Useful Insurance Information

From the old policy-holder’s viewpoint, he is getting a great deal. Since he cannot afford to keep making payments to keep his policy going, in his mind the value of the policy has dropped to zero. And here someone comes along and offers him $500,000 hard cash for it!

In this situation there is a loser, and a big loser too. It is the old man’s kids. Had he kept the policy alive, his kids would have been big winners at his death - just like the buyers of the policy will be, and even more so since unlike the investors the kids will not have to pay income tax when the policy pays off.

So if this transaction makes so much sense for the investors, it makes even more sense for the old man's kids. Basically, the old man is giving up a very valuable future asset for basically pennies now - it is simply not a good trade. However, few of the life insurance salesmen tell their clients to engage in life settlements really work to advise their clients that it is a bad trade to settle their life insurance policy instead of keeping it alive.

To an extent, the insurance company is also a loser. The reason has to do with what is called a policy "lapse", meaning that the insurance company receives premiums but does not have to pay out on the policy. Anytime a policyholder doesn't keep a policy up, there is a lapse. Suppose the old man did not sell his policy to the investor, but simply let it lapse. In that case, the insurance company would have collected premiums from the old man for years, but in the end never paid out any death benefits to the old man's estate.

Policy lapses are sweet money for life insurance companies, and do impact their profitability. A life insurance company can make bad underwriting bets but still be profitable if lapse rates are high enough. Some industry analysts even suggest that some life insurance companies are only profitable because of their lapse rates.

Life settlements can theoretically work to reduce lapse rates, because the investors who buy the policy will always contribute just enough money to keep it paid up until it pays off. If enough people hear about life settlements and sell their policies before they lapse, the lapse rates would go to zero and the life insurance companies would be forced to raise rates. This would make life insurance less competitive against other investments and probably lead to lower sales.