Journal of Financial Planning: March 2011
Peter C. Katt, CFP®, LIC, is a fee-only life insurance adviser and sole proprietor of Katt & Company in Kalamazoo, Michigan. His website is www.peterkatt.com.
I have written about various aspects of the life settlement world, but until now I haven’t described the life settlement process. This column provides details of a life settlement case I dealt with last year.
I have worked with Mark for 10 years managing three $2 million UL policies insuring him that are owned by an irrevocable trust. Mark, now 80, has been in poor health since my work began with him. It is getting worse. The insurance company involved, let’s call it AB Life, has only fair financial strength ratings that have been declining. However, the pricing for these policies has been excellent. Because of Mark’s poor heath we have used a just-in-time premium strategy of paying only the cost of insurance charges, leaving very little cash value in policies.
Although we have discussed and considered the possibility of selling one or more of the policies in the life settlement market for several years, it wasn’t until last year that Mark got serious about diversifying his risk due to AB Life’s declining financial strength ratings. Mark’s situation is significantly different than the typical life settlement circumstance. Mark is very wealthy. The life insurance isn’t needed and he definitely can afford to continue the premiums. The life insurance is viewed as other investments he has, thus the logic of wishing to pursue selling some of his policies to diversify his perceived risk with AB Life. (Mark and I have disagreed about the nature of the risk and I have counseled him to keep the policies, but he is the client and I follow his lead and carry out his wishes).
Can’t Tell the Players Without a Program
Several key players in life insurance have distinguishing roles and compensation channels that advisers should be aware of:
Life Settlement Firm: firms that obtain an insured’s life expectancy, secure a funder/buyer, and coordinate the transaction. The best known is Coventry First. Life settlement firms can receive a case directly from a policyowner (very rare), a fee-only adviser, a life insurance agent, or from a life settlement broker. A life settlement firm’s compensation isn’t disclosed. I believe they are compensated when a policy or blocks of policies are acquired by the funding source (actual buyer of the policy).
Settlement Broker: firms that coordinate the matching of a policyowner and life settlement firm. Settlement brokers may also be involved in obtaining an insured’s life expectancy. A well known settlement broker is Advanced Settlements. Because settlement brokers work with numerous life settlement firms they can often increase the purchase price through understanding the market and competition. Settlement brokers are compensated by the life settlement firm in the form of a commission. This commission reduces the amount that a policyowner receives, but as noted, the settlement broker may get a higher net price by going to multiple life settlement firms.
Life Insurance Agent: the agent generally initiates the idea for a life settlement sale in the first place. Usually an agent will go through a settlement broker. The agent receives a commission from the life settlement firm that comes directly out of the amount paid for the policy. (The very few of us fee-only life insurance advisers provide guidance in the process for our normal hourly fees and do not take commissions.)
The Client Strikes Out
Upon receiving his instruction to try and sell two of his AB Life policies, I contacted several life settlement firms and several settlement brokers about purchasing an AB Life policy. There was no market. No one was buying AB Life policies because its financial strength ratings were below minimum standards. For six months I would frequently go back to see if any buyers for AB Life had emerged. Still none.
Mark noticed an ad from a local agent promising results, so he called the agent. I cooperated with the agent and sat in the back seat advising Mark as he went along. The agent hooked up with a settlement broker and they were very lucky that during this period a buyer for AB Life did emerge. This wasn’t lucky for Mark because this meant large commissions would be subtracted from the purchase price, rather than if the buyer had popped up before the agent became involved. Such is business.
After months of “almost there” statements by the agent and broker, Mark was offered $525,000 for each of his $2,000,000 policies. $75,000 was subtracted from this amount for commissions to the broker and agent per policy. This would net Mark $350,000 per policy after taxes. Based on Mark’s life expectancy I calculated this purchase price represented a target IRR for the buyer of some 20 percent. This is about what I would expect.
I arranged through another settlement broker a loan for life alternative for Mark. Essentially a lender provides all future premiums in exchange for an origination fee and 10 percent interest on the premium loans. Mark’s trust would receive the balance of the death benefits after paying off the loan. There would be no tax ramifications. Mark would have no personal liability with regard to the lender in the event things went south with AB Life and premiums soared. Although interested, Mark decided against this because it didn’t offset his risk enough.
From the beginning the agent had promised Mark that a well-known financial institution would be buying his policy. Not only didn’t the purchase contract even name the buyer, it stated “(life settlement firm) may sell or otherwise transfer the policy (or an interest in the policy) to any Person without the Current Owner’s consent.” (Emphasis added). The contract states that “Person means any individual, partnership, limited liability company, joint venture firm, corporation, association, joint stock company, trust, trust company, estate, unincorporated organization, or any other entity.” This came as a complete shock to Mark. Obviously any seller wants to be careful who will end up owning his or her policy.
I know from experience that policies can end up being owned by small investor groups and individuals. Even if a seller knows who will initially own the policy, it is almost certain that policies will change hands several times before the insured passes. An insider recently told me of policies his firm was involved with that have changed hands four times in three years. Mark is absolutely correct in being concerned about who will end up owning his life insurance policies.
The purchase contract required Mark to authorize that his medical records be released to the life settlement firm or successors at any time. Mark would also have to agree to be contacted once a month about his health (actually to find out whether he has died) if he has less than a one-year life expectancy and once every three months if he has a longer life expectancy. The life settlement firm can keep track of life expectancy by checking medical records. Mark was furious about these intrusions.
Rechecking medical records of insureds allows and encourages policy investors to reshuffle the policies they own, keeping some and dealing others. This seems so contrary to how the life settlement business model is promoted. But I suppose the real money to be made in America is receiving transaction fees and commissions with the packaging, repackaging, and re-repackaging of financial assets until no one knows what they have or what the true value is.
I believe the final straw for Mark was that the closing package for selling his policies left out the promised escrow arrangement. The facilitator wanted Mark’s trust to simply sign over the policies and wait for payment.
This situation has been an unforced error. I have been warning Mark of life settlement realities for several years, but his desire to diversify his risk was too great and the agent’s promises along the way were too convincing. As this column is being written, Mark’s situation remains in flux.
Given the realities of the life settlement end game, only the most motivated sellers should enter the process. Otherwise, other options should be considered.