The Coming Death of the Insurance Industry

This is frank discussion about growing epidemic that is set to become one of this countries biggest scams. It is so monumental that it has the potential of bringing down the entire insurance industry… Seriously. If you scare easily, stop reading now. (Note: Podcast 28 has an amazing interview with Steven Leimberg on this subject, subscribe via iTunes to ensure delivery on Sept 19th)

Never before has the insurance industry faced such a cataclysmic onslaught of potential claims than they will begin to see in only a few decades from now. This is a crisis, which was set in motion by a rather innocent idea and has now turned into a greed-infested scheme. If left alone with no intervention, it will have us all looking back in 20-30 years wondering how and why we could of let this happen.

The financial media is finally picking this up as a front-page concern (Business Week Story) and we are seeing something new just recently with shares of Life Partners Holdings (LPHI) that is beginning to look rather ugly. But why is this coming to their attention just now? It is because for years now, the insurance industry has been systematically pilfered and companies are starting to worry about their future. What started out as a small crack, has now become a major crevasse. Is it will be a wonder if some of the companies will actually survive. No, No, No, not because of a hurricane or tornado. Not even from massive fires or devastating floods or the threat of global warming. Nothing natural can come close to how this is going to affect the industry. This is purely man-made.

It started with an idea from Prudential around 1988. At the time, it was innovative and extremely beneficial to policyholders. You see, back then; AIDS was causing a terrible problem as experimental treatments were very costly. When a patient‘s money ran out they had few alternatives. Prudential devised a way for those who were afflicted to sell their life policies for a substantial amount in return for assigning the death benefit back.

This was the incarnation of what was to become known as Viatical Settlements. The original plan quickly morphed into an investment scheme for many unscrupulous companies who realized that those that were in need of funds would sell their policies for almost any amount. Fair or not. Investors poured in with the promise that within a short time (as AIDS patients had limited life expectancies) they would profit by 15%-25% on their investment. Even as concern was raised about the morals of such a plan, Viatical Settlement companies were popping up in record numbers. It was on later that investors learned that this no-risk plan had many problems and their easy profit wound up turning into ugly losses.

Along the way, the greedy got rich by setting up phony guarantees and investors were fleeced of millions of dollars.

Death of Insurance IndustryThis was just the beginning. These days everyone profits from this (except the insurance industry) and it is finally becoming topic in focus. It can be said that the plan has morphed into a win-win-win-lose scheme.

Now you have a basic background and the genesis of Viatical Settlements – though they are now referred to as Life Settlements amongst the politically-correct. (Think of Stewardess/Flight Attendants and Garbage Men/Sanitation Engineers)

Today, the players are many and the scheme is gaining popularity: It did not stop there; in fact it only gets worse. Presently, the numbers are a lot bigger as the schemes get more and more crafty. These days, seniors are the ones that are selling policies to investor groups and why not? They too are in for a piece of the profit.

Here is how a typical plan works: First, an insurance agent approaches a senior (usually 75 years old or so) and sees if they are willing to have a life insurance policy bought on their life. Often times, the insured will be required to have a net worth well in excess of $1 million as this plan works much better with higher death benefits. A company, specializing in loans for this investment plan, will advance the annual premiums for 2 years. This is important, as there is no money actually changing hands or expended from the insured to the insurance company. When the policy is issued, the insured usually retains the rights for exactly two years, until the contestable period is over.

Contestable Period Definition – Life insurance policy clause that provides a time limit (usually two years) on the insurer‘s right to dispute a policy‘s validity based on material misstatements made in the application.

When the loan comes due at the end of the “contestabilty period” the agreement will usually stipulate that the policy will revert ownership to the company (depending on the exact terms of the arrangement) that provided the advance on the premium (premium plus interest of 10% plus annually). This is important, as this is where the profit potential is realized – For the second time! From this point they try to sell the policy to other investors looking to profit from the death of the original insured the third profit potential.

We could stop there and say that there are several issues that stink to high hell:

    1) Insureds are induced to do this, as there is BIG MONEY in it for them; assuming all goes well. I have personally seen insureds receive $100,000 PLUS for simply standing in for an insurance exam and signing policy paperwork. I know of several more who received much higher “inducements”.
    2) Agents stand to make huge profits as they are usually paid anywhere from 50%-70% of the first years premium on these types of policies.
    3) The loans for the premium are charged at a rate significantly above market
    4) The higher the death benefit, the better the plan works for all involved
    a. Higher Premiums equal higher agent commissions
    b. The greater the financial worth of an insured, the higher the death benefit
    c. The higher the death benefit, the higher the premium resulting in the more “inducement” the insured will be paid

Here is where it gets tricky. Since there is a significant financial incentive to showing a net worth as high as possible; financial creativity is key. Valuations can be “enhanced” on real estate and businesses rather easily as can the approximated value of other assets. This is a real conflict that should be (but isn’t) taken seriously. Unfortunately, I have also seen several occasions where agents show insureds how to “optimize” these values in order to qualify for a higher death benefit. Just to be clear, this is not just a friendly exaggeration of values that one may do on the golf course. This could be deemed FRAUD.

The risk is weighed against the potential for a nice payday if the plan is approved. The usual decision is no surprise. (Picture the three monkeys with their hands over their eyes, ears and mouth)

Now, here is the reveal of how the life insurance industry is facing potential extinction if nothing is done:

As a practical matter, insurance companies build assumptions as to the percentage of policies written that will lapse into their pricing models. Since policies purchased only to be sold to investors will never lapse, insurance companies will have to pay claims much greater than they paid for. To add insult to injury, rather than paying full premiums, investors usually pay in only the minimum necessary to keep the policy going, thereby depriving the carriers of the capital necessary to invest to pay interest or dividends and cover maturing claims.

As for the insurance industry: “Be careful what you ask for; you might get it.” To be fair, the insurance industry is not without blame. They welcomed the record breaking sales and have turned a blind eye to the potential abuses in pursuit of short term profits. As one described it, “they took a bite of the poison apple; and they liked it.” Now, they‘re bailing water as fast as possible to avoid the pending actuarial disaster.

The concept of life insurance was born out of a notion of public trust and common good and special tax incentives were granted as an inducement for bread winners to buy insurance to protect their widows and orphans from becoming wards of the state. While the greedy modern day robber barons will argue that it‘s property and you ought to be able to do what your want with it, we can not lose sight of the fact that it‘s a very special type of property and different from stocks, bonds, real estate and other commodities.

To purchase life insurance one must have an “insurable interest”- a risk of loss that would occur if the insured dies. Theoretically, one‘s life and children are presumed to be better off if their husband or father stays alive. The purpose of the insurance is to replace some or all of the income the insured would have earned had he lived.

In these pre-sold, financial arrangements, it‘s exactly the opposite. When outside investors are the beneficiaries, the sooner you die the better their internal rate of return. Life insurance is reduced to no more than a gambling contract which is against public policy.

With ever mounting deficits, it may only be a matter of time until congress strips life insurance of it‘s favored tax treatment; thereby making it more costly for “Average Americans” to obtain the coverage they need and upholding a sadly ever-expanding phenomenon of the greedy few destroying an important family financial instrument for the masses.

Many carriers are now fighting back. Some send out investigators to interview insureds as to why they bought the insurance or what they expected would happen so they can rescind contracts. Others simply are refusing to accept collateral assignments and requests for change of ownership. Many have updated their applications to include questions that require disclosure of any financing arrangements, up front incentives or potential sales opportunities.

Even though promoters still tell prospects “not to worry about it” there‘s no statute of limitations on fraud.

While the market for purchase of policies remains strong as fortune 500 pension funds and major financial institutions seek to acquire large trenches of life insurance as an uncorrelated asset, there‘s now so much “tainted paper” out there (i.e. insured‘s misrepresented their net worth, financing and/or intent to sell) that it is becoming harder and harder for “legitimate” policy owners whose circumstances may have changed, to sell their policies they no longer need or can afford. And it is becoming harder and harder, especially for older people with legitimate needs for life insurance for their business and estate planning, to be able to acquire the coverage they need and want for their own families.

One can only wonder how long it will be until this golden goose is dead.

And what about the tax consequences to the unsuspecting insureds who were induced to give their bodies to this science experiment with the lure of “free money”. What about the ordinary income tax they will owe on the sale of property not eligible for capital gains treatment; or worse yet, on the phantom income from the forgiveness of debt when policies are given up in satisfaction of the otherwise non-recourse debt?

This is story that is going to unfold with nasty consequences. The question is: What to do about it… Avoid or Short? Stay tuned….

Companies: (LPHI)(MET) (MMC) (PRU) (AEG) (MFC) (SLF) (ING) (PFG) (AIG)

Disclosure: Horowitz & Company clients do not hold positions of companies mentioned directly (may be owned in funds etc)