According to the Center for Retirement Research at Boston College, half of U.S. households are at risk of not having enough income in retirement to maintain their lifestyle. The primary culprit is a lack of savings, exacerbated by longer lifespans and rising healthcare costs. The current U.S. average lifespan of 78.93 years is projected to increase to 81.98 years by 2040. As well, an analysis from Fidelity estimates that the average retired couple will spend $295,000 cumulatively on out-of-pocket healthcare expenses, not including the cost of long-term care. Despite those trends, U.S. workers have only saved a median $22,217 in their workplace-sponsored retirement plans, according to a 2019 Vanguard analysis. That’s sorely insufficient, considering those savings need to provide income for at least 25 to 30 years.
Social Security isn’t a solution, as the federal program only replaces 40% on average of a beneficiary’s working salary. As well, the average Social Security benefit is about $18,000 per year in 2020 — roughly $5,000 more than the federal poverty level for a single-person household.
All of these factors put pressure on aging, cash-poor Americans to find other sources of retirement income. One increasingly popular source is the life settlement, or the sale of life insurance to a third-party investor for cash. Read on for an overview of how life settlements work as investments, who invests in them, the pros and cons of investing in life settlements, the types of life settlement investments, and how to get started as a life settlement investor.
What is a life settlement?
In a life settlement, a senior policyowner sells his or her life insurance for more than its surrender value. The buyer in this transaction is an investor who realizes a return when the insured passes away and the policy’s death benefit is paid. While the circumstances surrounding life settlements are somber, these arrangements do add value on both sides of the transaction. The selling policyholder generates extra retirement income by cashing out the life insurance asset for a good price. And the investor secures a fairly low risk, high return asset.
The mutual benefits of life settlements were documented and legally validated back in 1911 in the court case of Grigsby v Russell. Grigsby, a doctor, bought a life insurance policy from his patient, a man named John C. Burchard. The sale came about because Burchard needed a medical procedure he could not afford. He sold the policy to Grigsby for $100 with the agreement that Grigsby would pay the premiums and later receive the death benefit. Burchard had his procedure and Grigsby kept the policy in force. Burchard later passed away and his executor R. L. Russell subsequently contested Grigsby’s right to Burchard’s death benefit. The courts disagreed with Russell and upheld the legality of the transaction between Grigsby and Burchard. That case created the legal precedent for the life settlement industry that exists today.
Why would someone sell their insurance through a life settlement?
Life settlements do have a negative stigma, because the investor’s return is associated with the insured’s end of life. But the immediate outcome of a life settlement is an improvement to the policyholder’s quality of life. Sellers may be motivated to pursue a life settlement to pay off debt, retire early, cover living expenses, establish an emergency fund, pay for medical procedures, or even take a trip around the world. There are no legal restrictions on how the cash is used, though a portion of the proceeds may be taxable. Interestingly, there is no negative stigma around surrendering a life insurance policy for cash, a more common transaction that results in lower proceeds for the policyholder and a better return for the insurance company.
Because life settlements are regulated in most states, selling policyholders should receive a fair amount of disclosure and explanation throughout the process. They should be clear upfront that once the life settlement is complete, they’ll no longer have to make premium payments and they’ll no longer have access to the death benefit. All of that is to say that most people who sell their life insurance in a life settlement are fully informed about the consequences of the transaction. They know the alternatives, which may include surrendering or reducing the policy, and have decided to pursue the life settlement because it’s the best option for them, given their financial objectives.
Who invests in life settlements?
Both accredited investors and institutional investors can invest in life settlements and life settlement funds. Accredited investors are federally qualified by their size, net worth, and other characteristics to invest in non-registered securities. Institutional investors, such as mutual funds, hedge funds, financial institutions, and endowments, pool money to invest on behalf of others and include.
What are the pros and cons of life settlements as an investment?
Pros of investing in life settlements
A life settlement investment delivers strong returns at a low risk for investors, while satisfying liquidity needs of the selling policyholder.
1. High rate of return
Research indicates that life settlement investments can yield double-digit returns for investors. A study by the London Business School, for example, found that the average expected return among institutional life settlement investors was 12.4% annually — that’s competitive, considering the stock market’s long-term average annual return is about 9%. Another analysis done by the Journal of Risk and Insurance estimates the average returns on life settlement investments are 8% annually, which is still a very competitive yield for an alternative investment.
2. Low risk
Life settlement investments don’t fluctuate in value based on market trends or interest rates. The primary risk the investor faces is longevity risk, because the insured’s life expectancy is uncertain at the time the transaction closes. That life expectancy dictates when the death benefit will be paid and how much investors will have to fund in premium payments to keep the policy in force. Investors can address longevity risk by adjusting the offer they make on the policy. They can offer less for a healthy insured and more for an insured with a history of medical conditions, for example.
3. Win-win for both parties
Policyholders who’d sold their policies in life settlements collectively received more than four times the amount they would have raised by surrendering those policies, according to the London Business School report. Even so, the Harbor Life 2020 Life Settlement and Retirement Survey found that 29% of adults have surrendered or lapsed a life insurance policy — essentially giving up their life insurance for far less than it’s worth. Life settlement investors benefit from the return characteristics of life settlement policies, but they allow seniors to get maximum value for their insurance asset.
Cons of investing in life settlements
The disadvantages of life settlements as investments include confusing regulatory requirements and longevity risk.
1. Highly regulated
Life settlements are regulated at the state level, usually by a state’s department of insurance. That means the disclosure, contracting, and other requirements that are placed on brokers, buyers, and sellers do vary by state. Many states follow the National Conference of Insurance Legislators (NCOIL) Life Settlement Model Act or some adaptation of it.
2. Uncertain timeline
As noted, the insured’s life expectancy is unknown, and that affects the investor’s timeline and the annual yield produced by the life settlement investment. Prior to making an offer, the investor will have access to a lifespan estimate completed by a medical underwriter, but there’s no guarantee of that estimate’s accuracy.
Types of life settlement investments
Investors interested in diversifying into life settlement investments can directly purchase one or more standalone policies or they can invest in a life settlement fund.
1. Direct purchase of life insurance policies
Prospective life settlement investors can connect with brokers or providers to participate in life settlement acquisitions. The investors are responsible for carefully analyzing each policy to decide whether they should make an offer and, if so, what the offer should be. For the knowledgeable investor who has the time and expertise needed to identify the strongest investment opportunities, this is a low-risk, high-reward strategy.
2. Investment in life settlement investment funds
Alternatively, investors can purchase shares of a life settlement fund, which owns and maintains hundreds of life insurance policies. Life settlement funds have the advantage of diversity, which limits the portfolio impact of, say, a single insured who far outlives the life expectancy estimate. On the other hand, the investor has no insight into the individual policies that make up the portfolio. For that reason, investors should carefully research the fund’s screening process and investment approach to make sure they are aligned with his or her investment goals. Also, life settlement funds, like mutual funds, charge management fees which reduce shareholder returns.
Get started investing in life settlements
Life settlement investing is growing in popularity because of its unique risk-reward proposition. The payout is guaranteed and does not fluctuate in response to unstable market or economic conditions. Only the timeline is unknown, but investors have the opportunity to review the insured’s details including lifespan estimates and use them to model various lifespan scenarios before making their bid.
