You can bet your life this policy will end in tears

US money men are making a fortune out of buying and selling life insurance. Should we worry? Oh yes, says Stephen Foley

Should you be worried if a hedge fund manager you have never met has an interest in seeing you dead? Should we all be worried when people start taking out life insurance policies, not to protect their families, but to sell them later at a profit?

And the biggest question of all: are the Wall Street brainboxes who brought us the sub-prime mortgage meltdown charting a similar course for the life insurance market?

Some of the finest minds in finance are, as we speak, working on new ways to chop up and repackage old life insurance policies for sale on the global markets. They are creating insurance derivatives for the speculators to play with. Goldman Sachs has already launched an index of human life expectancy on which investors can bet money.

There are too many echoes of what has happened in the mortgage market to ignore, and insurance industry players, finance experts and politicians are among those with a queasy, uneasy feeling that we might be watching the beginnings of something bad. Something that could become the big financial scandal of the next decade.

"The lure of easy money is seducing participants into the secondary market for life insurance and putting life insurers in compromising positions," says Cynthia Crosson, analyst at the credit-rating agency Fitch.

"Capital from hedge funds, investment banks and pension funds in search of higher returns is flowing into the secondary market, enticing policyholders, producers and some insurers with the potential for large cash payouts, significant commissions and higher revenues, respectively. The flow of capital to date and the potential for this market have created a gold-rush atmosphere."

The main risk, says Ms Crosson, is that the buying and selling of policies in a secondary market "will distort the very purpose of life insurance by breaking the insurable interest link between an insurer, policyholder and beneficiary".

Which is why Goldwyn and Sylvia Schroeder, a couple in their seventies from Sacramento, California, have been in the national news in the US these past few weeks. The couple were targeted by an insurance agent who offered Goldwyn Schroeder $1,000 to fill out a survey about his health, but it turned out to be a legal document allowing access to their medical records. Sylvia Schroeder, meanwhile, was offered a life insurance policy. The policy would be for millions of dollars, the agent claimed, and when she passed away, the payout would go to a complete stranger. She was offered money to co-operate. "They said if they took life insurance out on me, they would give me as much as $60,000 to $120,000," she told local television.

The bewildered Schroeders – by turns scared and tempted – are among seniors caught up in a growing trend for "stranger-originated life insurance", or Stoli.

Individuals have long been able to sell their life insurance policies to so-called "life settlement" firms. The company takes on the premiums and takes the windfall on your death, in return for an upfront payment that is substantially larger than the surrender value of the policy.

It is a trend that took off in the Eighties, when terminal Aids patients needed cash to pay medical bills that their health insurance was walking away from, but now it is gradually changing the nature of life cover.

Many rich individuals buy life insurance with at least half an eye on selling it before their death, treating it more like an investment. And, increasingly, brokers are targeting senior citizens like the Schroeders, asking them to take out insurance specifically in order to sell it on. The Sacramento couple appear to have caught the blunt end of the sales practices, but other approaches are more sophisticated. One such is premium financing, where an investment company lends money to pay for life insurance premiums in the expectation that an individual will pay it back by selling the policy.

Because insurance firms and state laws typically require you to be taking it out for yourself, and not for the benefit of a stranger, this is risky and complicated. Some sales practices are above board, others are not. Some Stoli deal structures are clearly unacceptable, others are in a legally grey area. What is clear, amid all the confusion, is that there are vast profits to be made from life settlement.

This year, there is a battle royal going on in state after state across the US, as life insurers try to crimp Stoli and limit the size of the life settlement market, and as the settlement companies lobby to allow the market to grow.

There are no firm figures for its size – some estimates suggest it could reach $160bn (around £80bn) over the next few years – but growth appears to be exponential, having almost doubled in several of the past few years.

Wall Street has weighed in with its own well-funded lobby group, the Institutional Life Markets Association (ILMA) , set up by Goldman Sachs, UBS, Bear Stearns and others, to keep the market growing. After all, they need more second-hand policies to feed the derivatives market. So far, the repackaging of old policies through securitisations and structures akin to collateralised debt obligations (the structured finance products created out of sub-prime mortgages) has been done on an ad hoc basis between the banks and a small pool of investors. Within a year, though, participants say, there could be a public securitisation offering, rated by the credit-rating agencies and tradable on an exchange. Then we really are off to the races with these products.

This is why, says Jack Kelly, lobbyist for the ILMA, it is vital that dubious sales practices are stamped out right now and there is clarity on what is allowed and not allowed when life policies are taken out and sold on. "If people are recruiting seniors, conspiring and agreeing in advance to sell a policy even before the policy is written, ILMA opposes that," he said.

"But if someone wants to go out and buy insurance, after being told by the insurance agent that one of the options they have some day is to sell it, then they should be able to have that option. What we are fighting for is transparency at what I call the 'coffee table' level, at the point when a person actually sits down and decides whether to sell their policy – that principal point of contact where we need to know who is getting what commissions and what the policyholder is getting for their dollar."

Last week, politicians in Indiana held hearings on how to limit Stoli; in California, the Schroeders' case will be on the minds of politicians holding a hearing on whether to set new limits on when life insurance policies can be sold. Some 25 states are considering new legislation.

In all of these states, politicians will be acutely aware that there was a symbiotic relationship between the growth of the mortgage securitisation market and the take-up of sub-prime and other exotic mortgages, together with their accompanying dubious or even fraudulent mortgage broker sales practices.

Whatever the laws they write in the coming year, the most important law may yet be the one of un-intended consequences.

How stranger-originated life insurance evolved

1884

Former New York insurance commissioner and civil rights crusader Elizur Wright urges life insurance reform when he observes policies auctioned to speculators.1876

US Supreme Court holds that, due to public policy concerns, life insurance cannot be used as a vehicle for wagering on human life.

1980s

Aids grips the US. This prompts "viatical settlements" that allow sufferers, when terminally ill, to sell life policies on to third-party investors, with the aim of raising money before they die.

1990s

People marketing viatical settlements look for new ways to make money as policy features such as "accelerated death benefits" – allowing the terminally ill to receive benefits of policies early – become more common. Stranger-originated life insurance begins to emerge.2001

The National Association of Insurance Commissioners approves a new life insurance settlement Act amid mounting concern about possible abuses – but the Stoli market still grows.



2007

US insurance law-makers begin crackdown amid fears over Stoli and how its practitioners operate. Insurers now permitted to ask if someone has had a life expectancy examination and if they have an agreement to sell their policy on to a third party, before policies are issued.

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