Life Insurance Settlements Viewed Through the Eye of the NASD – A Study in Compliance

Life insurance settlements have caused a great deal of confusion for broker-dealers in the last 24 months. More and more registered representatives are becoming aware of this controversial wealth management strategy. The life settlement is the sale of an unwanted, unaffordable, or underperforming life insurance policy sold to an institutional purchaser instead of letting the policy lapse. As Registered Representatives grapple for the go-ahead with their compliance department, they are usually confronted with mixed answers about its viability. To be sure, this strategy is an area of concern for broker-dealers and NASD members alike. Mary Schapiro, Vice Chairman of the NASD, spoke at the Chicago NASD Conference on May 25th, 2005. She addressed, in part, three central issues:

Life Insurance Settlements

1. “The first risk is to assume that baby boomers have a level of financial acumen that eliminates the need for proper suitability analysis.”

2. “A second risk comes from the very product innovation that has generally served your customers so well.”

3. “A third risk is a failure to analyze the status of these new products under the federal securities laws.”

Chairman Schapiro says that equity-indexed annuities are securities and life settlements and may constitute a “selling away” problem, amongst other concerns. She explains: “Equity-indexed annuities are only one example of a financial product that a firm might erroneously treat as a non-security. Other examples include tenants-in-common exchanges and life settlements. NASD considers all of these products to be securities, subject to firm supervision.

The NASD is the “watchdog of the SEC,” Its sole existence is to protect the investing public. One of their preoccupations is keeping in check the “egregious overcharging” of fees generated by manufactured investment products. There seems to be a correlation by the NASD regarding their concern with the nature and size of fees that the life settlement transaction has generated.

The question remains; are life settlement transactions securities? The question of whether life insurance settlements are to be treated as securities is divided into two parts-whether we are discussing the back end sales activity, i.e., the distribution of interests in a policy or pool of policies, or the front end activity, i.e., the solicitation and facilitation of the sale of a policy to a life settlement company. Once the policy has been sold into the secondary market, one could conclude that the “transfer for value rule” has been applied, and the insurance contract could be construed as security. Many, however, would conclude that the up-front transaction of a life settlement would not be subjected to securities law and jurisdiction.

Why all the Fuss?

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Does the life settlement market deserve such attention? According to the 2004 Life Insurers Fact Book, compiled by the American Council of Life Insurers, $9.4 trillion of life insurance is in force on 167 million policies. Coupled with the fact that emerging demographics show our beloved “Baby Boomers” are hitting retirement, and you can clearly see that the life settlement market is getting on everyone’s radar screen.

Moreover, according to the Conning Research and Consulting whitepaper, “Life Settlements, The Concept Catches On” 2006, they explain that the average life settlement offer approximates 25% and 30% of the face amount.” If it is true that approximately 35% of all settlement proceeds will be re-deployed into new investment vehicles for growth or income, then one can conclude that broker-dealers should have a vested interest. This rings particularly true where there is competition for registered representative recruiting where they can potentially increase their gross commissions.

This article will examine the potential NASD issues and possible solutions towards adopting a life insurance settlement program. It is not intended to support the notion that a life settlement is a security but to understand better if a broker-dealer wishes to add the strategy as a new profit center.
The first consideration from a compliance perspective is how to treat the life settlement. Some wire-house compliance departments, for example, have treated life settlements as passive referrals and do not accept compensation.Instead, the common thought is that they can reap the compensation by re-deploying the proceeds towards a traditional product such as a stock, bond, or mutual fund. In that way, as the reasoning goes, they did not complete a securities transaction and therefore did not violate the NASD procedure. Moreover, many of these firms use the life settlement strategy to replace underperforming or outmoded insurance.

For example, Client Clara has a $1,000,000 life insurance policy and pays $60,000 a year in premiums. Broker Bob tells her that she can sell the policy in the secondary market and use the proceeds to pay for new coverage with a new no-lapse guarantee. She sells the policy for $300,000 and uses the money to buy a new $1,500,000 with premiums less than her original premium costs.

Many broker-dealers have adopted this passive non-compensation approach to life settlements. Other broker-dealers see the product to offset lagging markets and infuse new revenue streams for the firm.
We need to become more educated towards understanding how to address complex compliance issues as it pertains to life settlements. Many factors go into how the life settlement program should be installed into a BD system. For example, should the BD look at the program as security or strictly outside business activity. Few firms can provide answers to these complex questions that will provide consulting as it concerns life settlements.

Involving the notion that a life settlement is a security, it is critical to understand what a security is to determine if it applies to life settlements. The keystone case on the definition of securities is SEC v. W.J. Howey.1 In Howey, the Supreme Court was asked to define the term “investment contract” since the term is used in the definition of a security under the Securities Act of 1933. In its decision, the Court defined investment security as any transaction that: Involves the investment of money, in a common enterprise, with an expectation of profit and which occurs solely from the efforts of others. It is immaterial if the enterprise is evidenced by formal certificates or nominal interests in physical assets. In SEC v. Mutual Benefits Corp. the Eleventh Circuit affirmed a U.S. District Court finding that Mutual Benefits was involved in a viatical settlement contract that qualified as “investment contracts” under the securities act of 1933 and 1934. Before the Mutual benefits case, the settlement industry consistently cited a district court decision, SEC v. Life Partners Inc., as the basis for insurance regulation of the settlement business. Despite losing, the SEC has persisted in its opinion that investments in settlements are securities. The precedent set by SEC v. Mutual Benefits has created a cavalcade of potential securities issues that should be looked at by a seasoned expert in the settlement/NASD industry.

Just as important is that many Broker-Dealers have chosen to ignore the life settlement in the hopes that they can take one-day claim ignorance. This “stick your head in the sand” posture is a recipe for disaster because empirically, the NASD has made it quite clear that they will not tolerate this kind of strategy under any circumstances.
Common sense dictates that to avoid problems is always to place the client’s best interest first, thus preventing problems by not being compliant.

Many rules, regulations, and strategies would apply to life settlements under NASD guidelines. This article will only examine some very germane issues. However, it is important to note that any prudent compliance department will need to adopt written procedures on processing life settlements.


In offering life settlement services in a prudent SEC and NASD compliant manner, we must understand how the strategy must apply NASD procedures. Thus far, the SEC and the NASD have not definitively become the official SROs of the life settlement industry, although they have prosecuted and taken punitive actions on RRs. To be sure, the NASD has declared that the back-end of the transaction is a security and has made it clear that “fractionalization “is a dangerous area of the product. The program has gained in popularity, and the aforementioned regulation body will likely lead the regulatory charge. It is therefore imperative to understand written procedures concerning: While there are over 20 identifiable issues and strategies that may influence NASD procedures, here are 7 that should apply immediately:

1. NASD Rule 2320 (g) (1) (Best Execution)
2. NASD Rule 2110 “Standards of Commercial Honor and Principles of Trade.”
3. NASD Rule 2310 “Recommendations to Customers” (Suitability)
4. NASD Rule 2430 “Charges for Services Performed.”
5. NASD Rule 3030 “Outside Business Activities of an Associated Person.”
6. NASD Rule 3040 “Private Securities Transactions of an Associated Person.”
7. NASD Procedures (*should be Written and Consistent)

NASD Rule 2320: Best execution via the “3 Quote Rule” is applicable anytime there is an offering to the general public. That is to say, we as professionals are held to the highest of standards and have a fiduciary to get the best pricing for our clients. This due diligence process is to ensure against improper favorite company choices and price-fixing. The fact that the firm has multiple offers may not be enough. Indeed, it is imperative to have more than 3 quotes to get the best execution due to the providers will”take a pass” at acquiring the insurance contract. Today, there are broker-dealers currently engaging in life settlements that are likely in violation of this procedure.

NASD Rule 2110: High Standards of Commercial Honor and Principles of Trade are paramount to stay compliant. The NASD has ruled and punished both broker-dealers and registered representatives, combining rules 2110/ 3030 & 3040 about life settlements. It is important to note that there may be “failure to supervise” issues selling away, and private placements are conducted.

NASD Rule 2310: The NASD has made it clear that we all must conduct our business in a manner consistent with the customer’s objectives and corresponding suitability. Moreover, we must disclose all material facts and maintain full disclosure. When appropriate, not offering a beneficial strategy is in direct conflict with NASD Rule 2310 (b) (4). (B.D. Beware)

NASD Rule 2430: Charges, if any, for services performed, including miscellaneous services such as a collection of money due for principal, dividends, or interest; exchange or transfer of securities; appraisals, safe-keeping or custody of securities, and other services, shall be reasonable and not unfairly discriminatory between customers. States that regulate excessive fees must be adhered to appropriately. Empirically speaking, the NASD sees excessive fees to be anything over 5-6%. Since life settlements create value over the insurance policies’ cash surrender value, a payout grid can be established to comply with NASD rule 2430. One should seek out professional consultation concerning this very paramount issue.

NASD Rule 3030: No person associated with a member in any registered capacity shall be employed by, or accept compensation from, any other person as a result of any business activity, other than a passive investment, outside the scope of his relationship with his employer firm, unless he has provided prompt written notice to the member. As previously stated, the NASD has made it clear that life settlements are included in their interpretation of “selling away,” and it is a paramount area of concern where improper supervision exists.

NASD Rule 3040: Provides, among other things, that before participating in a securities transaction outside the course or scope of his or her employment, a person associated with a member firm must give that firm prior written notification. In addition, if the firm is notified that the associated person may receive selling compensation, it is required to issue written approval or disapproval.

Licensing and Compensation Issues

The “Desk Drawer Broker-Dealer”
This strategy is very simplistic in nature and is a logical alternative to partnering with a single Funder. The interested broker-dealer would create a selling agreement with a specialized broker-dealer component that would conduct the life settlement transaction for a fee. All transactions would meet NASD requirements, including best execution. The broker-dealer with the unwanted policy would transact under an arm’s length arrangement.

NASD “Blue Sky” Regulations
Aside from having a general securities license series 7 and 63, some guidelines should be adhered to. First, although there is confusion by many of the Funders as to how life settlement transactions should be conducted from state to state, it is logical that the broker-dealer and its Registered Representative must maintain registrations in the state from which the compensation originates, i.e., the Funder’s home state of business transactions. However, it should be emphasized that it is a good business practice by a RR to become authorized in every state that he or she plans on conducting the business of life settlements.