A life settlement is the legal sale of an existing life insurance policy (typically of seniors) for more than its cash surrender value, but less than its net death benefit, to a third party investor. The investor assumes the financial responsibility for ongoing premiums and receives the death benefit when the insured dies. The primary reason the policy owner sells is because they can no longer afford the ongoing premiums, they no longer need or want the policy, or they need money for expenses.
The investors consider five variables when pricing a policy for purchase:
- Life expectancy of the insured (health status)
- Cost of future premiums
- Policy face value (the payout)
- Policy maturity date (risk of policy lapsing with zero payout)
- Investors targeted return (discount rate)
As a general rule, policies for insured persons under the age of 70 do not qualify unless there are severe medical problems.
The term viatical settlement refers to a life settlement where the life expectancy was under two years because the person was terminally ill. However, some states, like Maryland, refer to any life settlement as a viatical settlement.
Life settlement history
The U.S. Supreme Court case of Grigsby v. Russell, 222 U.S. 149 (1911) established and legitimized the life insurance industry, ruling that policy as private property, which may be assigned at the will of the owner. Justice Oliver Wendell Holmes noted in his opinion that life insurance possessed all the ordinary characteristics of property, and therefore represented an asset that a policy owner may transfer without limitation.
Despite the Supreme Court ruling, life settlements remained extremely uncommon due to lack of awareness from policy holders and lack of interest from potential investors. That changed in the 1980s when the U.S. faced an AIDS epidemic. AIDS victims faced short life expectancies, high unanticipated expenses related to medical care, and selling a life insurance policy that they no longer needed as a way to pay these expenses made sense.  However, by the mid-1990s, this investment strategy had faded away because of the rise of antiviral drugs.
In its place arose a new strategy focusing on acquiring policies of the elderly, although a niche business (roughly 2% of the market) persists to this day acquiring policies on terminally ill of all ages. Policies of terminally ill patients are rare for two key reasons. First, the market size of terminally ill insured interested in selling their policies is small. Second, carriers now offer accelerated death benefit riders, which pay out if the insured is terminally ill, so there is no need for a settlement.
Life settlements remain a niche asset class. For the year ending 2020, according to the Life Settlement Report by the Deal, there were 3,241 policies purchased with a total face value of $4.6B on the secondary market (from the original policy owner). This was up from 2019 when 2,878 policies for a total face value of $4.4B were purchased on the secondary market. In contrast, as of 2018, there were 267M life insurance policies in force in the United States.  Moreover, it is estimated that roughly 10M policies a year lapse. Since the policy owner would always be better off selling rather than lapsing, many believe the life settlement market has tremendous growth potential.
There are three major industry trends. First is the rise of institutional investors and multi-billion dollar funds. Currently, the largest life settlement investors are Blackstone, Apollo, Vida Capital, and BroadRiver. All have over one billion in assets. Because of the capital they must deploy, their focus is the tertiary market - which is acquiring pools of policies. Just as a clarification, the primary market is the issuance of life insurance by the insurance company. Secondary market is the initial acquisition of the policy from the original policy owner. Tertiary market covers all the trading of policies after the initial sale. Also, as a point of clarification, while companies like Coventry and Abacus claim to the largest buyers, they are really providers (see below) who buy on behalf of third-party investors like Vida and BroadRiver. With few exceptions, providers do not hold these policies.
The second major trend is the Direct-to-Consumer initiative. Frustrated by the high fees paid to intermediaries (often 30% of the purchase price) and inefficient transaction process, investors have started focusing on direct to consumer. This effort reduces amounts paid to policy owners and can help increase return on investment for the buyers.
The final trend is medical underwriting improvement. Early on, the investors really struggled because poor underwriting led to serious losses. While not perfect, underwriting has dramatically improved due to better data, including the use of population statistics. Additionally, some investment firms like Miravest and Vida have developed their own proprietary underwriting.
While the life settlement industry has dramatically cleaned up, there were multiple controversies in the early days. Most notably was the bankruptcy of Life Partners in 2015. Life Partners effectively bought policies off a long life expectancy and re-sold fractional shares to individual retail investors, using a much shorter internally generated life expectancy to justify the significant mark-up. As a result, over 80% of the insured lived past the life expectancy - generating shareholder lawsuits and regulator attention - especially since they were selling to retail investors.
The second major scandal was STOLI. STOLI is any act, practice, or arrangement, at or prior to policy issuance, to initiate or facilitate the issuance of a life insurance policy for the intended benefit of a person who, at the time of policy origination, does not have an insurable interest in the life of the insured under the laws of the applicable state. This includes an arrangement or other agreement to transfer the ownership of the policy or the policy benefits to another person. The main characteristic of a STOLI arrangement is that insurance is purchased as an investment vehicle, rather than to provide for the insured's beneficiaries. STOLI arrangements also may be called "zero premium life insurance", "no cost to the insured plans", "new issue life settlements", "high-net-worth settlements", or "non-recourse premium finance transactions".
Prior to 2008, STOLI was popular because investor demand dramatically exceeded supply, and this was a way to manufacture product (albeit illegal) to meet demand. In many ways, it was effectively a victimless crime because everybody benefited in the short term. The investor got to deploy capital, the insured/policy owner made money from selling the policy, the insurance agent got a commission, and the insurance company grew their business. However, this all collapsed in 2008 when funding dried up and regulators took a closer look at the practice. Additionally, STOLI policies turned out to be poor investments, so long-term investor demand dried up.
The third major challenge has been self-dealing by life settlement providers and brokers - to the detriment of policy owners and investors. Most notably, Coventry was fined $12M by the state of New York for deceptive business practices. Coventry also settled a lawsuit with AIG (a large life settlement investor at the time), where Coventry would use multiple shell companies to disguise policy ownership when reselling to AIG to obtain a higher profit. However, these activities are not just limited to Coventry, as other life settlement brokers and providers have engaged in similar activity, albeit on a much smaller scale.
Life settlement providers serve as the investor's representative in a life settlement transaction. In almost all states (42 of the 50), investors are required to use a state-licensed life settlement provider when purchasing a policy. Most providers represent multiple investors. Life settlement brokers represent the original policy owner on the sale of a life settlement contract. They shop the policy to life settlement providers (who then shop the policy to their investor network). In most states, the life settlement broker must be licensed by the state.
Most states regulate life settlements and impose a two-year waiting period. However, New Mexico, Michigan, Massachusetts, and Delaware only regulate viatical settlements, while Wyoming, South Dakota, Missouri, Alabama, and South Carolina neither regulate viatical settlements nor life settlements.
Major study findings
An academic study that showed some of the potential of the life settlement market was conducted in 2002 by the University of Pennsylvania business school, the Wharton School. The research papers, credited to Neil Doherty and Hal Singer, were released under the title The Benefits of a Secondary Market For Life Insurance. This study found, among other things, that life settlement providers paid approximately $340 million to consumers for their under-performing life insurance policies, an opportunity that was not available to them just a few years before. It also has been stated by Neil A. Doherty, the professor at Wharton, that this practice drives up the cost of insurance to all other consumers purchasing life insurance.
We estimate that life settlements, alone, generate surplus benefits in excess of $240 million annually for life insurance policyholders who have exercised their option to sell their policies at a competitive rate. - Wharton Study, pg 6
Another study by Conning & Co. Research, Life Settlements: Additional Pressure on Life Profits, found that senior citizens owned approximately $500 billion worth of life insurance in 2003, of which $100 billion was owned by seniors eligible for life settlements.
- LISA. "What Is A Life Settlement?". blog.lisa.org. Retrieved 2020-09-17.
- "Learn about life settlements". Top Dollar Settlement. Retrieved 2021-06-01.
- "Learn about life settlements". Top Dollar Settlement. Retrieved 2021-06-01.
- LISA. "Life Settlement Industry Timeline". blog.lisa.org. Retrieved 2020-09-17.
- Life Settlement History, Life Insurance Settlement Association, retrieved on March 5, 2012, at http://www.lisa.org/content/51/Life-Settlement-History.aspx Archived 2015-02-06 at the Wayback Machine
- "Covid Little Obstacle to Settlement Market Last Year: Survey". The Deal. 2021-05-20. Retrieved 2021-06-01.
- "Number of U.S. life insurance policies in force 2008-2018". Statista. Retrieved 2021-06-01.
- https://faculty.wharton.upenn.edu/wp-content/uploads/2016/11/Insurance41.pdf Extrapolated from 4.2% annual lapse rate
- See, e.g., New York Insurance Law section 7815.
- Consumer Alert: Stranger-Originated Life Insurance, Division of Insurance, Illinois Department of Financial and Professional Regulation, January 2008, retrieved on March 9, 2012, at "Archived copy" (PDF). Archived from the original (PDF) on 2013-07-28. Retrieved 2012-03-10.CS1 maint: archived copy as title (link)
- Life Settlement Law Map, Life Insurance Settlement Association, June 2011, retrieved on March 9, 2012, at http://www.lisassociation.org/vlsaamembers/legislative_maps/images/Reg-of-viatical-and-life-se.jpg
- Wharton study