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

III. ANALYSIS OF THE SECONDARY MARKET FOR LIFE INSURANCE

With a whole-life policy, earlier premiums are greater than necessary to compensate for the low death risk in the early years. As a result, the policy builds up a surplus from which future premiums can be subsidized.28 If we assume policies are priced in an actuarially fair manner, then, for any given policyholder, the expected value of the payment by the insurance company to the policyholder's beneficiaries equals the total expected value of the premium payments over the life of the policy.29

But what if a policyholder's preferences change and he no longer needs the policy he purchased? The policyholder naturally would wish to receive payment for the value that has built up in the policy by virtue of the policyholder's surplus payments. Indeed, if it were not possible to cash out a policy that was no longer needed, uncertainty about future insurance preferences would decrease the value of whole-life insurance to consumers. Because life insurance carriers recognize this, whole-life policies include an option for the policyholder to resell, or "surrender," a policy to the issuing insurer in return for a cash sum.30

Surrender values can be thought of as secondary market prices for policies. Before the entry of viatical and life settlement firms, the life insurance carrier could exercise monopsony power in the secondary market for its own policies. However, competition in the primary market prevented the incumbent from exercising this power in the repurchase of normal policies-policies for which the insured is of normal health. Primary market competition did not eliminate this monopsony power for impaired policies, and life insurance carriers historically have earned economic rents on the surrender of those policies.

A. The Purchase of Impaired Policies by Incumbent Carriers

Surrender values and conditions under which policies can be surrendered usually are specified in the insurance contract, and thus, they are determined in the primary market for life insurance. The primary market typically is characterized as having a relatively high degree of competition, which means the premiums and terms of life insurance policies are set at roughly competitive levels. Furthermore, surrender values are set to correspond roughly to the surplus value that builds up in policies over time, assuming the health of the policyholder unfolds on a normal path.31

The existence of a surrender value for a policy does not obligate an individual wishing to resell a policy to resell to the issuing insurance carrier. Indeed, life insurance policies are typically assignable, which means policyholders are free to transfer their ownership of the policies to other people. A policyholder's right to assign the policy to someone other than the insurance carrier has existed for some time, which means there potentially has been a secondary market for life insurance policies for as long as policies have been assignable. In its early stages, this market consisted of only the issuing life insurance carrier and a handful of individual speculators.