Let’s review the main parties involved in a life settlement transaction.
The policyowner owns the life insurance policy that is available for sale. The broker represents the policyowner in finding a buyer and negotiating the price. The provider represents the buyer in finding policies for sale and negotiating the price. The funder is the investor who buys the policy and pays the ongoing premiums.
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Other professionals may also be involved. Consulting actuaries, accountants, attorneys and other advisors review offers for the policyowner. Underwriters provide life expectancy appraisals. Servicing firms handle administrative tasks, such as premium payment and health updates, for the funder.
Transaction costs in the life settlement market have been absurdly high. Brokers could get away with charging 6% of face amount. If the purchase price was 25% of face amount, the broker's commission was 24% of the purchase price.
I can now report that it is possible to obtain competent brokerage services for a reasonable price. If the policyowner is willing to pay the cost of obtaining medical records and life expectancy appraisals, a broker may charge less than 3% of the purchase price. A higher rate may still be needed for complicated or risky cases, where the outcome is very uncertain.
So can we now say that total transaction costs for life settlements are reasonable?
I like to use the residential real estate market as a benchmark for the life settlement market. Each house is different, and its value requires some effort to assess. There is a lot of paperwork involved, and each transaction is large.
Real estate agent commissions are typically 6% of the purchase price; however, that includes both the sell side and the buy side. Mortgage closing costs and other expenses may add several more percentage points. So maybe the total is 9% or so.
The life settlement broker’s commission is for the sell side only. On the buy side, the provider’s compensation is not disclosed, but it could be at least several percentage points of the funder’s gross price. Post-purchase servicing fees could be several percentage points on a present value basis, although those services may be performed by some providers.
So the total transaction costs for a life settlement may finally be getting close to the familiar level of residential real estate. Further progress may require more transparency on the buy side.
Other problems in the life settlement market must still be addressed. Here are four:
- Can you trust the broker? There have been well-publicized cases of collusion between brokers and providers against the interests of the policyowners whom the brokers supposedly represent. New platforms such as Life Policy Trader may solve this problem by facilitating direct communication between policyowners and providers. Brokers can continue to be involved in the transactions, but they will not be sitting alone with the providers.
- Are the insured’s medical records confidential? This problem is difficult to solve, because it is so easy to transmit medical records electronically, and there are so many parties involved in life settlement transactions. Anyone who sells a life insurance policy should assume that there is some risk that the insured’s medical records will be seen by someone who has no business seeing them.
- Do providers know how to value life insurance policies? Most valuation software is designed for nonguaranteed universal life, which has only minor modeling variations from one policy to another. No-lapse universal life, on the other hand, requires customized modeling to accurately represent the wide variety of no-lapse guarantee designs. When a universal life policy has lower premiums on a no-lapse guarantee basis than on a nonguaranteed basis, how is the provider coming up with its offering price?
- What is the income tax treatment of a life settlement? IRS Rev. Rul. 2009-13 states that the policy’s cost basis must be reduced by the cost-of-insurance charges since issue, but it is vague about the details. For example, if you own a no-lapse universal life policy, which set of cost-of-insurance charges is relevant: the current (nonguaranteed) cost-of-insurance charges or the no-lapse cost-of-insurance charges? They can be very different.