Investors love a sure thing, and in this life, it doesn't get more certain than death. So it's no surprise that in recent years the market for investing in life settlements — buying a stake in someone else's insurance and collecting the reward when they die — has grown tenfold to nearly $20 billion. Life settlements can offer legitimate value to investors and policyholders, but the industry remains largely unregulated. And just like the overcooked mortgage securities market, they've launched a flood of fraudulent policies — this time on people's lives.
A life settlement occurs when someone decides to sell his life insurance policy; perhaps he can no longer afford the premiums or the beneficiary has passed away. Through a broker, he sells the policy for a percentage of the death benefit. The policy is then passed on to investors who pay the premiums until the policy matures and collect the death benefit as a return on their investment. A life settlement typically pays more to the policyholder than surrendering the insurance back to the company that issued it.
More than a dozen multimillion-dollar life-settlement scams have come under investigation in states across the country since the start of 2008. "Life settlements serve a useful purpose by enhancing the value and liquidity of life insurance policies," said Fred Joseph, president of the North American Securities Administrators Association. "But they also pose significant risks. Thousands of investors, many of them senior citizens, have been victimized through fraud and abuse in life settlements."
Like any investment, life settlements attract capital by promising high returns. But the business also creates a sense of empathy among many of the individual investors. Often the senior investors empathize with the policyholders. "My parents don't have a lot of faith in government, and they certainly don't trust Wall Street," says the son of life-settlement investor Albert Scartz. "But they are growing older. They're feeling their own mortality and, I think, in an odd way, that gave them confidence in this investment."
The industry for selling life insurance first sprang up during the AIDS epidemic of the late 1980s. "Companies loved AIDS because it was a predictable death sentence," says Gloria Wolk, a life-settlement expert who learned about the practice while volunteering at AIDS services clinics. The shorter and more certain the life expectancy, the higher the returns promised to investors and the greater the lump sum offered to patients. It was a grim mix of free-market capitalism and human mortality. "But I saw the industry make a huge difference in the lives of terminally ill patients and their families," says Wolk.
The turning point came in 1996, when new anti-viral drugs destroyed the market for AIDS policies. But by 1999, the industry had reformed, offering its services to seniors instead of the terminally ill. Since then, the sector has experienced rapid growth. In 2002, it was valued at $2 billion. Now that number is closer to $20 billion. "When you look at the age of the population in the United States and the amount of life insurance in force ($15 trillion), you realize that the life-settlement market, as it stands right now, is just the tip of the iceberg," says Zohar Elhanani, COO of Legacy Benefits.
Just as the overheated market for securities backed by people's homes created a wave of subprime mortgages, the market on people's lives has created a boom in fraudulent insurance policies known as stranger-originated life insurance. STOLI is illegal. It begins with a life insurance agent, who, in many cases, is now also a life-settlement broker. The agent convinces seniors to take out large policies by offering meals, trips, and cash. The agent or life-settlement firm agrees to pay the premiums. Ownership is then quickly and quietly transferred, often to a trust, where it can be sold on the open market.
In the retirement communities of West Palm Beach, Fla., the practice of flipping life insurance for cash is common. "I think I first heard about it from friends on the golf course, maybe four or five years ago," says Wally, a retired doctor from New York. "A few years later a friend said her son was in the business and could be trusted." Wally passed that time as well, but he still gets offers. "Around here it's a very common thing, an easy way to make some money." Many seniors are unaware that participating in STOLI is illegal and may endanger their ability to collect on real insurance in the future.
A recent industry study found that more than 50 percent of life settlements were on policies less than four years old, and many were on policies two to three years old. "STOLI has to be the reason for the vast majority of this activity," says James Avery, president of Individual Life for Prudential. "And that is a major concern." Avery says the policies, which are big losers for the insurance companies, drive up prices and threaten insurance companies' ability to cover valid policies.
As regulators struggle to deal with the expanding life-settlement industry, the distinction between the worlds of insurance and investment becomes problematic. Circuit courts around the country have ruled both ways on the question. On the flip side, state insurance departments have seen their efforts to learn more about the industry challenged on the grounds that policies bought in one state and sold in another are exempt from local authority.
Some states have passed new legislation requiring brokers to register and expanding access to companies' books. But up-to-date legislation has yet to pass in New York, California, Florida, and Illinois — four states that, according to recent industry data, account for more than half of all life-settlement transactions. "In public, the life-settlement industry has come out against obvious problems like STOLI," says Mary Beth Senkewicz, deputy of insurance regulation in Florida. "But behind closed doors they are fighting against increased regulation tooth and nail."
Industry participants believe they are being unfairly targeted. "It's interesting, because STOLI is basically nonexistent," says Robert Stark, a life-settlement broker and president of Melville Capital in New York. Stark, a former mortgage broker, deals only with institutional, accredited investors. "These guys do incredible amounts of due diligence. If I tried to pass off STOLI policies to them, I wouldn't have any customers."
Stark represents the latest iteration of the industry, which is trying to clean up its practices and attract institutional capital. But many participants remain from the Wild West days. "There is an element in our industry that doesn't want to see any regulation," says Doug Head, president of the Life Settlement Association. "The players that deal with institutional investors want to see more regulation, but not everybody does business that way." Life Partners of Texas, one of the oldest and most profitable firms in the business, deals with individual investors and has won several court cases arguing that life-settlement investments are not securities.
Congress is taking note. Last month, Sen. Herb Kohl chaired a special committee meeting on the dangers of life settlements. He has contacted the IRS and SEC to discuss the gaps that may be left by state-by-state legislation, and the SEC has agreed to look into the registration and regulation of life-settlement providers and brokers.
Meanwhile, life settlements continue to be sold to individual investors. The recent activity by the Senate, coupled with the general climate surrounding exotic investments, seems to have jarred the SEC into action. But until concrete steps are taken, it will be difficult for investors and policyholders to know if they are making legal, well-informed decisions. And every new fraud scandal only scares off the kind of institutional investors the business needs most. Major firms in the life-settlement market may resist regulation, but they're digging their own grave.