An article appearing in the July 2003 "Broker's World" magazine.

Ever Since Sally Bryant Quinn used her Newsweek column to tell us all to "Buy term and invest the difference", the sales of term life insurance relative to permanent forms have been skyrocketing. (Apparently, most people didn't recognize her conflicted logic in a subsequent column that suggested retirees supplement their income by accessing their highly tax favored permanent life insurance cash values.) The vast majority of life insurance policies sold over the past 15 years have been term life contracts, and they present unique challenges to the life settlement process.

Annual term life policy premiums were once reflective of the increasing mortality as insured persons aged; annually renewable term. The costs per benefit were higher at issue ages, and they increased each year the policy was kept. About 20 years ago, aggressive, less traditional insurers began offering term contracts with premium schedules that remained level for a period of years, then offered aggressively priced renewal rates available to anyone who could state that his health had not declined from the original policy issue date. If health became an issue in the years since policy origination, the insured would either be offered a higher level premium option, or the carrier would slip the insured into an unfavorable, increasing annual cost schedule.

In situations where deteriorating health occurred before the insurance premium schedule reached its renewal date, a shrewd insurance consultant would council his client to convert (if permitted) the term policy to a form of permanent coverage; taking advantage of the more favorable underwriting classification under which the policy was issued, but which would no longer be available to him. The result was that the insured, now in declining health, could purchase permanent life insurance at lower rates and with higher values than under any other circumstances.

Within the past decade, the guaranteed level premium periods offered by term policies have expanded to as much as 30 years, and the maximum age for the guarantee to hold can exceed age 80. However, the privilege to convert many of these term policies has been eliminated. In its place, policies that survive to the end of the initial premium guarantee period before age 80 are slotted into an annually increasing term premium until they reach 80, then into a level premium to age 100 - often at excessively high rates.

The process most often used to determine policy pricing in life settlements is to weigh the policy annual premium, projected mortality of the insured(s), policy net cash value, growth rate for the cash value, insurance face amount, and financial strength of the company. These are all put into a formula to develop a price agreeable to both seller and buyer. Term insurance removes at least two of these keys, and potentially a third. Cash values and their rates of return become non-factors, and premium projections are likely to show significant jumps once guaranteed premium schedules reach their end. As relates to life settlements, this results in unpredictability when pricing a policy - and nothing makes this nascent market more uncomfortable than not being reasonably certain of what lies ahead.

There are two ways to mollify this concern: converting term policies into permanent plans and making buy/sell decisions based on the new, Universal Life or Whole Life contracts; or, buying term policies that will remain at the same term premium well beyond an insured person's projected mortality.

Not all term policies are convertible. Some don't permit conversion and clearly say so within the contract. If this is the case, the only reasonable way to approach to a life settlement transaction is with the term premiums guaranteed well beyond life expectancy. A 65 year old insured at 59, for example, with by 20 year level premium contract issued with favorable underwriting rates but now with a four year life expectancy, would offer a viable policy for life settlement consideration. Even though the policy could only remain term through age 78, the life expectancy projections are short of the end of the premium guarantee period by ten years. If the mortality projection and the premium guarantee period were significantly closer - two or three years for example - a buyer should be leery of the premium risk should the policy remain in force beyond the premium guarantees.

If a policy allows conversion and the conversion is still available at the insured's attained age, the life settlement transaction should be based on the converted policies costs and values. A converted policy allows the owner to manage premiums and cash values into the future by adjusting annual outlays based on reasonable projections into the future by the insurer. These newly permanent contracts can retain their market viability even if the mortality projections prove much too aggressive. Since the conversion is done at the same underwriting classification as when the term plan was issued, the rates will be lower and the cash values higher than any contract available to the insured who would now be a significantly impaired risk, or uninsurable.

Philip E. Lian
Parcside Equity LLC

Parcside is a voting member of the Life Insurance Settlement Association (LISA).
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