The quiet “life settlement” industry was shaken recently when the federal government warned investors about the risks associated with these little-regulated investments. Although a life settlement still may be a viable option for savvy investors, you’re advised to proceed with caution.

The basic idea of a life settlement is that the owner of a policy can sell it to a funding company, typically for more than the policy’s cash value but for only 30% to 80% of its death benefit. In most cases, the seller is someone who no longer wants or needs the policy, or who can’t afford to pay the premiums. The owner generally receives a lump sum cash payment.

The funding company then pays the premiums to keep the policy in force until the insured person dies, at which time the company receives the face value of the insurance. Meanwhile, the funding company sells shares in pools of the policies it owns. Investors don’t know how long premiums will have to be paid or when the policy proceeds will be distributed, both of which help determine the returns on this investment. If the insured people die sooner than expected, that boosts returns; if they die later, returns will suffer.

A report from the Government Accountability Office (GAO) raised concerns about a “lack of clear, consistent state oversight” of life settlements. A dozen states and the District of Columbia don’t have laws specifically addressing life settlements, and in those jurisdictions, policyholders may not know whether they’ve received fair value for their policies, and investors may be in the dark about an asset that isn’t tied to stock market performance.

The GAO report follows a recommendation from the U.S. Securities and Exchange Commission (SEC) that investors would benefit from tighter regulation of this industry. The largest regulatory body for the securities industry—the Financial Industry Regulatory Authority (FINRA)—came to the same conclusion in 2009.

Investors in life settlements face at least four key risks. The first is longevity risk—that with life expectancies increasing, the people insured by policies in life settlements may live longer than expected. A second, related risk is underwriter error, in which the insurer underestimates life expectancies, while a third is legal risk—that because of fraud, the failure of insurance companies, or other problems, policy proceeds don’t go to investors. Finally, there’s liquidity risk. If investors are unable to pay policy premiums, the insurance will lapse and there will be no payout.

These are complicated investments, and whether you’re buying or selling, it’s crucial to understand the risks and potential benefits. If you have questions about life settlements, please give us a call.