A life settlement is the sale of a life insurance policy for a cash payment greater than the policy’s surrender value, but less than its face value. Historically, policy owners who found themselves with a policy that they no longer wanted or needed had only one option – to surrender the policy to the issuing carrier for whatever surrender value it possessed. The creation of the secondary market for life insurance has given consumers another option – the ability to sell their unneeded life insurance policies for fair market value.
As the life settlements market has matured, another category of seller has emerged – a policy owner who no longer wants to pay premiums on the policy, but still needs or wants some insurance coverage. For instance, assume a 75-year-old purchased a policy with a $1,500,000 death benefit when he was 60 years old. His children are grown and moved out, but he has a special needs grandchild to whom he wishes to leave a specific bequest. Instead of selling the entire policy for a lump sum cash payment, he could, instead, sell a portion of the death benefit either in lieu of cash or as reduction to the cash purchase price. For example, the policy owner might agree to sell $1,000,000 of the death benefit in exchange for a $500,000 retained death benefit. This means that even though he has sold his rights to the policy, and no longer has to make another premium payment, his estate (or designee) will receive $500,000 upon his passing.
This sounds like a sensible win-win for both the investor, who gets to purchase a $1,000,000 death benefit for little or no cash up front, and the seller, who never has to pay another premium and whose grandchild will receive $500,000 upon his death. The California Department of Insurance has decided to weigh in on retained death benefit transactions in a manner that could, unfortunately, result in this option no longer being available to California residents.
Specifically, the California DOI has proposed Section 2548.8 as an amendment to its life settlement regulations. Much of the amendment is reasonable as it creates a process for retained death benefit transactions and ensures that the policy seller is given important disclosures. However, the amendment also addresses the situation in which a policy purchaser might decide that it no longer wants to keep the policy. This can happen, for instance, if the insured significantly outlives his life expectancy or the issuing carrier increases significantly the cost of insurance to keep the policy in force. The amendment requires that the provider (whether or not the provider then owns the policy) “notify the owner that the policy will lapse thirty (30) days before the policy lapses, and provide the owner the opportunity to pay the entire premium to maintain the policy. . . .” This obligation assumes that the provider will know that the funder who purchased the policy has decided to lapse a policy, which may well not be the case. In addition, the original funder could have subsequently sold the policy without the provider’s knowledge. However, a far more troubling provision is triggered in the event the original owner does not want to pay the premium to keep the policy in force, which is a virtual certainty. In that event, the provider is required to pay the original owner “an amount equivalent to the death benefit that the owner’s designated beneficiary would have received had the policy reached maturation within 30 days after the policy lapses.”
In essence, the California DOI is making the provider in the transaction a guarantor of the retained death benefit obligation to the original owner, even though the provider is extremely unlikely to own the policy at the time the decision to lapse is made. The result of this unfortunate obligation is that it is unlikely that providers licensed in the State of California will be willing to offer the retained death benefit option to California consumers, once again proving the old adage, “If it ain’t broke, regulate it."