Meet 2 experts calling for a revamp of the life settlement market

Freedman (pictured at right): Investor capital is coming into the market, but not to the same levels enjoyed in prior years. For the life settlement space to grow on the order that Dr. Cohen is talking about, there has to be greater market transparency. Investors need to see financials, such the cost of capital and the costs of acquisition, in order to determine return on investment. This is starting to happen.

Another development is the merging of investors with life settlement providers, or the parties that contract with the policyowner's broker.

These providers previously had been independent, buying policies and selling them to third-party investors. A number of providers are now integrated with investors firms. GWG owns its life settlement provider, as do several other investor companies. That integration boosts market efficiency and the alignment of interests among the market's participants.

Hersch: Dr. Cohen, do you believe that the market's growth hinges on further integration of investors and providers?

Cohen: That's a key component, but two other fundamental problems have to be addressed. One concerns the financial incentives: Life settlement providers, and their broker counterparts, are paid a commission when a close a sale, rather than on the basis of policy performance. The result is they're often not getting the sale price right.

Paying a commission for doing a deal is an awful incentive in any type of market, but especially so in a bidding market. These bidding markets often create a "winner's curse," a tendency for the winning bid in the auction to exceed the fair market value of the item purchased. And that happens because the players transacting the sale don't care if they have the price right. The winner in this case, the investor, is really the loser.

Freedman: To my earlier point, this issue is resolved on one side of the transaction when the investor owns the provider. The interests of the two parties, now one and the same, are aligned in respect to the cost of policy acquisition.

Cohen: Agreed. And in GWG's case, there is such an alignment. But separate from this concern is a second issue, intermediation costs. There are currently two layers of intermediation: (1) the broker on the policyholder's side; and (2) the life settlement provider on the side of the investor.

Both parties are paid generally high commissions. From all the anecdotal evidence I've seen, those intermediation costs can be huge — commissions so high as to retard the growth of the market. You cannot have a well-functioning market develop if the intermediation costs are astronomical and not publicly reported.

Hersch: So the solution to this problem is disclosure of transaction costs, yes?

Freedman: Let's be clear: Disclosure is already a hallmark of life settlement transactions in that consumers are required to receive disclosure of brokers' compensation. Statutes are now in place in most of the states stipulating mandatory disclosure of the gross and net offers on policy sales. So buyers and sellers can easily determine what's being paid in commissions.

Hersch: So what are the intermediation costs?

Freedman: They range. To the point Dr. Cohen was making, these costs are still very high, and thus an obstacle to new investor capital if not addressed. Institutional investors are tackling the problem by, as we've discussed, purchasing policies through their own provider.

They're also cutting transaction costs through direct-to-consumer marketing — thereby cutting out the broker. The trend aligns with the growing number of do-it-yourself consumers who are saying, "I don't need a broker. I can sell my policy on my own."

Cohen: These are positive trends, but to ensure fair market value and minimize intermediation costs of policy sales there has to be an additional step: public disclosure of sales prices and commissions. While sellers know the closing prices and transaction costs on their own policies, absent public disclosure, they don't have such data on contracts sold by other policyholders. And because this information isn't publicly available, policyholders can't know whether the amount they're receiving on a sale and paying in commissions is higher or lower than the market average.

If and when such public disclosure becomes the norm, not only will the increased transparency producer better policy benchmarking for investors, but also reduced costs for policyholders. That may happen either by cutting out one or both intermediaries — independent providers and sellers' brokers — or by reducing their compensation. Hersch: GWG Holdings and like-minded companies aside, do you see the life settlement players as being receptive to these points?

Cohen: I don't at this point. The main reason is that each player is individually a beneficiary of the current fee structure. So what you'll need is either a new, disruptive player coming in and saying, "We'd all be better off if we could grow this market by [undertaking the aforementioned measures]."

Or you need to see some results. In other words, the life settlement providers who are incented to get good returns to pick good policies really do pick better policies. And there needs to be transparency across transactions that all capital investors and policy sellers can observe.

See also:

• Don't get confused: Life settlement transactions are safe and regulated

• Life settlements: Lack of policy flow due to lack of knowledge

• It's time to re-introduce life settlements to accountants