insurance builds a growing "cash value" into the policy to offset the amount of  "pure insurance" offered by the insurer.  For years, the insurer would keep any accumulated cash value if the policy lapsed -- which many did.  In 1905, the Armstrong Commission met in New York state to investigate abuses in the insurance industry.  As a result, states enacted laws guaranteeing that the policyholder, not the insurer, was entitled to cash values if the policy was surrendered.  These are the so-called non-forfeiture options.  

Today all states require permanent policies to project a table of "guaranteed cash values".   Those cash values are based on "endowment at age 100" -- which means that the cash value is scheduled to grow until it equals the policy's face value when the insured reaches age 100.  In a traditional whole-life policy, the policyholder can refer to his or her policy to find what the accumulated cash value will be at any age.  This cash value grows tax-deferred, providing an investment aspect to the policy.  If the insured dies, the insurer pays the full face value of the policy to the beneficiaries tax-free.  Those death benefits represent return of the policyholder's cash value with the insurer contributing the balance.  If the policyholder were to surrender the policy prior to the insured's death, the policyholder would simply receive the accumulated cash value.  Any cash value in excess of the policyholder's cost basis (total premiums paid) is taxable as ordinary income.  Until recently, those were the two values available under the policy -- death benefits or cash surrender value.  The lack of alternatives led to the buy-and-hold mindset that has predominated life insurance policyholders.

"Distorted Values"

While the Armstrong Commission's non-forfeiture values addressed the outright "theft" of policyholder assets by insurance companies, "endowment at age 100" distorts the accumulated cash value available to the policyholder.  Let's consider an over-simplified example.  Assume a $500,000 whole-life policy; the insured is age 75.  The policy currently has a guaranteed cash value of $100,000. Also assume the insured suffers from severe health problems and has approximately one year to live.  Looking at this situation in a little different light, the policyholder could sell the policy to the insurer today for $100,000 or collect $500,000 in a year.  Holding the policy for that last year results in a dramatic annual return of 400%!    Obviously there is a distortion between these values -- a distortion caused by two factors:  an assumption of perfect health resulting in endowment at age 100 and the fact that there is only one purchaser, i.e.,  the insurance company.  Now suppose there is a purchaser willing to buy the policy today for $350,000.  The purchaser, who is responsible for any future premium payments, names himself as beneficiary.  When the insured dies -- perhaps in a year, perhaps sooner, perhaps later -- the purchaser collects the death benefits and earns a return on his investment.  The original policyholder is relieved of future premium payments and receives a quarter million dollars more than the cash value offered by the insurance company; money that can be invested or used immediately for other purposes.  Granted, the original beneficiary receives nothing under the policy.  And that is a trade-off the original policyholder must consider -- but it is an alternative that may be attractive to many policyholders.  

Since insurance companies' "guaranteed cash values" are based on a life expectancy of age 100 -- which statistically speaking very few of us reach -- they undervalue the "true" value of that policy.  That distortion is even more pronounced when the insured's health is impaired, as in the earlier example.   The insurance companies' monopsony power -- in essence, they are the only game in town -- allows them to enforce a "below-market" valuation of their policies based on the insured's perfect health.  Policyholders are given a "take it or leave it" choice.  Approximately 40% of life policies issued in the U.S. terminate without paying out a death benefit -- in other words, 4 out of 10 policies are "bought back" by the insurance companies at "below-market" prices.  

An Emerging Market

When distortions occur in markets -- due to structural imperfections or otherwise -- investors, typically known as arbitrageurs, will seek to profit from those market differences.  Until recently, the "market" for existing life insurance policies was limited to surrendering or selling the policy back to the original issuer -- at prices that are below what a more-free market would allow.   It is simply human nature in capitalism for investors to create a better market and profit from the freer flow of capital.  

Free markets develop when willing buyers and willing sellers can see a mutual advantage in making a trade. Usually markets develop from informal beginnings -- the New York Stock Exchange started out as a gathering under a buttonwood tree on Wall Street and, as we've seen, Lloyd's was a coffee shop in London.  As more and more willing buyers and sellers enter the market, those markets become more formal and increasingly subject to government oversight.  This is exactly the case with the emerging secondary market for life insurance policies.

The impetus for today's emerging secondary insurance market arose from the AIDS crisis of the 1980s.  Policyholders who found themselves suffering from a new terminal illness needed to raise cash to meet ever-increasing medical costs and day-to-day living expenses.  Those stricken with AIDS in the United States were, for the most part, young men.  Cash values in the life policies they owned had not accumulated much -- so surrendering their policies would generate little.  Given their reduced life expectancy,  death benefits could be expected to be paid out in a relatively short period of time -- creating an ideal situation for outside investors.   The first transactions undoubtedly were informal agreements between friends and acquaintances.  As the profit potential became clearer, disinterested investors would purchase policies.  Over time, agents and brokers entered the developing market connecting widely-scattered buyers and sellers.  A nascent market in "viatical settlements" emerged.  ("Viatical" comes from Latin viaticum: "provisions for travel").   As new markets typically do, a  number of  competing configurations emerged.  Some investors purchased individual policies.  Other investors pooled their funds and purchased a diversified portfolio of policies.  Some brokers sold partial interests in pools of policies to individual investors.  Some configurations worked; others didn't and were discarded.  

Until the mid-1990's, much of the viatical market's activity took place outside the purview of government regulation -- and inevitably a few bad actors tried to turn the situation to their own gain.  Some buyers would fail to reimburse sellers for their policies.  Some sellers would try to pass off fraudulently acquired policies to unsuspecting investors.  Eventually, better medications would prolong the lives of those suffering with AIDS,  calling into question possible investment returns if AIDS were to become a chronic, rather than terminal, illness.  The abuses of a few, coupled with changing medical and economic realities, led to a reassessment of the market.  State regulators began to impose licensing and other restrictions on market participants.  Shady operators -- both buyers and sellers -- were put under stricter scrutiny.  The insurance industry responded to the new market forces by updating their policies with accelerated benefit provisions: offering higher lifetime payouts in an effort to deter the sale of in-force policies to outside investors.  In effect, the insurers began competing with investors in the secondary market.   Congress addressed the tax consequences of viatical settlements and accelerated benefit payouts in its sweeping health-related legislation:  Health Insurance Portability Accountability Act of 1996 (HIPAA).     

But like a genie let out of a bottle, the concept of selling life insurance policies took on a force of its own.  Instead of concentrating on those who were terminally ill, the market began to focus on pay-outs to senior citizens with less serious health problems -- these are referred to as  "life settlements", "high net worth settlements" or "senior settlements" instead of viaticals (The term "viatical" is now reserved for when the insured is terminally ill, i.e., has a life expectancy of two years or less).  The size of the potential market expanded dramatically.  Approximately 40% of all life policies owned by those age 65 or older will expire.  According to the National Association of Insurance Commissioners, more than $1.5 trillion of face value lapse each year -- and each lapsed policy was a potential source of wealth had the owner sold it on the secondary market.   Not only did the market expand in size, the market has became more formalized -- a natural event that occurs when markets mature.  What was once dominated by small investors purchasing relatively small number of policies has shifted to multi-national financial firms purchasing large numbers of policies.  In effect, these large corporations investing millions of dollars have inverted the insurance industry's Law of Large Numbers to their own advantage.   "Settlements" grew from $40 -$50 million  in 1990 into the $500 million - $2 billion range ten years later.   A 1999 study by the Conning Corporation, a Connecticut-based research and investment management firm, said the potential market for senior settlements could be "conservatively" estimated at more than $100 billion.  Lifetime settlements are here to stay.

The purpose of this course is to explore the new opportunities available to life policyholders, and how those opportunities change the landscape facing those engaged in financial planning.

The Wharton School of the University of Pennsylvania investigated the forces driving this market -- for more information on market development please refer to: