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

Although a few policyholders did sell their policies to individual speculators, most were unwilling to make those sales because there were no safeguards against the financial interest of the speculator in the early death of the insured. Thus, for the majority of policyholders, the issuing life insurance company was the only viable buyer of its policies in the secondary market. Because surrender values are set ex ante in the primary market rather than ex post in the secondary market, competition in the primary market prevented the exercise of monopsony power over policyholders with normal health.

Figure 1 shows how the surplus payments of a whole-life policyholder create economic value in the policy over time and how the surrender value tracks this increased value.33 In this case, the policyholder buys the policy at age forty. The buildup of policy value assumes that the policyholder's health follows a normal pattern as he ages. The vertical distance between the two curves is the economic margin earned by the life insurance carrier on the surrender of a healthy policy, together with an allowance for transaction costs.

Now consider a policyholder whose health suddenly deteriorates significantly at age sixty-five. Because the policyholder's life expectancy is curtailed, the present actuarial value of the policy will be much higher than for a sixty-five-year-old in normal health. Figure 1 demonstrates that if the issuing insurance company creates a single schedule of surrender values based on a uniform assumption of normal health, the company's surrender terms will be low relative to the actual policy value for an individual with impaired health.

A policyholder with impaired health cannot bargain effectively for a more generous surrender offer ex post because the issuing carrier is the monopsony repurchaser of the policy. The policyholder would be forced either to accept an amount that is substantially less than the true economic value or to elect not to surrender the policy.

If competition in the primary market constrains an insurance carrier's monopsony power over the surrender of a normal policy, then why does competition not have the same effect on the surrender of an impaired policy? In principle, a life insurer could increase its market share in the primary market by committing, in the primary market, to a set of healthdependent surrender values. Such an offering of explicit health-dependent surrender values by a life insurance carrier, however, would be fraught with regulatory, actuarial, and administrative difficulties. The costs of enforcing such ex ante conditions likely would be high and laden with moral hazard. This is a good illustration of what economists call unenforceable contracts and such precommitment has not been forthcoming. While it is true, as examined later in this Article, that insurers have made concessions for the surrender of impaired policies (ADBs), the timing of this development suggests that it resulted from competition in the secondary, and not the primary, market.