A Life Settlement is the name for the contract by which an investor purchases an in-force life insurance policy from the current owner. In most cases, the policy owner is also the insured person. The benefit to the seller is receipt of cash today, versus some unknown future point. The benefit to the buyer is the prospect of recouping the purchase price, plus an additional return on investment.
People sell their insurance policies for a variety of reasons, but most policy sales are probably driven by one of two primary factors.
First, in the 80s and 90s there were a lot of life insurance policies sold to people on the premise that if they paid premiums for a certain number of years, the policy would be fully paid for and they wouldn’t have to make any future payments. Unfortunately, the part of the story that got lost in the conversation was the fact that the projections were based on a set of assumptions about what would happen on the investment front during those years. The policies and the coverage were guaranteed. But the assumptions weren’t. It was common practice in those days to assume a 12% annual return for stocks and stock-like assets. We of course know now that those types of investments didn’t do anything like 12% year-over-year during that period. As a result, the policy values didn’t achieve the necessary levels to be fully paid forever. Which meant that premium payments would have to start again at some point for the coverage to stay in place.
So retirees who face the prospect of having to re-start premium payments may not have room in the budget to do so. The cost of insurance gets higher the older you get, so having to resume payments in your 70s could lead to 5-figure premium bills. Those who find themselves in this situation are often facing a tough choice: blow the budget to keep the policy in force, or let the policy lapse altogether, essentially throwing away all the dollars which were previously used to pay premiums in the past.
The sale of the policy affords a third option. The insured/owner won’t get the amount that the death benefit was supposed to deliver someday, but they get back considerably more than what they put in. They got the benefit of being covered all those years, and also converted the cash flows into a de facto investment which paid a healthy dividend upon exit.
Where the first reason focuses on the cost of keeping the policy in force, the second focuses on the cash available on exit. Many retirees find that their savings alone cannot cover their budgetary needs. The two most common places to go looking for non-portfolio resources are the home (thus the popularity of home equity loans and reverse mortgages) and the sale of life insurance policies. A policy can easily be worth several hundred thousand dollars in the investor market. In some circumstances that’s more than enough to fill any gaps. So rather than let the policy ride to be a benefit to the estate, these retirees go ahead and convert the value now so that they can get the benefit of the asset during their lives.
From the investor perspective, the why of the sale matters a lot less (we just mentioned it in the discussion above because it’s a question we get a lot). What matters to the investor is the relationship between dollars deployed, dollars returned and the time interval in between. Life settlement investments do not have periodic cash flows like bond interest or dividends. They are longer-term holdings designed to pay a lump sum. As such, they are typically used for only a portion of the portfolio (which is good practice for pretty much any asset class).
The event which causes the repayment of the investment is of course the death of the insured. It is not possible to know exactly when this will occur ahead of time, but in practice, life settlement investments frequently last between 2 and 8 years. Most policies that make it to the investor market are for those who are age 75 and older.
Life Settlements are available both as whole policies and as fractional interests (typically within a trust or similar structure).
The appeal of the life settlement investment is simple: they are not correlated to any external financial market or metric, making them a great candidate for diversification. Also, they often pay rates of return which are substantially higher than bonds and other income investments. Finally, since the policies themselves are typically underwritten by only the highest rated insurers (e.g. Met Life, Prudential, John Hancock, Pacific Life, etc) there is not a concern for default risk, as such. As long as the investor has the wherewithal to pay future premium payments (if necessary) then both the principal and the return are on par, risk-wise, to any other insurance company payout.