The heightened scrutiny of financial products by state and federal regulators resulting from the recent credit crisis has included "life settlements," a product created in the mid-1990s that, according to the U.S. Government Accountability Office, now supports an industry generating roughly $9 billion to $12 billion annually.

A life settlement occurs when the owner of a life insurance policy, or consumer, sells the policy to a purchaser, or provider, typically through a broker, for an amount that exceeds the policy's cash surrender value, but that is less than the expected death benefit under the policy, with the broker being paid a commission by the provider.

Life settlements typically involve high-net-worth consumers 65 or older whose policies exceed $1 million in death benefit. According to the GAO, life settlements can provide consumers a "valuable option" because the payment to the consumer upon the closing of a life settlement is more than the cash surrender value of the policy.

In addition to providing an option for consumers, life settlements may also be a vehicle for investors. Providers can pool large numbers of policies and resell them to investors, either in whole or as fractional interests. In acquiring a policy, the provider undertakes payment of the remaining premiums and becomes the policy's beneficiary. Some providers have developed sophisticated actuarial models that may assist investors in assessing the risks of their potential investment.

The validity of life settlements has been challenged by insurers, whose premium structures are based, in part, on the lapse of a percentage of their policies, as opposed to the sale of those policies in life settlements, and by the relatives of consumers who would otherwise have been the intended beneficiaries of policies transferred in life settlements. Such challenges have typically sounded in fraud or been grounded in assertions that the purchasers lacked an "insurable interest" in the acquired policy.

In 2010, both the GAO and the Securities and Exchange Commission's Life Settlements Task Force, established in August 2009, submitted to Congress extensive reports focused exclusively on life settlements that included in-depth analysis of, among other things, the development and evolution of the product, the participants in the life settlements market, settled and unsettled legal issues surrounding life settlements, and various economic aspects of the market. On Jan. 19 the SEC's Office of Investor Education and Advocacy issued its "Investor Bulletin on Life Settlements," focusing on considerations investors in life settlements should keep in mind when assessing their investment.

In their 2010 reports, the GAO and SEC provided Congress with the following recommendations, among others, that, if adopted and implemented, could provide greater protection for consumers of life settlements and greater certainty for life settlement investors. Some of those recommendations, in particular those concerning life expectancy underwriting, were recast in the recent SEC Bulletin.

First, the GAO and SEC suggested that industry participants take steps toward greater transparency. In particular, the SEC task force recommended that the Securities Act of 1933 and the Securities Exchange Act of 1934 be amended to include "life settlements" as a "security." This change would provide consumers and investors with a baseline of anti-fraud protection, such as subjecting providers to the acts' disclosure requirements and requiring brokers to register with the Financial Industry Regulatory Authority.

Second, they suggested that life settlement providers continue to enhance their underwriting practices. Because underwriting affects both life settlement prices and anticipated returns, misestimates by underwriters, unintentionally or otherwise, could negatively impair the entire transaction. Accordingly, the SEC task force recommended greater state and federal regulation of life settlement underwriters. Such regulation could cover the licensing and qualifications of underwriters, ensuring the privacy of medical information and developing minimum standards for assessing the life expectancy of insureds. The SEC task force even suggested the possibility of a federal agency playing a role in oversight.

Third, the SEC task force and the GAO recommended that industry participants strive to clarify the legal issues surrounding life settlements. Under Grigsby v. Russell, 222 U.S. 149 (1911), consumers have the right to sell their life insurance policies because such policies are considered property. However, under most state laws, the owner of a life insurance policy must have an "insurable interest," that is, a close relation or financial interest, in the continued life of the insured.

In applying these principles, courts throughout the country have treated the transferability of life insurance differently. Consequently, detractors of life settlements, such as insurers and relatives, have had varying degrees of success in challenging life settlements on the basis that, among other things, the brokers and providers lacked an insurable interest, and/or the life settlement was fraudulently induced. However, in a Nov. 17 decision, Kramer v. Phoenix Life Ins. Co., the New York Court of Appeals held that, absent fraud, a life insurance policy is freely transferable even if it was obtained with the intent to transfer.

The SEC task force's recommendation that life settlements be included in the definition of "security" is significant because, among other things, it suggests an expectation that life settlement securitizations will continue and possibly grow.

Interestingly, life settlements offer investors an asset that may hedge against the volatility of today's markets. Unlike other traditional securitized products, such as mortgage-backed securities, life settlements are not correlated to economic indicators or market conditions. Instead, the success of a life settlement securitization is correlated to the life expectancy of the consumers. The number of policies pooled and the underwriting methods utilized by the provider will be among the variables dictating the risk to investors.

It is also worth noting that, to date, rating agencies have rated only a few life settlement securitizations. While several rating agencies are developing life settlement credit rating models that focus on the procurement of policies, the underwriting practices employed, the relative strength of the providers and insurers, and the provider's ability to meet its cash flow obligations, no such rating model has been employed as an industry standard.

Notwithstanding the potential value to both consumers and investors, the National Association of Insurance Commissioners, or NAIC, has expressed concern that the growth of the life settlement market has outpaced the patchwork system of state regulation, exposing life settlements to fraud. Indeed, in some states there is little or no regulation of life settlements.

In addition, the NAIC has expressed concern that the expansion of the life settlement market could result in increased insurance premiums because, among other things, writers of insurance currently assume the lapse of a certain number of insurance policies. Were those lapses not to occur, insurers might have to re-evaluate the premiums charged to consumers.

Notwithstanding those concerns, the GAO and SEC task force have recognized the viability of life settlements, and they have suggested to Congress and market participants ways to better protect life settlement consumers and to increase certainty for life settlement investors. Those enhancements could result in additional investor capital, increased consumer demand and, consequently, market expansion in the wake of the recent credit crunch.

Seth A. Goldberg is a partner at the law firm Duane Morris LLP. He practices in the areas of commercial and complex litigation, with a particular emphasis on fraud/misrepresentation, fiduciary duties and securities law violations. James J. Halligan is an associate at Duane Morris. He practices in the area of litigation.