The past two years have not been overly kind to the life settlement market.

The economic crisis of 2008 dried up much of the capital of the institutional investment community, resulting in the life settlement universe being cut by nearly half. Then the Internal Revenue Service issued an often-confusing ruling last August that attempted to clarify the tax treatment for life settlements. Adding to that were major changes in the actuarial tables in late 2008, extending life expectancy by as much as 10-25 percent.

And lastly, the predatory image of life settlement brokers coercing seniors to take out and subsequently sell their policies was amplified by a high-profile lawsuit filed by former New York State Attorney General Eliot Spitzer against Coventry, one of the country's largest life settlement brokers, accusing it of bid-rigging to keep seller prices down.

Yet with roughly $1.5 trillion of in-force life insurance either lapsing or surrendered on an annual basis, life settlements - the sale of an existing policy to a third party via the secondary market in exchange for a one-time cash payment - are slowly inching their way back onto the investment landscape.

"We're seeing more institutional buyers re-entering the marketplace," reported Amy Garvartin, director of advanced markets for Melville Capital, a life settlement broker in Scottsdale, Ariz. "But there's a lot of misconceptions out there about life settlements and bad press."

YEA OR NAY

Proponents of life settlements contend that allowing the sick or elderly to sell their life insurance policies to a third party when they can no longer afford the premiums or otherwise don't need the policies is a sounder investment than the insurance carrier's cash surrender value, which is often a fraction of the policy's death benefit.

Opponents argue that the industry is unregulated and thus ripe for fraud, although 40 states now have some form of life settlement regulation through state insurance boards.Most recently, New York, Illinois and California have established regulations on the sale side of life settlement policies, requiring buyers of life settlement policies to be licensed.

"Do you know of any other industry in which the buyers have to be licensed and not the sellers?" asked Doug Head, executive director of the Life Insurance Settlement Association in Orlando, Fla., a 130-member trade group, who estimated that the market, which was once valued at roughly $16 billion, has been winnowed down to somewhere between $6 billion and $8 billion. "There's a potential for a lot of investment here," he opined. "But you also have to realize that it's not a short-term investment. Now I think the market is more reflective of moderate growth with better-informed investors and sellers."

However, Head said that last year's IRS ruling on the tax treatment of life settlements may spark some investor reluctance.

The guidance, Rev. Ruling 2009-13, was issued to clarify when and the extent to which policyholders must recognize capital gains when they sell a policy.

When an original owner surrenders a policy, the owner's taxable profit is reduced by the amount of any premiums paid. However, if they sell it to a third party, the owner's basis is not equal to the full amount of premiums paid, but instead the cost basis consists of the cumulative premiums paid into the insurance contract plus a subjective "cost of insurance" or "provision of insurance" figure (see "Life and taxes," at left, for an example).

"It's simply a bad and confusing rule," stated Head. "It needs to be rethought."

A NEW MODEL

Daniel Powell, chairman and chief executive of Los Angeles-based investment concern Christian Stanley, echoed Head's optimism about future growth in life settlements, but said that the industry model itself remains a large part of the problem.

"There's a lot of potential, but [the life settlement industry] is archaic. They're still using the same buy-and-hold model they have for years," said Powell. "As a result, there's not enough new money coming in and the policies that have been purchased are just sitting in someone's vault waiting to mature."

Powell said that his firm has created a new financial vehicle, a "Life Shares" mutual fund comprised solely of reverse life insurance policies. "What we've done is turn it into a securitization business," he said. "Everyone should know what they could sell their policy for, just as you would your house or your car. You should have it appraised. You and your accountant need to sit down and figure out what's best."

PROCEED WITH CAUTION

However, not everyone is as anxious to wade into the life settlements market.

"I'm skeptical of them," said Glenn S. Daily, a fee-based insurance consultant in New York who provides reviews of life settlement offers. "I work off the presumption that the policyholders are giving up too much money. In a case I did last year, the insured was 85 years old and the son was the owner of the policy. We reviewed the policy as an investment, but if she lived a long time, he could lose money. He only got two offers and knew he was leaving a lot of money on the table."

Dave Mickelson, a chartered financial consultant, accredited estate planner and principal of Mickelson Capital Consulting in Oceanside, Calif., maintains that every case is different and requires a professional to assess the risks and rewards: "When it's all said and done, you need to have a financial planner look at the situation. ... There's never a simple answer. But it's not rocket science."

Life And Taxes

An owner buys life insurance on his own life with his family as beneficiary. He pays $64,000 in premiums over eight years, then surrenders the policy for $78,000. During the eight years, he pays $10,000 in "cost-of-insurance" charges. If he surrenders the policy, he has $14,000 of ordinary income ($78,000 cash surrender value minus $64,000 in premiums).

However, should he sell to an investor for $80,000, the owner now has $26,000 in taxable income. That includes $14,000 in ordinary income ($78,000 CSV minus $64,000 premiums paid) and $12,000 long-term capital gain income ($80,000 sale price minus $78,000 CSV).

Under Rev. Rul. 2009-13 the IRS analyzes the transaction as "the sale or other disposition of property," and inserts an "adjusted cost basis," rather than "investment in the contract."

Therefore, the seller's basis in the contract must be adjusted to reflect the hypothetical $10,000 cost of insurance. Thus, the adjusted cost basis then drops from $64,000 to $54,000. Therefore even though the seller received just $2,000 above the CSV, the total gain is $26,000 ($80,000 sale price minus adjusted basis of $54,000).

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