The Worth of a Life

Janus is the god of beginnings, endings, doorways and gates in Roman mythology. He is traditionally depicted as a head with two faces looking in opposite directions. This symbolizes his association with time; he looks into the future and surveys the past.

Janus is the source of the word January. The first month of the year is marked by resolutions and goals looking forward, but Janus and we also look back to reflect upon the past year and what we have learned.

On a macro level, we’ve got some challenges going forward. With the economy flirting with recession, the banking industry in upheaval and the political landscape uncertain, we would do well to recognize our shortcomings, learn from past mistakes, and try to do some things better going forward. On a micro level, January is a good time for personal assessment of our successes and failures in the year past. The point is to use what we have learned from the past to shape the future.

On that note, let’s look at what we have learned from the past with respect to the market for and regulation of life settlement-backed securities. (Since this topic will likely never just “come up” in a discussion on this blog or elsewhere, this may be as good a segue as there is likely ever to be).

A life settlement-backed security (sometimes referred to as a “death bond”) begins as a life insurance policy for an individual. The individual may determine that he or she no longer has a need for the right to benefits under the policy. Instead of allowing the policy to lapse or surrendering it to the insurer for its surrender value, the insured can sell his interest in the policy via a life settlement contract. The insured assigns his contractual right to benefits on his death (the “policy”) to a third party for cash. Presumably, the insured will choose this option only when the price the third pary will pay (the settlement offer) is higher than the surrender value offered by the insurer to obtain a release of its obligations under the policy.

The third party who purchased the policy then pools those rights together with similar rights obtained by purchasing other life policies. He “securitizes” the pool by selling interests in the pool to investors for cash. The investors get an interest in an asset that generates a smooth stream of income as the original policy holders die and their life policies pay off. They get a lovely return on investment to boot. (The typical return is somewhere between 8-11%).

Life settlement-backed securities are analogous to securities backed by mortgage obligations issued by a REIT. The difference is in the nature of the underlying income-generating asset. In the first case, the securitized asset is the borrowers’ obligation to pay home mortgage debt to retail mortgage lenders. In the second case, the securitized asset is an insurer’s obligation to pay benefits to an insured's assignee when the insured person dies. In some respects, the insurer’s obligation on a life policy is more attractive as an investment than a borrower’s obligation on a mortgage. Unlike default rates, death rates are not correlated to market events like changes in interest rates or declines in real property values.

It’s an inspired idea when you get past the ghoulishness of it. (Everyone, except immortal gods like Janus, will surely die). Unfortunately, the industry is not without its share of trouble. First, the life settlement contract is relatively new. It is currently unregulated by the SEC (the D.C. Cir. decided in 1996 that life settlement contracts were not securities, because mortality fails prong three of the Howey test for an investment contract). The IRS has provided almost no guidance as to the proper tax treatment of the life settlement transaction. To the unwary, the life settlement market is a dangerous frontier. The most important issue to understand is that it is a violation of the "insurable interest" laws of every state to purchase a policy with the intent to sell it to someone who lacks insurable interest. It is the insurable interest violation which snags ambitious entrepreneurs who are interested in expanding the life settlement market, to sometimes cross the line from creative marketing to fraudulent inducement.

Stranger-Originated Life Insurance (STOLI, as it is known), is just now coming under legal scrutiny. A STOLI policy is one in which the intended holder of the right to benefit has no insurable interest in the life on which the policy is issued. Here’s what happens. A STOLI investor approaches an individual and induces him to take out a policy on his life with the intent of later selling the policy to the investor. The individual is wooed with cruises, theater tickets and the offer of “free” insurance coverage for the two years while the policy is still “wet” (life insurance cannot be re-sold during the first two years of the contract). Additionally, the investor finances the premium payments for the insured during the initial two years. It sounds like a great deal, the insured is seemingly out nothing. However, because the insured contracted for the insurance with the intent to sell the rights to the death benefit to the investor who lacks insurable interest in the insured’s life, a STOLI policy will likely be void ab initio under state law on lack of insurable interest grounds. (An insured may even be criminally liable for insurance fraud.) If a STOLI policy gets securitized, and its STOLI nature exposed by the insurer, an investor will not realize the anticipated return in his investment.

Like the problems within the mortgage-backed securities market's tranches of investors with individually negotiated debt forgiveness (just read Red Lion Reports for a couple of weeks!), the possibility that some or all of the payment rights in a pool of life insurance contracts are STOLI is latent risk to a would-be life settlement-backed security investor. At present, traditional bond raters have no way of uncovering STOLI and so cannot factor in the risk of nonpayment due to STOLI in rating the security issued by the life settlement pool.

What have we learned? Is there something going on here that we should try to stop? Should people be allowed to assign their rights under a life insurance policy to a stranger? Is there something about these contract rights that justifies a restriction on alienation?

There is no nice way to say it; it is the sale of an economic interest in a life. Perhaps we realize that the quest for profit will sometimes bring out the worst in us; inspiring fraud in the inducement of the contract is only the beginning. Perhaps the market for life insurance benefit rights will spawn another and even more troubling industry. Agents of life settlement pool servicers make sure you “die on time” to protect the investor’s expected return - the very conduct insurable interest laws were intended to prevent. On the other hand, when the transactions are legitimate, a life settlement could be a wonderful alternative way a policy hlder can gain liquidity from an otherwise illiquid asset.

Even if you think that regulation of the life settlement market is a good idea, effective regulation may be hard to implement. The insurable interest laws which already govern enforcement of policy acquisition rights for life insurance could control the STOLI problem, if insurers could or would enforce them fully. The cost to insurer’s of detecting STOLI policies and asserting the lack of insurable interest defense is high. Regulation is not likely to make that task any easier or cheaper. Perhaps the history of the mortgage backed securities market confirms what we already suspected, that the market is a hungry beast. Almost anything of value that can be sold (commodified) will be sold. The market for life settlement contracts is driven by the market for life settlement backed securities. Neither are easy or cheap to regulate. (For an excellent point-counterpoint discussion of STOLI, by industry experts Steve Leimberg and Alan Jensen, see pg. 110 of the ACTEC Journal.)

Looking back over the market for life settlement contracts and the secondary market for securities backed by pools of them, we can begin to think about how to use what we learned from analogous markets to maximize the benefits and minimize the costs here. Whatever we have learned should be used as the foundation upon which we base our decisions on how to best handle the situation going forward. And that’s a benefit that so far, there’s no way to sell.
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Thank you to Professor Reilly for your feedback and mentoring on this post! As I dip my toes into the world of scholarship, I appreciate your support.