Key Points in This Section
- Market distortions attract arbitrageurs — investors who profit by correcting pricing inefficiencies. The life settlement market developed exactly this way
- The secondary market originated with viatical settlements in the late 1980s, driven by the AIDS crisis. Viaticum is Latin for “provisions for a journey”
- HIPAA (1996) addressed the federal tax treatment of viatical settlements and accelerated death benefits, providing regulatory clarity that helped legitimize the market
- As AIDS became manageable with medication, the market shifted its focus to senior policyowners with reduced but non-terminal life expectancies — giving rise to the broader term “life settlement”
- A viatical settlement today specifically refers to transactions where the insured has a life expectancy of two years or less
- The market has grown from roughly $40–50 million in 1990 to over $4 billion in annual transaction volume today, with institutional investors as the dominant buyers
An Emerging Market
Market Forces at Work
When distortions occur in markets — due to structural imperfections or otherwise — investors, typically known as arbitrageurs, will seek to profit from those pricing differences. Until recently, the “market” for existing life insurance policies was limited to surrendering or selling the policy back to the original issuer at prices below what a freer market would produce. It is simply human nature in a capitalist economy for investors to create a better market and profit from the freer flow of capital.
Free markets develop when willing buyers and willing sellers can see mutual advantage in making a trade. They typically develop from informal beginnings — the New York Stock Exchange started out as a gathering under a buttonwood tree on Wall Street, and as we have seen, Lloyd’s was a coffeehouse in London. As more willing buyers and sellers enter a market, it becomes more formal and increasingly subject to government oversight. That is exactly the history of the secondary market for life insurance policies.
Origins: The AIDS Crisis and Viatical Settlements
The impetus for today’s secondary insurance market arose from the AIDS crisis of the 1980s. Policyholders suffering from this new terminal illness needed to raise cash to meet ever-increasing medical costs and daily living expenses. Those stricken with AIDS in the United States were, for the most part, young men whose life insurance policies had accumulated little cash value. Given their reduced life expectancy, death benefits could be expected within a relatively short time — creating an attractive opportunity for outside investors.
The first transactions were undoubtedly informal agreements between friends and acquaintances. As the profit potential became clearer, disinterested investors entered the market. Over time, agents and brokers connected widely scattered buyers and sellers. A nascent market in “viatical settlements” emerged. The word viatical derives from the Latin viaticum, meaning “provisions for a journey.”
As new markets typically do, competing structures emerged: some investors purchased individual policies; others pooled funds into diversified portfolios; some brokers sold fractional interests in policy pools to individual investors. Some configurations worked; others were discarded.
Regulation, Abuse, and HIPAA
Through the early 1990s, much of the viatical market operated outside government regulation — and inevitably, bad actors exploited the situation. Some buyers failed to pay sellers; some sellers attempted to pass off fraudulently acquired policies to unsuspecting investors. Then, improved antiretroviral medications began prolonging the lives of AIDS patients, calling into question expected investment returns if AIDS became a chronic rather than terminal illness.
These abuses and changing medical realities led to a reassessment of the market. State regulators began imposing licensing requirements and other restrictions on market participants. The insurance industry responded by adding accelerated death benefit provisions to new policies, offering higher lifetime payouts to compete with outside investors in the secondary market.
From Viaticals to Life Settlements
Like a genie let out of a bottle, the concept of selling life insurance policies took on a force of its own. Instead of concentrating on the terminally ill, the market began focusing on payouts to senior citizens with less serious health impairments. These transactions came to be called “life settlements,” “senior settlements,” or “high net-worth settlements” rather than viaticals.
The Market Today
The size of the potential market expanded dramatically as the focus shifted to senior policyowners. Approximately 40% of all life policies owned by those age 65 or older will ultimately expire without paying a death benefit — each a potential source of wealth had the owner sold on the secondary market instead. An estimated $200 billion or more in life insurance policies are lapsed or surrendered each year that could potentially qualify for a life settlement transaction.
The market has also become far more formalized — a natural development as markets mature. What was once dominated by small investors purchasing relatively few policies has shifted to multinational financial firms, pension funds, asset managers, and hedge funds purchasing large portfolios of policies. These institutional investors have in effect inverted the insurance industry’s Law of Large Numbers to their own advantage: by holding diversified pools of policies, they can predict aggregate payouts with reasonable actuarial confidence.
The purpose of this course is to explore the opportunities available to life insurance policyholders through the secondary market, and how those opportunities change the landscape for those engaged in financial planning and insurance sales.