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Life Settlements: How Government Made Investing In The Death Of Other People A Profitable Business

August 10th, 2010 · No Comments · Investing

A life settlement is an arrangement in which an individual who owns a life insurance policy sells their policy to a 3rd party investor. These investors are called viatical settlement companies, or life settlement companies. A life settlement company typically purchased life insurance policies from terminally ill individuals or senior citizens.

The settlement company pays the policyholder an amount of money that is somewhere between the cash value of the policy and the death benefit. The policyholder, then assigns all interest in the policy over to the settlement company.

These settlement companies then market their investments to affluent investors. What does all of this mean? Well, it means that investors are buying up all of these life insurance settlements as investments and hoping that the old, sick, and dying people named as the insured individual on the policy croaks so that they can collect on their investment. The sooner the insured person dies, the more money the investor stands to make.

So, how did all of this start? Well, in the 1980s, many individuals started taking advantage of the tax-free nature of life insurance policies. Some of the casualties included mutual fund companies because investors had to withdraw their money from somewhere.

Just in case you're not familiar with my previous posts on life insurance, I'll give you a very quick run-down on cash value insurance. Cash values, along with death benefits, of life insurance policies are not taxed as income. They aren't taxed as capital gains. In fact, they're pretty much exempt from all taxation, except estate taxes in certain situations. This is a great thing for the insurance industry as well as individuals purchasing life insurance. Since you can use the cash values during your lifetime for any purpose, you end up with an incredible tax shelter.

Prior to the 1980s, you could buy a life insurance policy and put as much money into the policy as you wanted. Normally, permanent life insurance is comprised to two elements: The death benefit and the cash value account. When you purchase a whole life insurance policy, for example (the most basic permanent insurance policy), a cash reserve starts building up against the death benefit you've purchased. As this cash value builds up against the death benefit, the amount of actual death benefit decreases. So, for example, let's say you purchase a $100,000 whole life policy. With no cash value, you are paying for $100,000 worth of life insurance death benefit. With $10,000 of cash value, you are only paying for $90,000 worth of death benefit.

The difference between the cash value and the death benefit is called the "net amount at risk". It is the amount of money the insurance company is on the hook for if you die before the cash value and the death benefit equal each other. With whole life insurance, the cash value is typically designed to equal the death benefit when you turn 100 years old. But, really, do most people expect to live that long?

So, what the insurance industry did was create an "endowment policy". An endowment policy matures much faster than an ordinary whole life policy. Some of these policies would mature in 10 or 20 years. But, you could also fund these policies quite heavily and with mutual life insurance companies who paid non-taxable dividends to the policy's cash value, your policy's cash value could easily exceed the death benefit. If you were willing to put the money into the policy, you could have an incredible tax-free investment with extremely low costs of ownership. 

While whole life has always been a favorite, the alleged "abuse" of investment policies really came with heavily funded universal life insurance, which allowed individuals to buy a life insurance policy with a savings component that could be paid up in one to three years, if you had the financial means, with additional money always welcome to enhance the cash value later. With extremely high interest rates, these policies were projected to pay for your retirement, and then some, while maintaining ridiculously low operating costs.

What this meant was that if you wanted to fund your policy so heavily that (for all practical purposes) it ceased to be life insurance and became a high yielding, tax-free, investment account, you could do that. That is, until lots and lots of people caught on to the idea. When you have people draining their brokerage accounts to buy life insurance as an investment, someone is going to complain. And, those complainers were largely the ones selling securities (stocks, bonds, mutual funds, etc.) because....well....let's face it, they were losing clients to an investor's new best friend: the life insurance salesman.

As a result of this tax-free life insurance party, Congress decided to put rules on how life insurance could be funded. They enacted the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the Deficit Reduction Act of 1984 (DEFRA), and the Technical and Miscellaneous Revenue Act of 1988. Collectively, these laws defined what a life insurance policy was. But, more importantly, they defined what a life insurance policy wasn't.

And...what these policies were not were investments. At least not anymore. Politicians, and the IRS, saw investment policies as an "abusive" use of life insurance. In short, investment policies were "wrong" because life insurance was not supposed to be, primarily, an investment.

As a result of these laws, life insurance companies were no longer able to sell policies designed to accommodate an endless amount of premium payments. Not only did this place just a little more risk onto the insurance company, but it also put a damper on individuals who wanted to buy all the life insurance they could reasonably afford. It effectively kills investment life insurance-for a while.

Life insurance, from this point on, was limited in many respects. Most notably, Congress limited how quickly cash value could build inside the policy. The tax-exempt nature of the policy's cash values remained, but a permanent gap between the cash value and the death benefit was mandated by government regulations. This "gap" or "corridor" between the cash value of the policy, and the death benefit would last until the insured individual named in the policy was over 90 years old. At that point, the gap closed and the policy was allowed to grow the cash value to equal the death benefit (though only some policy designs actually allowed for this to happen-mostly whole life insurance policies).

A problem arose when terminally ill individuals needed money from their policies. Cash values were being artificially suppressed by government laws. The only option for these people was to borrow money from the policy or cash it in, and sometimes even that wasn't enough.

Eventually, some savvy businessmen saw an opportunity. What if someone could offer to buy these policies from terminally ill individuals for a price that exceeded what the insurance company could legally offer? What if someone offered to pay more than the cash value in the policy, but less than the death benefit? The only way it would work is if the deal was somehow mutually beneficial.

Thus was born the viatical settlement business. Because insurance companies had no way to offer more than the cash surrender value in the policy, viatical settlement companies could offer to buy up life insurance policies at rates that insurance companies simply could not touch. In exchange, the policyholder and insured agreed that these policies would be kept in force by the settlement company until the insured died, at which point the settlement company would collect on the death benefit to recoup its investment.

Eventually, the industry realized that they could profit from senior citizens too. Death could be quite a profitable business, apparently. By buying up policies from healthy , but old, insured individuals, settlement companies found a way to transform their business into a measurable investment opportunity using actuarial tables to predict a rate of return on their settlement "investment". They could then sell their investment to investors outside of the settlement company.

Today, the life settlement business is booming. Investors are able to profit off of other people's deaths. And, the sooner the individual dies, the more money investors and settlement companies make (because less money is needed to pay policy premiums to keep the policy in force until the insured individual dies). And, this investment opportunity was created, in large part, because some politicians in Washington D.C. thought that using life insurance as an investment was wrong. How ironic.

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