An Emerging Market

When distortions occur in markets -- due to structural imperfections or otherwise -- investors, typically known as arbitraguers, 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: