On April 12, 2007, the U.S. Securities and Exchange Commission sued a hedge fund, Lydia Capital LLC (Lydia), in the U.S. District Court for Massachusetts alleging fraud against investors in life insurance policies purchased by Lydia. SEC v. Lydia Capital LLC, No. 1:07-CV-10712, (D. Mass. Apr. 12, 2007). granting in part a motion by the SEC, the court entered a temporary restraining order freezing Lydia's assets. Whether deliberately or inadvertently, the SEC has jumped into one of the most controversial issues to roil the life insurance industry in many years.

According to the SEC complaint, Lydia is selling hedge fund shares to investors without revealing to those investors (all apparently Taiwanese) that the principal underlying assets of the hedge fund—namely, life insurance policies—may be either worthless or virtually worthless.

The life insurance policies may be worthless, according to the SEC, because the application forms submitted to the insurer asked the purchasers if they intended to sell their policies. On approximately half of the policies purchased by Lydia, the complaint alleges, the individuals purchasing the policies answered that question "no" even though they intended to sell their policies, and did sell their policies, to Lydia.

A material false representation on a life insurance application allows the insurer to rescind the policy. Because the purchasers of the insurance policies knowingly answered the question falsely, and because the insurers therefore have the right to rescind those policies, according to the SEC, the policies are virtually worthless. Since Lydia did not notify their investors that the policies are likely worthless, they were engaging in a fraudulent investment scheme, the agency contends.

It sounds open and shut, but it isn't. In fact the question of whether owners of life insurance policies have the right to sell the policies, and under what circumstances, is currently one of the hottest issues being debated by the National Association of Insurance Commissioners (NAIC). Persons who purchase life insurance have a long-recognized right to sell their policies to third parties, proponents of such transactions say. If they have that right, why should the insurers ask whether that is their intent and claim the right to rescind if the answer provided is incorrect? Insurers respond that life insurance is designed to protect the families and businesses of the insured, not to provide windfall profits to investors.

Buying and selling life insurance policies on a large scale is a recent phenomenon. It began with the AIDS epidemic, when young AIDS patients, often without families, who had contracted the disease sought to tap into the value of their life insurance policies to pay medical bills and other expenses. A number of states enacted viatical insurance laws that allowed them to do so and regulated the process. The selling of life insurance policies to third parties for market value, invariably substantially higher than the "cash surrender value" that insurance companies include in some life insurance contracts, suddenly developed into a thriving new secondary market for life insurance that has grown by leaps and bounds in the past five years. (These transactions are usually called "life settlements" and sometimes distinguished from the more narrow term "viatical settlements," which refers to sales by persons facing imminent death).

As a general point, the law has been clear for a long time that a life insurance policy is "property" and, like other property, can be sold, including to persons who have no insurable interest in the life of person who is insured. (Grigsby v. Russell, 222 U.S. 149, 1911). Such sales, however, can be regulated in order to prevent fraud and to ensure that they do not become mere "wagering contracts." (See, for example, Clement v. New York Life Ins. Co., 101 Tenn. 22, 46 S.W. 561, 1898).

To protect against the possibility that a life insurance policy is being procured for the sole purpose of selling it to third parties, life insurers have started adding a question to the standard life insurance application form, asking if the purchaser intends to sell the policy. Some carriers will turn down the application if the question is answered "yes." But answering the question "no" could raise the possibility that the policy could be rescinded at a later date for material misrepresentation, at least according to the SEC complaint, if in fact the applicant does intend to sell the policy to investors.

Leaving aside the problem of intent (I could intend not to sell the policy today when I fill out my application, but change my mind tomorrow, and have still answered the question honestly "no"), there remains the public policy issue of what limits, if any, should be placed on the ability of the owner to sell his policy.

The NAIC has worked for some time to produce a new life settlement model law (to amend or replace the viatical laws enacted in many states) that would set the standards for when and how and to whom life insurance policies may be sold. Among other features of the draft model law, it would prohibit owners from selling their policies for a period of years (the debate is over whether that period should be two or five years). If there is a waiting period on sales, however, should insurers still have the right to rescind the policy if the purchaser says he does not intend to sell when in fact he expects to sell the policy at the earliest allowable moment? Current laws typically do not contain waiting periods for sales. The SEC complaint is based,
instead, on the failure of the applicant to honestly answer a question about his intent.

The NAIC will discuss the proposed model law at its June meeting in San Francisco. One state, North Dakota, whose insurance commissioner until recently chaired the NAIC working group on the subject, has already enacted a statute based on the current draft legislation. But now the SEC has also weighed in, suggesting by its suit against Lydia that insurers have the unqualified right to ask applicants whether they intend to sell their policies and to rescind those policies later if they are sold to investors. That may create problems for the life settlements market no matter what the NAIC determines.