The life settlement industry is quite recent, growing from just a few billion dollars in late 1990s to about $12-$15 billion in 2007, and according to some projections, is expected to grow to more than $150 billion in the next decade. A life settlement is a financial transaction in which a life insurance policyholder sells the policy to a third party (a life settlement firm) for more than the cash surrender value offered by the life insurance company, thereby the third-party purchaser assumes responsibility for all subsequent premium payments to the life insurance company and becomes the new beneficiary of the life insurance policy at maturation (i.e., the time of the original policyholder's death).
The life settlement industry results from two key features of the primary life insurance market. The first feature is that the premium for life insurance is typically front-loaded in the sense that the premium exceeds the actuarially fair premium in early years, while it is lower than the actuarially fair premium in latter years especially when the policyholder has impaired health. The second feature is that the cash surrender value (CSV) for life insurance contracts is either zero for Term insurance, or at a level that is low and does not depend on the health status of the policyholder. Because the present actuarial value of a life insurance policy is much higher for individuals with impaired health, the fact that the CSV does not respond to the health status provides an opening for the gains of trade between policyholders with impaired health and the life settlement companies.
The emerging secondary market for life insurance has triggered controversies between life insurance companies and the life settlement industry. Life insurers are opposed to life settlements. Given the importance of life insurance market in the economy, it is important to rigorously study, both theoretically and empirically, how the emerging life settlement may affect the primary life insurance market.
This research has two goals. First, the researcher is using economic theory to analyze the effect of the secondary market for life insurance on primary market insurance contracts and on consumer welfare. Second, he conducts empirical tests of the theoretical predictions about how the primary life insurance market may respond to the threat from the settlement industry. Finally, he uses the results of these tests to ultimately calibrate the models and quantify the welfare effects of the life settlement industry. In particular, to the extent that the answer to the first question, particularly the consumer welfare question, depends on why policyholders lapse, i.e., whether it is due to loss of bequest motives or due to liquidity shocks, he also examines why policyholders lapse.
The research project will provide the intellectual knowledge for more informed government regulation regarding the life settlement industry. Because life insurance is one special type of dynamic contracts, the research can also potentially shed light on the secondary market involving dynamic contracts in general.
