BENEFITS OF A SECONDARY MARKET FOR LIFE INSURANCE POLICIES, THE

Real Property, Probate and Trust Journal, Fall 2003 by Doherty, Neil A, Singer, Hal J

Editors' Synopsis: This Article analyzes the benefits that accrue to policyholders and incumbent insurers from an active secondary market for life insurance policies. It begins by examining the benefits of secondary markets in the home mortgage and catastrophic risk insurance industries as points of comparison for the benefits of the secondary market for life insurance policies. Next, it outlines the economic theory of a life insurance market both before and after the introduction of a secondary market. Without an active secondary market, the equilibrium quantity of "impaired" policies surrendered is inefficiently low. Although competition among insurance companies in the primary market leads to reasonably competitive surrender values given normal health, surrender values based on normal health do not appropriately compensate individuals with impaired life expectancies for the resulting appreciation of their policies. If no external market for reselling policies exists, insurers have no incentive to adjust their surrender values for impaired policies to competitive levels because they wield monopsony power over the repurchase of impaired policies. Entry by firms in the secondary market erodes monopsony power. Finally, the Article examines the benefits of an active secondary market for life insurance policies to policyholders and incumbent insurers in the primary market and discusses the future of life settlements. The magnitude of the benefits is correlated positively to the quantity of coverage sold to life settlement firms and to the improvement in the terms of accelerated death benefits offered by incumbent carriers. The emergence of the secondary market for life insurance policies has been pro-competitive and pro-consumer. Lawmakers should therefore design regulations that encourage, rather than dissuade, participation and investment in this secondary market.

I. INTRODUCTION

The emergence of a robust secondary market for life insurance is a relatively recent phenomenon. The modern market began to take form in the late 1980s in response to the Acquired Immunodeficiency Syndrome ("AIDS") epidemic, as many young people began to have the sudden need for money to pay for medical treatment and to maintain their standard of living. These individuals sought liquidity from any long-term assets they owned, including life insurance policies. The shortened life horizons of those living with AIDS meant the actuarial values of their policies-the risk-adjusted value of the death benefit taking into account future costssignificantly exceeded the surrender values of their policies.1

Unfortunately for these individuals, incumbent life insurance companies wielded monopsony power2 over the repurchase of their own policies. As a result of this imbalance of bargaining power,3 the insurance companies have historically earned economic rents on the repurchase of impaired policies.4 In the case of the lapse of a term-life policy, a policyholder who could no longer afford premium payments simply lost his insurance coverage and received nothing. In the case of the surrender of a universal, or whole-life policy, the predetermined schedule of surrender values offered by the insurance company-representing at most the reserve set aside to fund future insurance costs at standard rates-did not compensate a policyholder for the full actuarial value of the impaired policy. Investors who did not share the same liquidity constraints as the policyholders were willing to purchase those policies for substantially more than the pre-arranged termination terms offered by the insurance companies. Viatical firms emerged to facilitate these sales, and the secondary market for life insurance was born.5

Viatical firms facilitate the liquidity goals of individuals living with terminal illnesses by making lump-sum payments to them and matching their life insurance policies with investors. Policyholders benefit from improvements in the quality of their final days, and investors benefit by having the opportunity to invest in a previously inaccessible asset class. The viatical industry has grown rapidly since the early 1990s. Between $1.8 billion and $4.0 billion worth of policies were viaticated in 2001,6 up from $50 million in 1990 and $1.0 billion as recently as 1999.7 The main shortcoming of this secondary market for insurance policies was that the investment criteria of viatical firms typically limited market access to policyholders with life expectancies of less than two years.8

The market responded to this shortcoming when, around the millennium, "life settlement" firms emerged to create access to the market for substantially more policyholders. The rise of life settlements in an industry that had previously focused primarily on the policies of AIDS patients can be traced to the availability of AIDS drugs in the mid-1990s, which increased the lives of afflicted individuals and made the purchase of these policies less profitable. This change in the financial calculus of viatical settlements led to a search for new areas of growth.9 Life settlement firms have developed more sophisticated underwriting models that allow them to purchase policies from individuals who are not terminally ill. In fact, life settlement firms do not purchase policies from individuals who are terminally ill.10 Rather, life settlement firms purchase policies from individuals who are over the age of sixty-five, have experienced a decline in health, and have remaining life expectancies of between six and twelve years (although in some cases life expectancies outside this range are considered)." Given the relative infancy of the life settlement industry, it is plausible that as the industry matures, life settlements will become available to even more policyholders.