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Key Points in This Section

  • Insurance traces its origins to ancient risk-sharing arrangements; the modern underwriting market grew out of Lloyd’s coffeehouse in London in 1688
  • The British Parliament’s Gambling Act of 1774 established the insurable interest requirement, transforming life insurance from a wager into a legitimate financial tool
  • The Armstrong Commission of 1905 in New York led to non-forfeiture laws guaranteeing policyholders — not insurers — are entitled to accumulated cash values upon surrender
  • Permanent life insurance builds a cash value that grows tax-deferred; upon surrender, any gain above the policyholder’s cost basis is taxable as ordinary income
  • Until the secondary market emerged, policyholders had only two options: collect the death benefit or surrender for cash value — the buy-and-hold mindset

Development of Insurance

Origins of Risk Transfer

Before exploring the life settlement market, it helps to understand how insurance came into existence in the first place. Since Biblical times, there have been arrangements for the transfer of risk. Merchants in ancient times who sought financing for overseas trading expeditions obtained loans from investors. If a ship and its merchandise were lost, the owners were not responsible for paying back the loans. Since many ships returned safely, the interest paid by numerous successful merchants covered the risk to the lenders for the few that did not.

Lloyd’s of London — 1688 Edward Lloyd was running a coffeehouse in London where merchants and bankers met informally to do business. Financiers who offered insurance contracts to seafarers wrote their names under the specific amount of risk they would accept in exchange for a premium — giving rise to the term underwriter. Within a century, Lloyd’s of London had become a formal syndicate of underwriters and has since grown into the foremost market for marine risks.

The success of transferring risk in the maritime industry extended to property/casualty risks, sickness, accident, and life insurance. Starting with those informal roots in Lloyd’s coffeehouse, the insurance industry has grown into an indispensable part of the modern economy.

Insurable Interest — The Gambling Act of 1774

As the industry grew and became more formalized, governments imposed regulations designed to foster solvent insurers and fair treatment of the insurance-buying public. In 1774, the British Parliament passed the Gambling Act, which outlawed policyholders from insuring the lives of those with whom they had no documented connection. This law transformed life insurance from a simple wager — whether a member of the royal family, for example, would live or die — into a far more respectable tool with legitimate financial purposes. The concept of insurable interest that underpins modern life insurance law traces directly to this statute.

Permanent Insurance and the Armstrong Commission

Life insurance — which started out as simple term policies — eventually evolved into permanent insurance. Permanent life insurance provided a lifetime of coverage at level annual premiums and built a growing cash value into the policy to offset the amount of pure insurance risk carried by the insurer. For years, however, insurers kept any accumulated cash value if a policy lapsed — and many did lapse.

In 1905, the Armstrong Commission convened in New York State to investigate abuses in the insurance industry. As a result, states enacted laws guaranteeing that the policyholder — not the insurer — was entitled to cash values upon surrender. These are the so-called non-forfeiture options.

How Cash Values Work Today

Today, all states require permanent policies to project a table of guaranteed cash values. Under modern mortality tables (the 2001 CSO and later the 2017 CSO), those cash values are scheduled to grow until the policy’s accumulated value equals its face amount when the insured reaches age 121 — the current industry endowment age.

In a traditional whole-life policy, the policyholder can refer to the policy to find the accumulated cash value at any age. That cash value grows tax-deferred, providing an investment element to the policy. If the insured dies, the insurer pays the full face value of the policy to the beneficiaries tax-free. The death benefit represents return of the policyholder’s cash value with the insurer contributing the balance.

If the policyholder were to surrender the policy prior to the insured’s death, the policyholder would receive the accumulated cash value. Any cash value in excess of the policyholder’s cost basis (total premiums paid) is taxable as ordinary income. Until recently, those were the only two values available under the policy — death benefits or cash surrender value. The lack of alternatives reinforced the buy-and-hold mindset that has long predominated among life insurance policyholders.

Looking ahead: The emergence of the secondary market gives policyholders a third option — selling the policy to a third party for a lump sum that is typically greater than the cash surrender value but less than the death benefit. The following pages explore how and why this market developed.
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