History of Life Settlements
Although the secondary market for life insurance is relatively new, the policy owner's
property right to transfer legal ownership and beneficial interest to a third party
at his or her own discretion has been enshrined in US common law since the 1911
Supreme Court ruling in Grigsby v Russell.
Life settlements grew out of a smaller market - that for viatical settlements, which
began in the mid- to late 1980s. Viatical settlements describes the practice of
transacting policies on the lives of the terminally ill, typically those with a
life expectancy of less than 24 months (although note that the exact definition
varies from state to state). A key driver for the development of this market was
the growth of the AIDS epidemic; those sufferers with existing life insurance sold
the policies for a percentage of their face amount, in order to fund ongoing medical
treatment.
The lack of regulation in the early years of the viatical settlements market led
to a period of largely unfettered growth. Early transactions in viatical settlements
involved the sale of policies insuring the lives of AIDS patients to "widows
and orphans", with the promise of a chance to double their money in six months
as long as they paid the premiums over this period. The "magic bullet"
effect caused by the availability of highly active antiretroviral therapy to combat
AIDS resulted in the insureds living much longer than the "widows and orphans"
had been led to expect, leading to retail investor losses and the inevitable lawsuits
from state and federal regulators.
In 1996, the Clinton administration unwittingly strengthened the case for life settlements
when it signed into law the Health Insurance Portability and Accountability Act
(HIPAA). Aside from imposing a series of administrative, physical and technical
safeguards on the storage and use of protected health information, HIPAA allowed
the owner and/or beneficiary of a life insurance policy to transfer the ownership/beneficial
interest in that policy to a third party, without that third party needing to have
an "insurable interest" in the life of the insured party. It also allowed
the proceeds of a viatical settlement to be free of federal income tax. A key driver
for this change was the need for AIDS patients, with little or no access to health
insurance, to be able to fund their healthcare through the liquidation of available
assets.
The bad press dealt to the life settlements industry by the lawsuits arising out
of the viatical settlements market might explain the historical lack of capital
markets interest in what should be an attractive asset class - after all, credit
derivative swap (CDS) pricing was derived from life insurance underwriting methodologies,
so credit traders should feel that they understand the risks extremely well. Intensive
regulatory and compliance requirements (over 40 states now regulate viatical and/or
life settlements - and no two states have the same requirements!), the lack of market
transparency and efficiency and extremely high barriers to entry have tended to
turn most investors away from the product. In March 2007, the Institutional Life
Markets Association ("ILMA") was formed by six leading investment banks
(Bear Stearns, Credit Suisse, Goldman Sachs, Mizuho International, UBS and West
LB) to promote legislative initiatives and best practices in the life settlements
and premium finance industry and this increased capital market attention will undoubtedly
result in greater investor interest in the near future.