A Fascinating Subject

Anyone who is still looking for an interesting Fall course should consider Insurance Law. Of course, I may be biased in saying so, but the subject is not only timely, it is a perfect "capstone" course. Insurance law can be thought of as advanced contracts, advanced torts, as well as a course on policy and complex financial regulations. Insurance touches on all areas of the law, and is sure to raise some thought-provoking issues. For example, Bloomberg just released this story on secret profits in life insurance death benefit payouts. What's not to love?!

STOLI Hearing on the Hill Today

David J. Stertzer, CEO of the Association for Advanced Life Underwriting, sent out the following update this morning.

"U.S. Senate Special Committee on Aging Chairman Herb Kohl (D-WI) will hold a hearing today focused on the life settlement market and stranger originated life insurance ("STOLI"). The hearing will be at 2:00 pm EDT and can be accessed from the Committee webpage. For a complete witness list and announcement of the hearing, please click here.

AALU submitted this written testimony to the Committee focusing on our stong efforts in conjunction with the broader life insurance industry to enact state laws to prevent STOLI, while protecting legitimate uses of life insurance and life settlements.

We hope the hearing will further those efforts, because we cannot allow STOLI to detract from the critical role life insurance products play for 75 million American families.
We will be covering the hearing and will provide you with a report tomorrow."

Optional Federal Charters for Insurers: Desperately Needed Medicine or a Step Toward Destruction?

“Any modern and comprehensive insurance regulatory structure should enhance competition among insurers in national and international markets, increase efficiency, promote more rapid technological change, encourage product innovation, reduce regulatory costs, and, above all, provide the highest quality of consumer protection.” Pg. 129 of the Paulson plan. Paulson’s “Blueprint” reads like a motivational speech, the recommendations contained within seem almost too good to be true. Since I do not know nearly enough about most of the aspects contained in the plan, I will leave the commentary to the expertise of the Red Lion herself, but I thought I would offer a few observations about the proposed nationalized insurance regulations.

Insurance is, as the plan points out, a national industry. Major insurance companies transact business across state and even national borders. Insurance companies currently need to conform their products to the jurisdictions of fifty states plus territories, this is costly and inefficient. Streamlining the governance of the insurance industry seems like a great idea. Plus, with all of the brewing issues surrounding the life settlement industry, it may be an ideal time for the Federal Government to step-in and facilitate consistency. The plan recommends only an optional federal charter, so if a small insurer prefers to be regulated locally, presumably this will be allowed – for now. In spite of 135 years of state-regulation, it may well be time for change. After all, insurance is big business: in 2006, insurance companies held $6 trillion in assets – half of the assets held by the banking industry. This brings me to my next point.

The more insurance looks like a financial tool, the less likely life insurance death benefits will retain their tax-exempt status. The primary purpose of life insurance is to provide security to one who would suffer loss upon the death of another, not to be a security for investors. Courts uniformly recognize the dual-component nature of life insurance, that of both providing a consumable benefit (insurance coverage) and an investment vehicle (the internal cash accumulation of a permanent policy and eventual death benefit). The Internal Revenue Code exempts life insurance proceeds from gross income if paid by reason of the death of the insured, in spite of the investment component of life insurance. Presumably, the IRS doesn’t believe anyone is willing to die for a tax shelter. Insurance companies are able to use this to their advantage in marketing insurance for estate planning purposes – it is a huge selling point. Recognition of the need for national regulation of insurance, to me, suggests that insurance is beginning to resemble other financial tools. This, in turn, makes the argument for special treatment of life insurance less compelling. While one could argue that there is a long way to go before reaching that point, this seems to be a step in that direction – a sobering thought.

Of course, on the flip side, a federal charter may give consumers an advantage they have not had before. The disclosures required of an insurer are minimal when compared to sellers of other financial products. For instance, insurers don’t disclose commissions paid to agents. In contrast, underwriters’ compensation structure must be disclosed when registering a security with the SEC. If commission structures or rates vary across insurance companies, disclosure would facilitate shopping and ultimately drive down cost. Another possible benefit to consumers is that the insurable interest laws, which vary slightly from state to state, could be clarified once and for all – which would have the effect of imposing a heavy burden on any individual seeking to induce an individual to procure insurance for the purpose of reselling it to an investor. This practice, known as STOLI (stranger-originated life insurance – see my earlier post) is poison in the secondary market for life insurance. With federal chartering and enforcement, the incentive for an investor to engage in STOLI may be lessened.

Perhaps the Paulson plan isn’t quite Faust’s deal with Mephistopheles, but we all must go into any situation which seems too good to be true with eyes wide-open.

Who Decides?

Prof. Fershee,

In response to your comment on my previous post, I absolutely hear your concern, and I share it. That is the critical balance that we must decide going forward, is an interest in mortality something that should be salable in the market, or is a "death bond" more like human organs, where for the sake of policy, we simply do not want to allow them to be sold. (For a fun read see Elisabeth Landes & Richard Posner, The Economics of the Baby Shortage, 7 J. LEGAL STUD. 323 (1978).)

Anonymous makes a great point, just pick up Dukeminier, et al. on Wills, Trusts and Estates, your family members are much more likely to "do you in" than an investment banker on Wall Street. But setting the statistics aside, the real issue is whether or not it should be the government's role to tell you who to trust.

Here's another piece to consider, there is a split among the states on the issue of whether you can sell the contract rights to the death benefit on the life policy that you own on the life of someone else. For example, I can take out a life insurance policy on my husband, because I have an insurable interest in his life. However, not all states think I should be able to sell my interest in *his life* to a third party without his consent, though, amazingly, some do.

Perhaps you would prefer the approach that requires the insured (not necessarily the policy owner) to consent to have the interest in his life sold to a third party, and then again if that interest was securitized. However, now we seem to be putting restraints on alienation that are not only potentially costly to enforce, but which may be difficult to factor into pricing. If consent is required, then the investor is actually purchasing an option rather than a pure asset.

My feeling is that life settlements and securitized pools of them, should be allowed. As long as the parties involved understand what they are doing, the practice will bring an increase in competition to a market that has unduly favored insurers. With a life settlement, consumers have another option with which to derive value from their assets. On the other hand, the corollary to an increase in life settlements is a decrease in policy lapse. Since lapse is figured into premium structures for insurance rates, insurers may have to increase premiums in order to account for this change in their expected cash flows (several already have). With an increase in premiums, it becomes more costly to procure insurance, which may dissuade a would-be insured from taking out insurance in the first place. As we still favor insurance from a policy perspective, this may be another reason to restrict life settlements.

How best to restrict the market place is not a question I am qualified to answer. So if anyone has ideas, please share. It is a fascinating web of issues, though, and something worth having on our radar.

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.