Health Status Determining Factors

Health status does not merely affect the cost of a given surrender to an insurance carrier. It also plays a large part in a consumer's decision to surrender a policy. If an individual's health is above-average, then that individual's life insurance is no longer a good value because he is paying premiums based on the average level of mortality risk—a figure which is higher than his actual mortality risk. Because such an individual's positive shift in life expectancy decreases the value he attaches to his policy, he will thus be more likely to surrender his policy than an individual with normal health. This propensity of policyholders to surrender their policies when their life expectancy exceeds the average is known as adverse selection, and is costly to incumbent insurers because it means that the average life expectancy for the remaining pool of policyholders is lower than projected at the time the policies were issued.

If an individual's health is below average, then he is less likely to surrender his policy because an impaired policy is worth more than a normal policy. On the other hand, a negative shift in life expectancy changes the consumption preferences of many individuals (in favor of current consumption), particularly if the motivating factors for the life insurance policy are no longer relevant.60 For example, many AIDS victims found it difficult to pay premiums and needed immediate money to pay medical bills to maintain their quality of life in their few remaining years. An individual whose consumption preferences have changed in favor of current consumption values cash more highly at the current time, and thus is willing to accept a lower price for his policy's surrender than he would have when his health was normal. Thus, absent entry by third parties into the secondary market, insurance carriers are able to reap significant gains by underpaying for the surrender of these impaired policies.

Because entrants into the secondary market both viatical and life settlement firms—are only interested in acquiring policies of individuals with impaired health, entry into the secondary market will systematically reduce the number and value of impaired policies that are surrendered to the incumbent carrier for less than the competitive rate. At the same time, viatical and life settlement firms do not affect the number of individuals with average or above-average health who surrender their policies to the incumbent carrier. It is obvious that, by lowering the number of cost-reducing surrenders to the incumbent without causing any corresponding reduction in the number of cost-increasing surrenders, entrants into the secondary market for life insurance policies cause net increases in incumbents' costs. CONTINUED