The question was: What is the economic basis for life settlements? That is, what makes them "work" for the investor and client?
The answer is: Life insurance was originally sold as pure risk protection. A principal person was responsible for another person's welfare or for payment of debts and, in the event of the principal person's early death, life insurance provided funds to pay these obligations.
At some later time, life insurance was marketed in many forms as savings, investment or estate planning tools, in addition to pure risk protection. For purposes of this discussion, such a later policy is referred to as a cash value policy (CVP).
CVPs are complex contracts that provide numerous economic values for policyowners, beneficiaries, insurers, agents, and advisors, plus various tax values to federal and state governments. CVPs create value for the policyholder in several ways: a) the death benefit to the beneficiaries (this can be a subjective value since it pays after the insured dies); b) policy earnings paid as interest or dividends by the insurer; c) accrual of premiums paid by the policyholder in excess of the insurer's cost of insurance and expenses; d) the ability to convert the policy to another policy; and e) in the case of variable investment policies, the expected value of the returns on the invested excess premiums….
At any time after a CVP is issued, the policy typically enables the policyholder to surrender the policy for its net cash surrender value, or the policy may be converted to another policy type having a comparable or lesser value. However, at the time of such surrender or conversion, the secondary insurance market (i.e., life settlement investors) determines a market investment value for the policy. This is generally equal to the present value of the future death benefit less the present value of the premiums required to keep the policy in force until the death benefits are paid.
