There has been much discussion in recent months over the revisions to mortality tables by several of the major life expectancy providers. While this should be a matter of concern to anyone interested in life settlements as an asset, another matter of equal or greater concern is just starting to get the attention of investors: the proper due diligence necessary to ensure that investors are purchasing an investment grade asset with clear and unencumbered title.
Life settlements have characteristics that make certification of title more difficult than typical investments. The life insurance policy may have been owned by an individual or entity, usually for a period of several years, prior to being sold as a life settlement. As a result, it may be subject to liens, loans, divorce decrees, judgments and other encumbrances. If these encumbrances are not discovered prior to an investor’s purchase of a life settlement, significant impairment to the value of the asset can result.
“Trust, but verify”
A policy can be owned by an individual, a corporate entity or by a trust, often an irrevocable life insurance trust, also known as an ILIT. ILIT’s can be complex, and are usually structured by trusts and estates experts. Whenever the purchase of a policy owned by a trust is contemplated, the trust agreement must be reviewed carefully for two particular issues: the state of the trust’s situs or location and whether the current trustee(s) of the trust are properly authorized to act on behalf of the trust.
Life and/or viatical settlement transactions currently are regulated in 41 states, and the state of residence of the policy owner determines which state’s settlement laws will govern the transaction. Trusts, like people, have a “residence,” also known as the trust’s situs. Determining the situs of a trust can be surprisingly difficult. If a trust agreement does not contain a situs provision, then several factors must be reviewed to determine the state of the trust’s residence, including, but not limited to: 1) any choice of law clause in the trust agreement; 2) the state of residence of the trustee; 3) the location of the bank account used to pay premium on the policy; 4) the location of the trust’s tax situs; 5) the state in which the physical policy is located; and 6) where the grantors lived at the time the trust was created. If an investor assumes that a trust’s situs is New York simply because the trust contains a provision stating that New York law governs the trust agreement’s interpretation, she might be in for an unpleasant surprise if it later turns out that the trustee lived in, and administered the policy from, the State of Florida, making the sale of the policy by the trust subject to Florida’s life settlement laws. Any life settlement that was originated illegally in an unregulated transaction from a regulated state will lose significant value if an attempt to re-sell the policy is made at a later date.
It is also necessary to confirm that the trustee of the trust is properly appointed and has the specific authority to sell the policy. Some trusts contain complex succession provisions, and if they are not followed the purported trustee will not posses the authority to act on behalf of the trust. Other trusts specifically prohibit the sale of a life insurance policy to anyone not having an insurable interest in the insured. Both of these issues can impair the value of a life settlement in a subsequent re-sale transaction because they call into question whether the policy was properly sold by the trust, thus creating tail risk of a challenge to the validity of the policy’s sale.
Background Checks
Because a life insurance policy can only be obtained by individuals making representations about their health and financial status, running a basic background check on the policy owner is a simple step that can help ensure the quality of life settlement assets. For instance, a background check can reveal whether a policy owner has a judgment or liens levied against him that cloud title to the policy to be sold. If the seller does not affirmatively disclose this fact, it could remain undiscovered until some later date, causing serious issues for the then-owner of the policy.
A background check can also show if the policy owner has filed for bankruptcy. And, notwithstanding a specific exemption for life insurance policies in the bankruptcy code, if the owner is currently in bankruptcy an order from the court approving the sale should be obtained to confirm that the bankruptcy trustee approves of the transaction and will not later try to unwind it.
Divorce Decrees
It is not unusual for one party to a divorce decree to have an obligation to keep a life insurance policy in force, with the other spouse as the beneficiary. Case law holds that the beneficiary spouse has an equitable interest in any life insurance policy subject to such an obligation, and it is probable that the insurance policy sale transaction could be unwound by the beneficiary spouse if it is undertaken without his or her consent.
Similarly, in states that have martial property laws, if the existence of the policy was not disclosed to the court and addressed in the property settlement agreement, the former spouse will retain an interest in it. If that former spouse learns of the sale of the policy, he or she might have a cause of action to challenge the sale of the policy to an investor.
Premium-Financed Policies
A profusion of premium-financed policies have flooded the secondary market in the last few years. Originally, sellers of these policies tended to disclose that the policies were originated through a premium finance program, but as the market for premium financed policies has bottomed out, promoters of these programs have been less forthcoming about the origin of the policies they are attempting to sell. This presents a particularly significant issue for investors in life settlements. If a policy was originated from an improperly structured premium finance program, the owner may not have had an appropriate insurable interest at the time it was issued, thereby potentially rendering it null and void. This is of particular concern given the recent aggressive steps some life carriers have been taking to challenge and rescind policies they allege were originated for the benefit of strangers without an insurable interest in the insured.
Conclusion
Thorough due diligence is a basic tenant of virtually every corporate transaction. Because of the relatively informal origin of the secondary market for life insurance, and its comparative nascency, however, the life settlement industry is only beginning to embrace a comprehensive due diligence regimen designed to ensure that the life settlement assets purchased by investors are of the highest quality possible. Any investor considering deploying capital into life settlement assets is well advised to make certain that any participants in the life settlement industry with whom they work has implemented a robust diligence program.
James W. Maxson is Of Counsel in the firm’s Insurance and Reinsurance Practice and co-chair’s the firm’s Life Settlement Practice. Mr. Maxson concentrates his practice in corporate and regulatory matters for the life settlement industry, as well as focusing on mergers and acquisitions and securities transactions. Jim received his bachelor’s degree from Denison University and law degree from the Ohio State University School of Law.