Better Off Dead

What are viatical settlements, and are they safe investments?

If Count Dracula were the investing type, he'd probably be drawn to viatical settlements, which involve purchasing the life-insurance policy of someone who's terminally ill and waiting for that person to die. Not only is this creepy -- it's a lousy investment, to boot.

Viaticals emerged in the late 1980s as an opportunity for AIDS patients to sell their insurance policies so they could afford costly medication. These days, in addition to traditional viaticals (which can be used for any type of terminally ill patient), the industry has expanded to include a relatively new product called "life settlements," which involves purchasing the policy of someone who's old but presumably healthy. Thanks to strong demand by healthy seniors eager to tap their policies, life settlements now comprise about 80% of the industry, according to the Viatical and Life Settlement Association of America (VLSAA). In 2002, viatical and life-settlement companies spent $2.5 billion on the policies of the old and sick.

How do these investments work? People sell their insurance policies to a viatical company, typically at a discount of 50% to 85% of the death benefit. The company then sells the policies to investors. Once the patient dies, the new policy holder receives the full value of the policy.

One thing is guaranteed -- the person who sells the policy will die. (We haven't found a cure for that yet.) But when that will happen is awfully hard to predict. For investors, this means that while the total return is guaranteed, the annual return is anything but. Sure, some salesman may say that you'll get a 12% to 14% annual return -- but that's usually based only on the statistical probability of when the original policy holder will die. Even terminally ill people can live much longer than expected. And for life settlements based on someone who's merely old -- well, you just need to watch the "Today" show to see Willard Scott's lists of those who've reached the century mark and beyond.

In addition to diminished annual returns, many investors face another problem when a policy "goes long." The viatical company typically sets aside money for the policy's premium payments based on the original life-expectancy estimate. But if the person lives longer than the estimate, the premium payments become the responsibility of the new owner. "If the escrow reserve is not adequate, (the company) will call you and tell you the premium account has run out and that you must keep paying or your policy will lapse," explains Doug Head, executive director of VLSAA. "And that's happened -- a lot."

Another problem: liquidity. Viatical companies generally don't buy policies back from investors -- making it difficult for investors to resell them. At best, companies might facilitate a transaction with another buyer -- but there's no guarantee on price, and the company will take a cut as a sales commission. Even if you do find a buyer, you very well might lose some of your principal.

And to top it all off, the viaticals industry is so rife with fraud that the North American Securities Administrators Association (NASAA) has been listing viaticals in its Top 10 Investment Scams since the list's inception four years ago. Last year, 15 individuals were indicted in connection with a scam that cost hundreds of investors a total of at least $100 million, according to NASAA. In this case, the company bought life-insurance policies from terminally ill individuals who lied to insurance companies about their medical conditions, telling them they were in fine shape. The company's managers raked in fat profits until insurance companies caught on and cancelled the policies.

Bottom line: Stay away from these investments, says Certified Financial Planner David Bohannon, a licensed insurance consultant and president of Consultants Corner in Louisville, Ky. Instead, investors should create a diversified portfolio of stocks, bonds and cash.