Let’s look an opaque industry that bets on stranger’s lives… known as the life settlement industry.
Stranger-originated life insurance (or, “STOLI”) are policies where the beneficiary is an independent third-party with no ‘insurable interest’ in the insured.
In other words, let’s say you’re 70 years old. You take out a life insurance policy with the immediate intent of selling it to an investor. The investor pays you 3% of the policy face value upfront. In turn, they pay the premiums and become the beneficiary if you die. So you’ve just sold someone a financial interest in your death.
Since the beneficiary is an investor (not someone close to you like a family member), this is a stranger-originated life insurance policy, which not allowed in most states.
This STOLI market took off in the early 2000s. Since then, states have cracked down on the schemes and have tried to limit the amount of new STOLI policies. But, policies that were issued and in circulation from the early 2000s are often now coming due as the seniors reach the end of their lives today.
This raises a question - what can an insurer do today when it finds itself on the other end of a STOLI policy for millions of dollars in death benefits? Does the fact that it’s a STOLI potentially deem the contract void?
Now that depends on the state in which the policy was issued.
Insurable Interest and Contestability
Life insurance policies must have an ‘insurable interest’ when written. The California Insurance Code defines insurable interest as
an interest engendered by love and affection in the case of individuals closely related by blood or law
or
an interest based upon a reasonable expectation of pecuniary advantage through the continued life, health, or bodily safety of another person
So, the obvious and ok scenario here is that I take out a policy and make my family member the beneficiary. That’s totally fine and meets the insurable interest requirement.
Most state law says that any policy in which the insurable interest requirement is not met is generally void… the policy is treated as if it never came into existence.
But think about it… let’s say someone walks into a senior living home and recruits a fella to take out a life insurance policy.
The salesman says that you will get 2 years of life insurance coverage in which you don’t have to pay any premiums plus thousands of dollars at the end of the 2 year period.
Great, you sign up. The salesman fills out the application and gets your policy written. After issuance, a third-party investor, who has a relationship with the salesman, pays the premiums on your policy during those first 2 years.
The reason this period is often 2 years is that it’s the ‘contestability period’ in which state law says that’s the amount of time an insurer has to contest a policy as issued under fraudulent circumstances.
Most states mandate the contestability period to be no more than 2 years… but sometimes it’s 3 years.
This makes sense… because on the one hand this provision is meant to offer carriers / insurers a window to contest fraudulent policies. On the other hand, it protects the policyholder from years of paying premiums to later have that policy contested and deemed void (thereby not receiving the death benefit money).
After this contestability period lapses, the investor purchases the policy from the insured, for 3% of the policy value (they will pay $30k for a $1mm policy). The third-party investor becomes the beneficiary of the policy and the senior remains the life insured on the policy.
There’s a twist, as there often is in these situations.
Insurable interest is only a requirement at the time of issuing the policy. The policyholder reserves the right to later sell the policy to a third-party.
When this sale occurs, the third-party pays the premiums, pays an upfront fee to the insured party to acquire the policy, and becomes the beneficiary in the event the insured dies.
The strange thing here is that the investor has no (financial) interest in the insured living a long time… in a different perspective, a third-party now has a financial interest in your death.
State Law
Different states have different approaches when an insurer tries to void a STOLI policy on suspicions of fraud.
Take Florida as an example. In 2016, the Supreme Court of Florida had a ruling which read that the incontestability provision trumps the insurable interest requirement for Florida-issued policies.
The case dealt with a broker, Gary Richardson, who persuaded Rosalind Guild to participate in a $10mm STOLI scheme.
Gary, the broker, submitted fraudulent financial statements inflating Rosalind’s net worth to receive larger policies. This is a piece of STOLI fraud that is all-too-common to get the largest possible policy. 2 years after issuance, Rosalind sold the policy to an investor.
Years later, the insurer tried to invalidate the policy, arguing it lacked a legitimate insurable interest upon issuance. The Florida Supreme Court ruled that the incontestability provision trumps the insurable interest requirement.
Here is what the court said
a policy that has the required insurable interest at its inception, even where that interest is created as the result of a STOLI scheme, is incontestable after two years
What does all of this mean for Florida? Well, it’s a pro-investor state. If you’re buying these STOLI policies, you might want to focus on a state like Florida with favorable precedent protecting your interests.
However, yet another spin, Florida issued legislation in 2017 that seeks to render STOLI policies as void and unenforceable. But, these provisions have not yet been applied or interpreted by a court.
Even further, it remains to be interpreted whether this 2017 anti-STOLI legislation has retroactive effect… meaning that a policy issued in the early 2000s during the hot STOLI market is void for lack of insurable interest upon issuance.
On the other side, New Jersey is the opposite. Jersey says that the insurable interest requirement trumps the incontestability provisions.
In a 2019 case, the New Jersey Supreme Court ruled that insurers can seek to void a policy after the contestability period if that policy lacked an insurable interest at time of issuance. New Jersey is pro-insurer.
So, if your an insurer, it seams like a good trade to still take ‘shady’ business that may be a STOLI scheme. You can receives years worth of premiums and then IF the insured passes away, you can contest the policy as void / fraudulent and save yourself from having to pay the death benefits..
Favorable state law lets the insurers keep the premiums and death benefit.
Capital Preservation and Law
An interesting theme here is how closely law relates to investing and the preservation of capital. In a simple model, the STOLI schemes sounds like an interesting proposition to both the insured and investor.
The insured who sells her policy can get liquidity from the investor. Alternatively, maybe they can no longer afford the premiums. Instead of letting the policy go void if she stopped paying premiums, an investor could take over the policy and pay upfront consideration to do so.
In return, the investor is compiling uncorrelated investment risk. Sounds interesting to both sides… but state law intervenes to make this more complicated.
And, we saw how understanding state law impacts where you would want to focus on this from an investor standpoint. It would make far less sense to go purchase a portfolio of STOLI policies in Jersey than it would in Florida.
Apollo
Apollo has been in the news this week for its involvement in a STOLI scheme. The firm holds a portfolio of STOLI policies wroth ~$20bn.
A complaint has been filed by the estate of Martha Barotz, found here, which alleges that Apollo has been “carrying out a widespread fraudulent human life wagering conspiracy designed to not only hide its involvement, but to create the false appearance that the policies it owns are somehow legitimate.”
The setup in this specific case is as follows.
Martha Barotz, a New York resident, took out a $5mm life insurance policy in 2006. She received $150k upfront (3% of policy value) from Life Accumulation Trust III (LATIII).
A trust was then setup in which LATIII became the beneficiary of any death benefits and in turn paid the policy premiums.
Then, in 2011, LATIII sold the Barotz trust to an affiliate of Apollo. When Barotz died in 2018, this Apollo entity received the $5mm lump sum.
Now the Barotz estate is arguing to void the policy taken out on Martha’s life.
Which seems strange right? Martha Barotz received $150k in selling the policy to LATIII. She didn’t have to pay premiums. The investor purchased her policy, paid the premiums, and when she died, believed they were entitled to the benefit.
Now Martha’s estate is saying no, no no, we are entitled to that benefit. And the Supreme court of Delaware agreed (here)!!
Delaware said that even though Barotz participated in the scheme, this does not invalidate Delaware’s policy against human life wagers.
Here’s what Apollo has to say about all of this:
A life insurance policy is one of the most important assets in a person’s financial life; it can provide certainty and financial security unlike any other asset can. Courts repeatedly have upheld a person’s right to sell his/her insurance policy, much like any other financial asset, and that is what the original policyholder voluntarily did here. People choose to sell their policies for any number of reasons personal to them, and a robust and entirely legal market exists to purchase those policies. The life settlement market developed in response to seniors’ and retirees’ need for liquidity, and provides the opportunity for seniors and retirees to maximize the value of life insurance policies they no longer need or cannot afford to continue to own. In the years leading up to the GFC, large banks and other financial institutions acquired a substantial amount of life settlements that were owned on their balance sheets.
Apollo established Financial Credit Investment I (“FCI I”) in 2010 coming out of the GFC as a vehicle to acquire pools of life settlements and other insurance-linked securities from banks and other large financial institutions who needed to raise capital amidst the GFC and chose to sell portfolios of life settlements in that effort. FCI I was formed to generate compelling uncorrelated investment returns and provide attractive financial outcomes in the life settlements industry, proving successful in both regards. Importantly, FCI I never participated in the origination of any life insurance policy. The law firm that brought this current lawsuit has a cottage-industry practice of challenging life settlements all over the United States, including some in which the FCI funds or their subsidiaries are indirect beneficial owners. The defendants in those cases have largely been successful in defeating this law firm’s claims. In this particular case, the Delaware court found that the original issuance of the policy in 2006, as opposed to anything FCI did, was improper under Delaware insurance law. The original lawsuit on this policy was filed in 2020 – four years ago – and does not allege any wrongdoing by Apollo or Athene; rather it simply seeks to recover assets from a fund, FCI I, that was wound down in 2019 in an orderly and common process before the original lawsuit was even filed. Importantly, this lawsuit only involves FCI I and related entities, and does not have any bearing on other Apollo businesses or funds. We believe these claims to be baseless and the suit’s description of Apollo’s historic activities within the life settlements market to be a gross mischaracterization, disingenuous, and flat out wrong.
Conclusion
Secondary markets often increase liquidity in that respective market. Secondary selling of startup stakes increases liquidity in-between capital raises. Private equity fund secondaries offer limited partners liquidity before the closing of a fund. Etc. Etc.
Life insurance is not immune to a resale market as well. This can be thought of as a net positive to the insured who may have had their circumstances change and need money now rather than when they die.
They can now sell their policies to a life settlement business and receive upfront liquidity. The alternative, when the insured can no longer afford the policy, is to let the policy lapse, in which case it becomes worthless. So even if they receive 3% of the policy value, that’s a net positive compared to $0.
So an investor (being the life settlement business) can buy a policy for 3 cents on the dollar. Depending on when the insured dies, that 3 cents cost will blend upwards as they are now responsible for the premiums.
The sooner the insured dies, the lower that overall cost will be, and the more upside the investor will receive.
If we assume annual premiums are 3% of the insured amount, then after 5 years, the total cost will be 18 cents. 3 cents to takeover the policy and 5 years of 3 cent premium payments. Plus commissions to the carrier and broker. Then, if the insured dies, you get paid out at par (100 cents). Less litigation fees if it’s a STOLI policy!
You buy a dollar for 3 cents, premium payments will blend that cost upwards, and presumably you’ll eventually get paid out at par if the insured dies within the contract term. Some of these policies in your portfolio will go to 0, so that will blend down the overall returns.
Insurers clearly don’t like life settlement businesses because they support policies that would otherwise lapse. Lapsing policies allow the carrier to keep any premiums they’ve received and de-risk on the death benefit liability.
This study shows that almost 85% of term policies fail to pay a death claim. 88% of universal life policies do not terminate with a death benefit claim.
The main reason policies lapse is due to income and unemployment shocks.
So, insurers make money when policies lapse.
The overwhelming majority of policies have lapsed historically.
As a result, insurers price their policies knowing this estimate of how many policies will lapse. But, with the rise of life settlement businesses, fewer policies may be lapsing, which then impacts how carriers price these policies (as their profitability would decline with fewer lapsing policies).
Anyways, thank you for reading.
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Until next time.
John Galt