Life Markets E-Book

Vishaal B. Bhuyan

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 404

Veröffentlichungsjahr: 2009

Beschreibung

A complete guide to longevity finance As the Baby Boomer population continues to age and the need for the securitization of life insurance policies increases, more financial institutions are looking towards longevity trading as a solution. Consequently, there is now a need for innovative financial products and strategies that have the ability to hedge longevity exposure for pension funds, reinsurance companies, and governments. These products and strategies are currently being developed with the use of life settlements. Here, author Vishaal Bhuyan provides a complete guide to this burgeoning sector. In Life Markets, Bhuyan and a team of expert contributors from leading firms offer an extensive look at how to trade life settlements. * Provides practical guidance to the growing field of longevity finance * Outlines the innovative financial products that are populating this field * Highlights a safe haven for investors seeking returns in troubled times Covering everything from the history of life settlements to making a transaction-pricing, service providers, exchanges, and more-this book contains extensive coverage of the many issues surrounding longevity finance.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Praise

List of Contributors

Foreword

Preface

Acknowledgements

PART One - Life Settlement Basics

CHAPTER 1 - A Brief History of Life Settlements

CHAPTER 2 - Features of Life Insurance

CONTESTABILITY PERIOD

TYPES OF POLICIES

CHAPTER 3 - What Is a Life Settlement?

NOTES

CHAPTER 4 - Parties Involved in a Life Settlement

FINANCIAL ADVISORS

PROVIDERS

BROKERS

INVESTORS

UNDERWRITERS

CHAPTER 5 - Other Involved Parties

ASSET SERVICERS

EXCHANGES

CHAPTER 6 - Underwriting

MEASURING PERFORMANCE

MORTALITY TABLES

SELECT AND ULTIMATE MORTALITY RATES

MALES, FEMALES, SMOKERS, NONSMOKERS

SAMPLE MORTALITY RATES

LIFE EXPECTANCY

FUNDERS COMPUTATIONS

RISK MANAGEMENT STRATEGIES

CHAPTER 7 - Life Insurance Policy Swaps

CHAPTER 8 - Premium Financing

NOTE

PART Two - Securitization

CHAPTER 9 - Life Settlement Securitization

A.M. BEST RATING POLICY

ANALYSES BASED ON AN EXISTING PORTFOLIO OF LIFE SETTLEMENTS

A.M. BEST’S ANALYTICAL APPROACH

PART Three - Analytics and Pricing

CHAPTER 10 - Life Settlement Pricing

KEY DRIVERS OF POLICY VALUES

DISCOUNTED CASH FLOW AND NET PRESENT VALUE

LIFE SETTLEMENT PRICING MODELS

SUMMARY

CHAPTER 11 - Using Life Extension-Duration and Life Extension-Convexity to ...

INTRODUCTION

THE STRUCTURE OF THE LIFE SETTLEMENT MARKET

METHODOLOGY

LE-DURATION AND LE-CONVEXITY

CONCLUSION

NOTES

REFERENCES

CHAPTER 12 - Real Options Approach to Life Settlement Valuation

THE ACLI’S PROPOSAL

SUMMARY

CONCLUSION

NOTES

REFERENCES

PART Four - Risk Explored

CHAPTER 13 - Risk Mitigation for Life Settlements

CONTESTABILITY

INSURABLE INTEREST RISK

COST OF INSURANCE

INCORRECT PURCHASE PRICE

MISSING BODY RISK

LIFE INSURANCE COMPANY CREDIT RISK

LONGEVITY RISK

NOTES

CHAPTER 14 - The Risks of a Securitized Portfolio of Senior Life Settlement Contracts

Life Expectancy, Duration, Convexity, and Their Metrics

CHAPTER 15 - Synthetics

New Swaps to Hedge Alpha and Beta Longevity Risks of Life Settlement Pools

RISKS AFFECTING POOLS OF LIFE SETTLEMENTS

BUYING STRATEGIES AFFECTED BY ALPHA LONGEVITY RISK

HEDGING LONGEVITY RISK

BENEFITS AND USES OF LONGEVITY SWAPS

WILL LONGEVITY SWAPS FLY?

NOTES

PART Five - Regulation

CHAPTER 16 - Life Settlements

Regulatory Framework; Insurance Carrier Reaction and Next Steps for the Marketplace

CHAPTER 17 - Regulatory Issues and Insurance Company Reaction

NAIC MODEL

CHAPTER 18 - Tax Implications

OPEN ISSUES CONCERNING CHARACTER, BASIS, AND SOURCE

STRUCTURES TO DEAL WITH LIMITATION ON INTEREST DEDUCTION

LOAN PROGRAMS: VARIATIONS ON A THEME

TAX LEGISLATION AND FUTURE DEVELOPMENTS

NOTES

PART Six - Ethical Issues

CHAPTER 19 - The Ethics of Profiting from Mortality

THE FAIR TREATMENT OF POLICYHOLDERS

STANDARDS OF BEST PRACTICE AMONG INTERMEDIARIES

TRANSPARENCY FOR INVESTORS

CLEAR AND CONSISTENT REGULATION

CONCLUSION

NOTES

EPILOGUE

About the Author

Index

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Copyright © 2009 by Vishaal B. Bhuyan. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Bhuyan, Vishaal B., 1983-

Life markets : trading mortality and longevity risk with life settlements and linked securities / Vishaal B. Bhuyan. p. cm. - (Wiley finance series)

Includes index.

eISBN : 978-0-470-50814-5

1. Viatical settlements. 2. Life insurance. I. Title.

HG8819.B48 2009

368.32-dc22

2009007402

To my family, especially my parents “There are no rules in life, only consequences.”

—Prashant B. Bhuyan

“Life insurance has become in our days one of the best recognized forms of investment and self-compelled savings.”

Supreme Court Justice Oliver Wendell Homes in his 1911 opinion of the Grigsby v. Russell case

List of Contributors

Vishaal B. Bhuyan

Managing Partner V.B. Bhuyan & Co.

Professor David Blake

Director

The Pension Institute

Desk Research by David Blake is sponsored by Goldman Sachs, Deutsche Bank, Royal Bank of Scotland, and EFG International

Professor

Cass Business School

City University of London

Micah W. Bloomfield

Partner

Stroock & Stroock & Lavan

Matthew C. Browndorf, Esq. Chief Investment Officer Browndorf PEM, LLC

I. James Cavoli

CEO

Life Settlement Insights

Michael Fasano

President

Fasano Associates

Dr. Debbie Harrison

Research Associate

The Pension Institute

George J. Keiser

National Association of Insurance Commissioners

House of Representatives R-North Dakota

Joseph R. Mason Ph.D

Senior Fellow

The Wharton School

Emmanuel Modu

Managing Director

A.M. Best Co.

Antony R. Mott

Managing Director

Structured Insurance Products

ICAP Capital Markets

Nemo Perera

Managing Director

Risk Capital Partners

Jonathan T. Sadowsky

Managing Director of Finance / Portfolio Manager

Browndorf PEM, LLC

Joseph Selvidio

Associate

Stroock & Stroock & Lavan LLP

Hal J. Singer Ph.D

President

Criterion Economics LLC

Charles A. Stone

Professor

Brooklyn College

CUNY

Department of Economics

Boris Ziser

Partner

Stroock & Stroock & Lavan LLP

Anne Zissu

Professor

Citytech

CUNY

Department of Business

The Polytechnic Institute of NYU

Department of Financial Engineering

Foreword

The great fact of the modern world is that people are living longer, and living better, almost everywhere. Medicine is better; diagnoses are better; health care is more available, despite the comments to the contrary by some on the left. The problem with this wonder is that as people live longer they are creating greater and greater problems for themselves and for governments as pension funds are simply not able to keep up with the extended lives of retirees. Living longer is wonderful; living longer in poverty is not.

Mr. Vishaal Bhuyan has written this excellent book that explains how we as investors can better prepare ourselves for our confusing and perhaps underfunded futures. Dealing with these problems is not for the faint of heart and might appear far too daunting for most writers and analysts, but Mr. Bhuyan has indeed dealt with them in a readily understandable and eminently readable fashion. Anyone with concerns about the investment future for themselves, their families, their friends, and the country should take the time to read this book . . . immediately.

DENNIS GARTMAN

Editor of The Gartman Letter

Preface

The idea that aging will have a profoundly negative impact on the global economy has been around for decades but has been dismissed or taken a back seat to other, seemingly more important problems. Unfortunately, all the years spent avoiding the aging and pension problem has served to magnify the issue.

In 2008, the number of deaths in Japan outnumbered the number of births 1.14 million to 1.09 million, respectively, and the population fell by 51,000 according to the Health Ministry. By 2050, both Japan and Russia will lose over 20 percent of their populations and 38 percent of Korea will be over 65, making it one of the oldest nations in the world. Since 2006, an astonishing 330 people have turned 60 every hour in the United States. Over 12 percent of the U.S. population and 16 percent of the U.K. population is 65 or older, compared to 5.2 percent in India and 8 percent in China, suggesting a major problem for the West.

Although longer living populations are a good thing, increased longevity can strain the economy, specifically retirement and health care programs. In the United States, Social Security and Medicare currently account for roughly 7 percent of the GDP, but within the next 25 to 30 years these programs will account for nearly 13 percent, essentially the majority of the entire federal budget. Proposals have been made to prevent these disasters, such as opening borders to immigrants to prop up the workforce, privatizing government programs, and increasing the retirement age from 65 to 71. These proposals, however, have failed to adequately address the matter and gain widespread acceptance. Plans have been made to extend the retirement age by 2 years in some countries over a 20-year period, but this is simply not enough. The retirement age should be at least 71 in order to adjust for dramatic increases in life expectancy over the past 100 years relative to a static 60- to 65- (in some places 55-) year-old retirement age, which has been in place since as far back as the nineteenth century.

Mass immigration will cause a number of national security problems and people are simply not fungible assets. Skill and education level must be comparable for immigrants to take on many of the skilled labor jobs the baby boomers will leave behind. Moreover, the sheer number of immigrants necessary to counteract the baby boomer phenomenon would be unthinkable.

It is not only an increase in life expectancy that is troublesome, but also the increasing uncertainty of life expectancies. For many pension funds this uncertainty creates a tremendous amount of unquantifiable risk, leaving them unprepared to address future obligations. Given that each additional year in life expectancy at age 65 adds roughly 3 percent to the present value of pension liabilities (according to the Pension Institute London), the cost of providing pensions in 2050 may be 18 percent higher than currently expected. Coupled with the current economic crisis, which has left major U.S. corporations with $400 billion in underfunded programs (from a $60 billion surplus at the end of 2007); longevity risk management should be of the utmost importance to pension fund managers.

The capital markets have developed a number of possible solutions (such as longevity bonds and swaps) to allow pension programs to hedge and manage this longevity risk and to allow large investors to capitalize on this extension in life expectancy. Although these longevity products are still in their nascent stages, given the magnitude of the market (according to Watson Wyatt’s Global Pension Assets Study in 2007 there is roughly $23 trillion of longevity risk exposure among benefit pension funds) I am confident in the impact longevity derivatives will play in the coming years.

As pension funds continue to lose value over the next several years, greatly amplifying the current economic crisis, seniors will be left wondering how they will be able to fund their retirements. This unfortunate chain of events will give rise to “reverse equity transactions” such as life settlements and reverse mortgages. Although these types of transactions have been around for quite some time, in the coming years seniors will scramble to extract the remaining equity in their homes and sell their insurance policies to meet their daily cash obligations.

A life settlement is a transaction whereby a senior sells his insurance policy to an institutional investor for more than the cash surrender value but less than the coverage amount. The investor pays all subsequent premiums until the death benefit is collected. This gives investors revenue streams uncorrelated with other markets and allows consumers to receive a lump sum to pay off debt or simply provide financial stability. Life settlements also trade in pools on the tertiary market, allowing investors to capture substantial returns insulated from the broader economy. Many large investment banks and multistrategy hedge funds have already deployed billions of dollars in life settlements or linked products.

This book aims at providing a complete analysis of the life settlement market, while touching upon some of the derivatives available in the longevity risk market. Each chapter draws on industry experts, who have several years of experience in the life markets.

Acknowledgments

I would like to extend my deepest and most sincere gratitude to all of the contributing authors who have helped shape and build this new market, and who have been kind enough to share their knowledge with us all. I would also like to thank Pia for always encouraging me to think bigger, and Mark for giving me my start.

PARTOne

Life Settlement Basics

CHAPTER 1

A Brief History of Life Settlements

Vishaal B. Bhuyan Managing Partner, V.B. Bhuyan & Co.

The legal and conceptual basis for a secondary market in life insurance originated from the U.S. Supreme Court case of Grigsby v. Russell (1911), which established that policy owners have the right to transfer an insurance policy in a manner similar to any other asset. Justice Oliver Wendell Holmes represented that life insurance contained all of the legal attributes of property such as real estate, stocks, and bonds, so was therefore “transferable without limitation” by the policy owner. Holmes stated, “Life insurance has become in our days one of the best recognized forms of investment and self-compelled saving.” The case set forth the rights of a policy owner, allowing an owner to:

Name the policy beneficiary.

Borrow against the policy.

Sell the policy to another party.

Change the beneficiary designation of the policy.

The first form of the modern day life settlement market was the viatical settlement market of the 1980s, where men diagnosed with AIDS sold their life insurance policies to third party investors. A viatical settlement is defined as the sale of an insurance policy when the insured’s life expectancy is less than two years. The majority of the population diagnosed with AIDS in the 1980s was homosexual, so most did not have wives or children to consider when making their financial plans. Moreover, these transactions allowed viators to generate cash for their medical expenses. At the time, the medical community understood very little about the virus, so life expectancies were typically very short once a patient was diagnosed. But as researches started to effectively prolong the lives of infected individuals, investors holding viatical settlements in their portfolios started to amass considerable losses. Moreover, the generally controversial nature of the investment curbed institutional interest in the market.

Although a small number of U.S. and European investors continued to participate in the viatical settlement market in the mid 1990s, due to favorable tax regulation (viatical settlements were not subject to income or capital gains tax), the market’s rebirth occurred around 2000 when regulatory bodies began to establish industry standards to minimize fraud and encourage best practices. Moreover, the formation of the Life Insurance Settlement Association from the Viatical and Life Settlement Association of America in 2004, further helped to establish the modern day life settlement market and separate it from the controversial and speculative market of viatical settlements.

Today, life settlements are experiencing tremendous growth, exploding from a $3 billion market in 2003 to more than $15 billion in 2008 and are projected to grow to a whopping $160 billion market in the next several years, according to Conning & Co. Moreover, trade associations such as the Institutional Life Markets Association, which is composed of major financial institutions focusing on the regulation and development of life settlements and other life-linked financial products, helped to legitimize the industry.

The growth of the market can also be attributed to strong demographic shifts such as the aging baby boomers and instable financial markets, which are creating further incentives for seniors to part with their life insurance policies and attracting investment funds that wish to gain exposure to assets with a low correlation to other markets.

CHAPTER 2

Features of Life Insurance

Vishaal B. Bhuyan Managing Partner, V.B. Bhuyan & Co., Inc.

This chapter explores only the most important features of life insurance contracts as they apply to the trading of life settlements. Life insurance and life settlements cannot be discussed without examining the topic of “beneficial interest,” which is covered in depth in Chapter 19, but is also touched on briefly in this chapter. Overall, it is important to develop a strong understanding of retail life insurance before developing a strategy to invest in the secondary life market.

A life insurance policy is a legal contract between a policyholder (the owner of a policy) and an insurer (such as MetLife), whereby the insurer agrees to pay a death benefit (a lump sum of money) to the beneficiary or beneficiaries of the policy upon the death of the insured. The insured and the policyholder are not necessarily synonymous, although in most cases the insured and policyholder are the same person (see beneficial interest). As with all types of insurance, the policyholder, whether it be the insured or a third party investor, is required to pay monthly, quarterly, or annual premiums to keep the policy in force (active). The beneficiary of the policy is the individual(s) or entity that receives the death benefit once the insured has died. The beneficiary of the policy is designated by the owner of the policy at origination and may be anyone he wishes. The initial beneficiary of death benefit proceeds is required to have a beneficial interest in the contract.

Beneficial interest is defined as “the rights to receive distributions of interest or principle from a trust,” but is used to determine whether the beneficiary of a policy will experience “loss” once the insured has died. Corporations and family members are said to have beneficial interest in the life of an insured. For example, it is commonplace for a wife to purchase a life policy on her husband, as she will most likely have an interest in his life. Moreover, a corporation may own a life policy on its partners to ensure the company has enough capital to purchase the partners’ shares (if their families do not wish to hold an equity stake) if any of the partners meets an untimely demise. The corporation would pay the monthly premiums and would also be designated as the beneficiary of the death benefit at the origination of policy. In both of these scenarios the beneficiary of the policy has an interest in the insured’s longevity. There must be beneficial interest when the policy is originated, but the beneficiary of the policy may be changed to an investor after the contestable period, unless the original contract contains an irrevocable beneficiary clause.

CONTESTABILITY PERIOD

The first few years that a life insurance policy is in force is known as the “contestability period.” Although this period is typically two years there is a strong push from regulators to increase the period to five. During this period an insurance carrier can contest a death benefit if it suspects misrepresentation or fraud on the application or believes suicide to be the cause of death. Although in previous years a number of investors acquired policies during this two-year period due to large discounts in pricing, the overall trend in the market is to shy away from contestable policies (also known as “wet paper”) due to regulatory risks. Investing in contestable policies is also known as STOLI/IOLI and will be discussed later in the book. It is important to note that the price of a traded life settlement increases dramatically after the contestability period is over.

Once a life insurance policy has passed the contestability period the insurer is not legally able to deny death benefits; however, if the insured is currently living, the carrier may rescind a policy at any time if it believes that the owner of the policy lacked insurable interest at the time of origination.

TYPES OF POLICIES

There are two primary types of life insurance contracts: permanent life insurance and term life insurance. Permanent insurance provides coverage for the insured until the policy matures and includes whole life, universal life, and variable universal life policies. Permanent insurance also contains a cash component, which builds up as premiums are paid into the policy. If a policyholder wishes to exit his policy at some point during the contract he is eligible to receive the cash value of the policy. Policyholders can access the cash value in their policies by either withdrawing or borrowing against them. Funds borrowed against the policy can either be repaid or deducted from the cash value or the death benefit of the policy. The way the policy’s cash account is managed is what makes one type of permanent life insurance different from another. Term insurance typically offers lower premiums as it only provides coverage for a specified term such as 10 years. Term insurance is usually purchased by relatively younger customers so the comparative lapse ratios for term life are much higher, which enables carriers to offer coverage for low rates. See Exhibit 2.1.

Term life policies are typically not desirable for life settlement investors (unless the policy is convertible term) as there is a low probability that the insured expires during the coverage period. Variable universal life (VUL) policies may also be unattractive to secondary market participants as VUL contracts are regulated by the Securities and Exchange Commission requiring additional securities licenses; however, this varies among individual life settlement firms.

The following outline illustrates the various types of permanent life insurance most commonly found in the marketplace.

• Whole Life insurance covers an insured for the duration his life and offers both a death benefit and a savings component. Moreover, many carriers will pay dividends to policyholders for excess premiums.

• Universal Life insurance is a more flexible type of whole life insurance that provides a savings component, which generally accrues a guaranteed rate of interest. In addition, policy owners may borrow or withdraw funds from their savings accounts. Universal life policies also allow policy owners to adjust the death benefit and/or premium payments (within limits) to customize cash flow streams as necessary. For life settlement investors this is important as proper cash management and premium optimization results in higher returns.

• Variable Life insurance offers a variety of professionally managed investment options to customers in addition to a death benefit. Funds accumulated in the savings account may be used to invest in stocks, bonds, and money market mutual funds. Although there is some increased potential for upside (usually there is also a cap rate on returns), the policy is exposed to market risks. In variable life policies both the cash account and death benefit may decrease during times of market volatility, which may result in higher net premiums for the owner. Some policies, however, do guarantee a certain level of death benefit. Policy owners may also borrow against or withdraw the cash value, but this also may reduce the cash accounts and death benefits.

• Variable Universal Life insurance is a hybrid product that combines the characteristics of both variable and universal insurance such as the

EXHIBIT 2.1 Life Insurance Policy Features

ability to alter premium payments and the death benefit and also have an investment component to the policy, which is subject to market exposure.

• Convertible Term Life insurance is a term policy which may be converted into a permanent policy without any additional medical information on the insured and without an increase in the premium amount if the insured’s health has changed.

CHAPTER 3

What Is a Life Settlement?

Professor David Blake Director, The Pensions Institute, Cass Business School

Dr. Debbie Harrison Senior Visiting Fellow, The Pensions Institute1

Desk Research Sponsored By: Deutsche Bank EFG International Goldman Sachs

The Royal Bank of Scotland

Whole life policies can be assigned, which means that the insured individual—or policyholder if this is a different individual or entity—can sell a policy and assign the interest in the death benefit to the purchaser. When a third party buys the rights to the benefits of a life insurance policy, the arrangement is known as a “life settlement” or “traded life policy” (TLP).

Under noncontestability provisions that govern U.S. life insurance, life insurers cannot usually contest the payment of death benefits after the end of the contestability period, provided premiums have been fully paid up to the date of the policyholder’s death.

To understand how the secondary market works, it is important to appreciate why whole life policies are purchased in the first place and why they might be sold at a later date.

The most common reason for the original purchase is to secure life cover so that dependants (or businesses) receive a capital sum in the event of the policyholder’s death. However, this need can be met through the purchase of term insurance, which is considered to be a simpler and, in many cases, cheaper product than whole life. So, why buy the more complex and expensive alternative? It might be because of customer preferences (the buy side), but it might also be due to insurance company and intermediary marketing (the sell side). From a behavioral perspective, whole life looks more attractive than term insurance to consumers who are not comfortable with buying pure insurance products—that is, policies that only pay out if a claim arises (in this case upon death). Motor and home insurance fall into this category, as does term insurance, which only pays out if the policyholder dies within the term covered. Whole life insurance might, therefore, be perceived as an easier sell because the investment element of the policy provides an additional cash value that can be used in various ways, while the insurance value will be paid on the insured’s death, whenever this occurs. There is a further potential distortion due to the large sales commissions paid to life insurance agents on whole life and universal life, which are not available on term products.

Whole life policies are sold by policyholders for a range of reasons. Typically the policyholders’ circumstances have changed so that they no longer need the life cover and would like to gain access to the embedded capital value rather than simply let the policy lapse. In a period of comparatively low interest rates, the growth of the investment element (linked to deposit and fixed-interest bond rates) might be limited, and this might provide an additional reason for a sale.

The Bernstein study, which reports the findings of the Hartford 2003 Consumer Survey, lists four main reasons for the purchase of life settlements.2 Here we reproduce the headline percentages (that is, the percentage of policies purchased for the stated reason) and then for each we consider briefly why the purchaser might subsequently wish to sell.

1. Income protection (79 percent): This is by far the most common reason for purchase, with the objective of replacing the income of an individual who dies and who has financial dependants, for example, a working parent with children still in school. Once the dependants become independent financially, the insurance might be considered redundant and the sale of the policy might appeal if this would secure a capital sum and remove the need to continue paying monthly premiums, which in retirement, for example, might become unaffordable. Where ill health is an issue, the capital secured on surrender or on sale in the secondary market could help fund medical care and other needs.

2. Estate planning (9 percent): Estate planning refers to the use of the policy by individuals who would like to provide a lump sum on their death to their beneficiaries, for example, to cover any tax bills that might arise on the value of their estate. Changes in family arrangements—for example, a divorce or the death of a dependant—might make the policy redundant as might a significant reduction in the estate’s value. A change to estate tax legislation in the United States in the future could also reduce the need for this type of protection.

3. Retirement planning (8 percent): Retirement planning is likely to be a reason for purchase on the part of those who are seeking a combination of insurance and investment, with the ability to borrow against the cash value or to use it for drawdown purposes, where this is possible. Reasons for the sale might reflect age and also the desire to consolidate retirement financing vehicles.

4. Business planning (4 percent): This is the smallest component and refers to the purchase of policies by businesses that would suffer if an important employee or partner were to die. Key-man insurance pays the policyholder (the employer or partnership) upon the death of the named individual, which might otherwise destabilize the business in some way. It might also be used by a partnership to assist with succession planning, so that the remaining partners have sufficient capital to buy out the rights of the family of a deceased partner’s share in the business. Such needs might change if an insured employee/partner leaves the business or a partnership dissolves, for example.

Of these four reasons for a policy sale, we suggest that the last is the least contentious from an ethical perspective, as the third-party nature of the arrangement avoids the potential for distress sales. However, the potential for market abuses still remains.

The Wharton report observes that, generally speaking, life policies are assignable, which means they can be taken over by a third party who purchases the rights to the benefits.3 When a policy is genuinely no longer wanted, or the need for capital is more urgent than the need for life cover, the policyholder has three options: let the policy lapse, which occurs when premiums stop, in which case there is no return to the policyholder; sell back to the insurer and receive in return a surrender value; or sell in the secondary market in the hope of receiving a larger sum than the surrender value.

Surrender values tend to be based on normal health assumptions—indeed there might be complex regulatory issues for insurers that offer explicit health-dependent surrender values—and so for those with impaired lives, they are not generally attractive. The life settlement market focuses on senior impaired lives—that is policyholders over age 65, who have a reduced life expectancy. Opinion varies as to the length of life expectancy that investors consider acceptable: It can start as low as 3 years and is generally capped at between 15 and 20 years. The sale of a policy where the insured is expected to live less than two years is classed as a viatical settlement, and such policies are excluded from the life settlement market.

A.M. Best describes the secondary market in this way:

The life settlement market is an outgrowth of the viatical settlement market in which policies of the terminally ill—normally those insureds expected to die within two years—are bought and sold. In the life settlement market, however, insureds generally are 65 years or older, with medical impairments resulting in life expectancies of about 3 to 15 years.... The more severe the chronic illness of an insured, the lower the life expectancy and, hence, the higher the price paid for the life settlement.4

As the Wharton report notes, the availability of a secondary market introduces liquidity to an otherwise illiquid market. It provides a potentially better deal for policyholders who want to sell (or are forced to sell) policies, and it also stimulates competition among insurers, who otherwise would be under no pressure to improve surrender values or to offer other arrangements, such as a loan against the policy, which would be repaid on the death of the policyholder:

If there is no external market for reselling policies, insurers have no incentive to adjust their surrender values for impaired policies to competitive levels because they wield monopsony power over the repurchase of “impaired” policies. Viatical and life settlement firms erode this monopsony power.5

It could also be argued that the secondary market might have a beneficial effect on the primary market. When customers see that they are not locked in for life, they might be more willing to take out life insurance in the first place. In these two respects—greater competition and a more positive consumer attitude to life insurance—the secondary market would seem to offer, in principle, ethically sound consumer benefits, provided it is well regulated and customers fully understand the nature of the transactions in which they are involved.

Life settlement companies have sprung up over the past decade to buy unwanted policies in the hope of making an attractive return on the capital employed. They offer a larger capital sum to policyholders than the provider’s surrender value, but still purchase policies at a deep discount on the face value.

Life settlement companies might purchase policies for their own investment purposes or with the objective of selling the acquired policies to third parties. In the latter case, they act as an intermediary between the seller (the policyholder) and the ultimate buyer (the end investor). The ultimate buyer could be an institutional investor, such as an investment bank, insurance company, hedge fund, or pension fund, or it could be a retail investor. While a wealthy private investor might buy direct, a typical retail investor would buy units in a pooled fund established by an asset manager or in a bond issued by an investment bank (a different type of pooled fund that usually has a fixed term—say, five or seven years). The asset manager or investment bank will have bought the underlying policies from a life settlement company and will need to hold cash in addition to the life settlements in order to maintain the premium payments and to pay investors who request a drawdown of cash, where this feature is offered. An investment bank bond might offer a target annual return over the term of the investment and might aim, but not guarantee, to return the investor’s original capital at the end of the term.

When the original policyholder dies, the proceeds from the traded life policy accrue to the life settlement investor. The return on a traded policy can be calculated as follows: the difference between the total payout (policy face value) on the policyholder’s death and the sum of the purchase price, maintenance costs, and operating costs. Maintenance and operating costs include the periodic premiums, which can be monthly, quarterly, semi-annual, or annual, paid between the date of purchase and date of death, plus any transactional and operational costs, including sales commission to intermediaries. Based on Bernstein’s research, the estimated return on a life policy held for seven or eight years is likely to be in the region of 9 to 13 percent. The ultimate return to the investor might be higher or lower, depending on transaction costs and the time of death. A.M. Best’s analysis shows that the typical transaction costs can be between 50 and 100 percent of the price paid to the policyholder. Therefore, where the settlement company pays a policyholder 15 percent of the face value, it might sell the policy to investors for 23 to 30 percent of face value. These figures vary significantly, depending on the individual’s age, state of health, and the premiums required to maintain the policy.

Where the purchaser of policies constructs a fund for sale in the institutional or retail market, there will also be intermediaries (consultants, private client advisors, and sales representatives), who recommend these products to investors and who receive a fee or commission in return. Finally, there are the fund-rating agencies, which issue ratings for securities backed by life settlements based on a wide range of factors. However, we understand that, at the time of writing, there had been no issues of rated life settlement securities with longevity risk.

It can be seen that, although in its infancy, the life settlement market has already developed a comparatively complex infrastructure. Certain processes clearly are critical to the market’s operation, but others are potentially unnecessary and add to the cost for the ultimate investor. While A.M. Best’s research indicates that the transaction costs can add between 50 percent and 100 percent to the price the life settlement company pays the insured, in the future these costs might be reduced as a result of the development of auctions with platforms linking seller and buyer without the need for a fully intermediated purchase and resale. The newer synthetic transactions, which are linked to pools of (anonymous) older individuals, can also reduce such costs.

NOTES

1 This chapter is drawn from a Pensions Institute report, “And death shall have no dominion: Life settlements and the ethics of profiting from mortality,” published in July 2008 (http://pensions-institute.org/DeathShallHaveNoDominion_Final_ 3July08.pdf).

2 Suneet Kamath and Timothy Sledge, “Life Insurance Long View: Life Settlements Need Not Be Unsettling” Bernstein Research Call, March 2005. Hereafter referred to as “Bernstein,” www.bernsteinresearch.com.

3 Neil A. Doherty and Hal J. Singer, “The Benefits of a Secondary Market for Life Insurance Policies,” Wharton School, October 2002 www.coventry.com/pdfs/wharton.pdf., hereafter referred to as “Wharton.”

4 “Life Settlement Securitization,” A. M. Best, March 2008 www.ambest.com/debt/lifesettlement.pdf.

5 Wharton, p. 1. “Monopsony” refers to a situation where there is only one purchaser of a good or service in a given market.

CHAPTER 4

Parties Involved in a Life Settlement

Vishaal B. Bhuyan Managing Partner, V.B. Bhuyan & Co. Inc.

This chapter further examines the parties involved in a life settlement transaction. Exhibit 4.1 is shown from the perspective of an investor.

FINANCIAL ADVISORS

Due to the complexity of a life settlement, it is in the interest of a policyholder to consult with a financial advisor to decide whether a life settlement is an appropriate option. The following are various advisors a policyholder should seek out before entering into a life settlement transaction.

• Accountants, CPAs

• Attorneys

• Financial planners

• Insurance advisors

• Estate planners

• Certified senior advisors

• Charitable trust officers

PROVIDERS

A life settlement provider acts on behalf of institutional investors (pension funds, investment banks, hedge funds, etc.) to purchase life insurance

EXHIBIT 4.1 Life Settlement Transaction Micro View

policies from senior citizens (either through life settlement brokers or directly from seniors). Institutional investors may purchase life settlements through a number of providers, and providers may draw on a variety of investors for funds (see Exhibit 4.2). Provider firms are responsible for valuing individual life insurance policies and executing the paperwork necessary to

EXHIBIT 4.2Life Settlement Transaction Macro View

transfer ownership of the policy and delivering funds to the original policyholder. Providers are required to be licensed in the state in which a policy is originated so most major provider firms are licensed in the 41 states where life settlements are regulated. In order to adhere to strict regulation, most providers maintain in-house compliance departments. Because policyholders wish to sell their policies only to credible investors, working with a reputable provider firm is of the utmost importance. Well-established provider firms will strive to maintain the confidentiality of the insured and will be well versed in life settlement regulation and life settlement asset pricing. Of the states that regulate life settlements, most require that investors purchase and policyholders sell life settlements through a licensed provider.

Below is a list of major provider firms in the life settlement industry.

Abacus Settlements, LLC708 Third Ave. New York, NY 10017 www.abacussettlements.com

Peachtree Life Settlements8301 Quantum Blvd, 2nd Floor Boynton Beach, FL 33426 www.peachtreelifesettlements.com

Coventry7111 Valley Green Road Fort Washington, PA 19034 www.coventry.com

Legacy Benefits350 5th Ave., Suite 4230 New York, NY 10018 www.legacybenefits.com

Life Settlement Solutions, Inc9201 Spectrum Center Blvd Suite 105 San Diego, CA 92123 www.lss-corp.com

Q Capital Strategies950 3rd Ave. New York, NY 10022 www.qcapitalstrategies.com

Secondary Life Capital1010 Wisconsin Ave., NW Suite 620 Washington, DC 20007 www.secondarylifecapital.com

The Lifeline Program1979 Lakeside Pkwy 2nd Floor Tucker, GA 30084 www.thelifeline.com

BROKERS

Life settlement brokers aim to receive the highest possible offer for a life insurance policy by submitting the case to multiple providers. It is the broker’s duty to seek out reputable provider firms who have access to stable funding, meet regulatory requirements, and who respect the privacy of the clients. Life settlement brokers act much like residential or commercial real estate brokers; however, their commissions are relatively higher and the transaction consists of considerably more sensitive information, thus requiring the highest level of ethical standards. Disclosure of broker commissions is currently the subject of much debate in the life settlement industry as many feel these unreported commissions come at the expense of the seller. Typically, settlement brokers should charge the seller 0.5 percent to 2 percent of the face value of the life insurance policy.

Although the broker must solicit various bids on the policy, it is up to the policyholder to decide which offer to accept. This decision is usually made along with a financial advisor and is based on various aspects specific to the seller.

Much like providers, brokers must be licensed in the state where the policyholder resides; however, brokerage firms do not require the in-house compliance, or call on capital that providers do.

INVESTORS

Life settlement investors, also known as financing entities, acquire life insurance policies for a speculative purpose. Investors acquire life insurance assets through a provider firm that executes the transaction on behalf of the policyholder, but ultimately the owner of the contract is the investor. Investors in some cases become licensed providers or acquire a provider or premium finance firm (covered in Chapter 8) to ensure a steady inflow of policies.

Life settlement investing is not meant for individual investors (unless through an indirect vehicle such as a mutual or hedge fund, or life settlement sector stock), and providers do not conduct transactions with any entity that is not a well capitalized and reputable institution. Aside from the obvious privacy issues, the liquidity and longevity risk associated with life settlements is too great for individual investors to bear. Life settlement investors must be qualified institutional buyers as defined in the federal Securities Act of 1933. A qualified institutional buyer (QIB) is defined under Regulation D, Rule 144A as:

As used in rule 144A, this shall mean any of the following entities, acting for its own account or the accounts of other qualified institutional buyers that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity.

QIB requirements ensure that buyers of life settlements are sophisticated investors and have the market knowledge, risk management expertise, and capital to not only maintain solvency during volatile periods, but also to protect the consumer from questionable market practices.

Institutional investors may design a myriad of trading strategies based on investment horizon, capitalization, and profit model. Most financing entities utilize their own proprietary modeling tools to price life settlement investments but use life expectancies calculated by major underwriting firms. These pricing tools also aid in developing an appropriate trading strategy that meets the firm’s overall thesis.

UNDERWRITERS

Underwriters are medical risk assesors that provide life expectancy projections for market participants based on the medical records of the insured.

Underwriters employ a number of actuarial methodologies to determine the level of impairment of an insured: however some underwriting firms are more fundamentally “actuaries” than others. In a limited fashion, underwriters may be compared to rating agencies such as Moody’s or Standard & Poor’s. Life expectancies are used by investors to model all relevant cash flows of a policy, namely the duration of premium payments and time of expected death benefit.

There are a few major underwriting firms that are used by almost all providers and investors. In most cases, providers or investors will require that two of the three firms below are used when submitting a case:

AVS Underwriting175 Town Park Drive Suite 400 Kennesaw, GA 30144

21st Services200 South 6th Street Suite 350 Minneapolis, MN 55402 www.21stservices.com

Fasano Associates1201 15th Street, N.W. Suite 250 Washington, DC 20005 www.fasanoassociates.com

ISC Services17755 U.S. Highway 19 North Clearwater, FL 33764 Suite 100 www.iscservices.com

Global Life Underwriting3655 Torrance Boulevard, 3rd Floor Torrance, CA 90503 www.globallifeunderwriting.com

CHAPTER 5

Other Involved Parties

Vishaal B. Bhuyan Managing Partner, V.B. Bhuyan & Co., Inc.

This chapter examines the role of other involved parties in a life settlement transaction.

ASSET SERVICERS

Once policies have been acquired by an investor, the policies must be maintained; this can either be done in house, through most providers or through the use of an asset servicing firm.

Asset servicing firms specialize in managing premium payments on behalf of the clients, tracking the insured and delivering up-to-date mortality status information, and processing death benefits when an insured individual dies. Servicers generate monthly reports for investors detailing their profit and loss, their total holdings, and verification of premium payments. Some firms also provide analytics for their clients and are able to assist with optimizing their portfolios and reducing premium payments by drawing upon policy cash values.

These firms track the insured by phone, e-mail, mail, and various database checks such as the Social Security database. Close contacts of the insured such as a brother or neighbor may also be used for tracking purposes.

Note: Life insurance carriers will void a life insurance policy if a premium payment is missed. In some cases given sufficient funds, premium payments may be deducted from the cash value of the policy.

The costs incurred for servicing life settlement investments through providers may be cumbersome and institutional investors may work with various providers so it is not always reasonable for its life settlement holdings to be serviced by several different provider firms. Due to both of these reasons many institutional employ third party servicing firms which may offer servicing solutions for considerably less and through one central access point.

More important than the cost of an asset servicing firm, is working with a servicer(s) that ensure the safety and proper management of a portfolio of life settlements. Although most asset servicing firms will cover any policy that has lapsed due to premium payment error (this rarely occurs among reputable firms) using a backup servicer and tracking agent can be beneficial. This may seem to contradict the statement above regarding investors using multiple provider firms, but there is a difference between using two independent servicing firms and multiple providers. Provider firms offer less flexibility and centralization than third-party servicers.

EXCHANGES