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Manulife head office in Toronto

Manulife Financial Corp. has become embroiled in a high-stakes battle in the United States that pits insurers against investors who are buying up individual life insurance policies.

Traditionally, when an individual decides that he no longer wants a life insurance policy or can't afford the premiums any more, he either lets the policy "lapse," in which case the insurer pockets the premiums, or turns it in for its cash surrender value, which costs the insurer less than the death benefits would have.

Insurers routinely make assumptions about the amount they will save from those policies. But in the U.S., a business known as the "life settlements" industry has sprung up to try to capture some of those savings. Investors look to profit by buying policies from individuals, paying the remaining premiums, and claiming the benefits when those individuals die.

Now Manulife's U.S. subsidiary, John Hancock Mutual Life Insurance Co., is being sued in a California district court for allegedly trying to stop customers from selling their policies.

The lawsuit launched by Coventry First LLC, a large life settlement firm that buys policies and often sells them to major institutional investors, alleges that "life insurance companies, such as Hancock, are seeking to destroy the [life settlement industry]because they want to reap the profit from collecting premiums without having to pay death benefits."

The suit accuses Hancock of using bullying tactics to retroactively terminate a policy that was sold. Manulife declined to comment on the allegations, which have not been proven.

The life settlements market has never gained traction in Canada because most provinces don't allow individuals to sell their life insurance. But a number of Canadian players, such as Alberta Investment Management Corp. (AIMCo), are investing in U.S. products in this area.

The issue is taking on greater importance because life insurers are struggling to regain their footing in the wake of the financial meltdown. Standard & Poor's says investors are showing renewed interest in life settlement securitizations, in which large pools of policies are bundled up and sold. But so far the rating agency has decided not to rate these asset-backed securities because of their risks.

Investors are attracted to life settlements because they essentially boil down to a bet on life expectancies that is not correlated to other traditional investments such as stocks and bonds. Life settlements allow individuals to sell their policies to an investment company for amount that's usually more than the cash surrender value of the policy or the amount of premiums that they've paid, but less than the death benefit.

"You are kind of taking a position on whether someone's going to die, and that's a little bit off-putting," said Peter Routledge, an insurance analyst at National Bank Financial. "But you can imagine if someone's got a policy, and something went wrong in their investment portfolio, and they can quickly cash the policy out and live the rest of their years in relative comfort, that's not a bad thing."

Industry experts say it's extremely difficult to quantify the impact that the issue is having on insurers because of a lack of data.

"The companies would never tell us how much they make off of lapses - it's too sensitive and is important competitive information," said Canaccord Genuity analyst Mario Mendonca. "What we do know is that lower-than-expected lapses have resulted in very significant experience losses for as long as I can remember."

The life settlements business has received more attention of late because of a recent New York Court of Appeals ruling that said it was legal for individuals to take out life insurance policies on themselves for no other purpose than to immediately sell them, another evolution of the market that's become known as stranger-owned life insurance, or STOLI policies.

That case involved a New York lawyer named Arthur Kramer who took out $56-million (U.S.) of life insurance and sold hedge funds the right to collect the death benefits. Insurers had initially refused to pay.

The New York ruling is a negative for life insurers, "since an increase in policies that are sold to investors in the secondary market will reduce insurers' profitability as the value in such policies is extracted and maximized by third-party investors," Moody's said in a research note.

But life settlement investments are not a sure thing - and some have lost value because the individuals lived longer than expected, increasing the number of years in which investors had to pay premiums.

The investments have become controversial in Australia. A newspaper there has taken AIMCo CEO Leo de Bever to task for a $1-billion investment that the Victorian Funds Management Corp. made in a life settlements fund prior to the financial crisis, back when Mr. de Bever was the pension fund's chief investment officer.

Last year, the fund wrote down the value of that investment by almost half, the newspaper said. "That valuation implies an 18 per cent expected return," Mr. de Bever said. "I've offered to buy it at that price but I don't think I'm going to get any takers."

He said the investments, which some newspapers have dubbed "death funds," have been unfairly criticized. "If someone sells you an annuity of $1-million per year, people would say that's okay. No one expects the seller to have a lugubrious interest in your death. It's just business," he said.