As they look for new sources of profit, some Wall Street -- and Main Street -- investors have embraced a ghoulish way to make money from the death of ordinary Americans. Their unsavory activities could eventually result in people paying more for, or losing access to, the products that provide financial protection to families and help individuals achieve their retirement goals.
Stranger Originated Life Insurance (STOLI) is a scheme in which unscrupulous operators persuade older Americans with health problems to take out new life insurance policies, paid for by "investors" who hope to profit from the insured's death.
These operators aggressively seek out senior citizens with health issues that suggest shortened life expectancy -- because the sooner the insured individual dies, the more money the investor stands to make. To get seniors to pass underwriting requirements, the operators may collude with the "applicants" to submit incomplete or inaccurate medical and financial information to the insurance company.
These elderly victims not only unknowingly risk criminal and civil liability for their actions, but they often expose themselves to major tax liabilities for any financial benefits realized through a STOLI transaction.
To protect older Americans from these practices, 28 states have already banned STOLI transactions. That's the good news.
The bad news is that 22 states have not yet enacted strong STOLI regulation. Moreover, there is a growing interest in life insurance securitization, in which multiple policies are bundled into financial instruments and then sold into the capital markets. Securitization is particularly dangerous because it can fuel the demand for STOLI transactions.
Proponents of securitization argue that it will increase the availability of funds for policyholders seeking to sell their policies and provide investors with strong returns. However, policyholders who no longer need or want their coverage can easily sell it via the existing, very active and more than adequate life settlement market. And many insurance companies offer their clients early access to policy benefits when they are faced with limited short-term life expectancy.
Securitization of life insurance settlements has the potential to generate hefty fees and profits for Wall Street. With $19 trillion of life insurance in force in the United States, some argue that tapping into just a small portion of that pool could produce a $500 billion market and a huge stream of fee income for the originators of these new financial instruments. It's no surprise, then, that Wall Street firms have been looking closely at this business.
However, the money flowing into this market could serve to incent the questionable practices of those seeking to make a fast buck at the expense of elderly Americans.
Individual life insurance products are priced on the basis of the needs, preferences and behaviors of the retail consumers they insure and for whom they are intended. Institutional investors have an entirely different interest in these products and thus behave differently in regard to how they treat the policies they own. As a result, gains that accrue to investors can only be generated at the expense of all retail consumers, who will ultimately have to pay more for the life insurance coverage they need.
Securitization-fueled STOLI could also lead to higher policy costs because life insurers would need to spend more money detecting and preventing fraud.
In addition, an increase in STOLI transactions may cause some life insurers to reduce the amount of insurance they provide to older segments of the population, thereby restricting access to life insurance for individuals who need it for legitimate reasons.
Along with the American Council of Life Insurers, we believe STOLI transactions need to be banned in all states to protect Americans from those who choose to prey on them, and the securitization of life insurance settlements should be prohibited. If permitted, these troublesome practices could also be extended to and have a negative impact on other financial products, such as annuities.
Actually, that's already happening. Despite recent headlines about fraud and abuse in the life insurance market, unscrupulous operators are now lobbying regulators to pass legislation allowing the sale of annuity benefits to third parties -- a practice known as Stranger Initiated Annuity Transactions (STAT).
Although many annuity contracts specify that the benefits cannot be transferred to a third party, proposed legislation in Kentucky, for example, would override these contracts and permit STAT.
As with life insurance, when an individual's benefits from an annuity can be sold to a third party, it creates enormous potential for fraudulent activity. Ultimately, this type of fraud drives up costs and reduces everyone's access to needed products.
We have already seen how the unregulated "chase for profit" led to the origination and securitization of sub-prime mortgages -- and how this activity helped fuel the real estate boom and bust. Let's not make the same mistakes again in the life insurance and annuities markets.
James Avery Jr., president of Prudential's Individual Life Insurance business, The Prudential Insurance Company of America, Newark, N.J.