Contingent Capital using Life Settlements

Background

A life settlement is a financial transaction in which the owner of a life insurance policy sells an unneeded policy to a third party for more than its cash value and less than its face value. Until recently, if a policy owner opted out of a policy by surrendering the policy or allowing it to lapse, the additional value was relinquished back to the issuing life insurance company. In some cases, an insured’s health may have declined since the policy was issued and the policy may be worth considerably more than the surrender value. A life settlement is an alternative to this surrender or lapse of a policy, or when the owner of a life insurance policy no longer needs or wants the policy, the policy is under performing or can no longer afford to pay the premiums.

Providers

Life settlement providers serve as the purchaser in a life settlement transaction and are responsible for paying the client a cash sum greater than the policy’s cash surrender value cash surrender value. The top providers in the industry fund many transactions each year and hold the seller’s policy as a confidential portfolio asset. They are experienced in the analysis and valuation of large-face-amount policies and work directly with advisors to develop transactions that are customized to a client’s particular situation. They have in-house compliance departments to carefully review transactions and, most importantly, they are backed by institutional funds.

Life Settlement providers must be licensed in the state where the policy owner resides. Approximately 41 states have regulations in place regarding the sale of life insurance policies to third parties.

Brokers

Financial advisors who choose not to submit cases directly to a settlement provider may opt to work through a life settlement broker. Life settlement brokers are intermediaries who bring together policy owners who wish to sell a policy and providers seeking to purchase them. Brokers, in exchange for a fee, will shop a policy to multiple providers, much as a real estate broker solicits multiple offers for one’s home. Not all buyers are alike and a life settlement broker will help ensure that cases are sold to reputable buyers who are likely to close without significant difficulties. It is unlikely a financial advisor will achieve the highest possible price without going through an experienced life settlement broker.

While it is the broker’s duty to collect bids, it is still incumbent on the advisor to help the client evaluate the offers against a number of criteria including offer price, stability of funding, privacy provisions, net yield after commissions, and more.

Compensation arrangements vary significantly and should be fully disclosed and understood to determine if engaging a broker will benefit the client. In many states, brokers must be licensed to do business in that state.

In regulated states there are material regulations as to procedure, privacy, licensing, disclosure and reporting which must be met and which in some cases carry criminal penalties.

Investors

Life settlement investors are known as financing entities because they are providing the capital or financing for life settlement transactions (the purchase of a life insurance policy). Life settlement investors may use their own capital to purchase the policies or may raise the capital from a wide range of investors through a variety of structures. The life settlement provider is the entity that enters into the transaction with the policy owner and pays the policy owner when the life settlement transaction closes. In most cases, the life settlement provider has a written agreement with the life settlement investor to provide the life settlement provider with the funds needed to acquire the policy. In this scenario, the life settlement investor is effectively the ultimate funder of the secondary market transaction. However, in some life settlement transactions, the life settlement provider is also the investor; the provider uses its own capital to purchase the policy for its own portfolio.

Life Expectancy Providers

Life Expectancy Providers (LEPs) are specialized independent companies ( Towers Watson be a premiere entity for this ) that issue life expectancy reports (LERs) that estimate the life expectancy (LE) of an individual (typically the insured individual on whose life a life insurance policy involved in a life settlement is based). Life expectancies are not a prediction of how long an individual will live, but rather are the average survival time amongst a particular risk cohort. Risk cohorts are typically grouped by age, gender, smoking, and relative health/morbidity. LE is a key component in the pricing of a life settlement.

LEPs are typically made up of actuaries and medical underwriters who utilize actuarial models based on published or proprietary mortality (life) tables and medical underwriting based on various debits/credits for various morbidity characteristics similar to the medical underwriting performed by life insurance company underwriters and reinsurance underwriters. Until recently, the most commonly used mortality table was the 2001 Valuation Basic Table (VBT) published by the Society of Actuaries based on data supplied by contributing life insurance carriers. In 2008, the Society of Actuaries published a new table, the 2008 VBT, that is based on 695,000 lives representing $7.4 Trillion in death benefits which is almost 3 times more lives than the former 2001 VBT. Included with 2008 VBT are relative risk tables (RR Tables) that separate insured lives into various underwriting categories based on the health/morbidity of the insured at the time the policy was issued. Note that no impaired lives are included in any of the RR tables, but rather were designed for companies that subdivide their standard policies into more than one sub-class. Most LEPs have factored in the experience data underlying the 2008 VBT, as well as their own experience data and other factors, as a basis for their mortality tables. This resulted in a significant lengthening of average LEs in the fourth quarter of 2008 for some LEPs. All major LEPs have continued the practice of developing and using proprietary and confidential mortality tables based on extensive medical research and mortality experience. One new LEP has adopted the use of the 2008 VBT RR Tables as a replacement for proprietary multipliers, despite the fact that Relative Risk Factors are in their infancy and not designed for impaired life nor life settlement underwriting. 

Life Settlement History

Although the secondary market for life insurance is relatively new, the market was more than 100 years in the making. The life settlement market would not have originated without a number of events, judicial rulings, and key individuals.

The Policy as Transferable Property

The Supreme Court case of Grigsby v. Russell (1911) established the policy owner’s right to transfer an insurance policy. Justice Oliver Wendell Holmes noted in his opinion that life insurance possessed all the ordinary characteristics of property, and therefore represented an asset that a policy owner could transfer without limitation. Wrote Holmes, “Life insurance has become in our days one of the best recognized forms of investment and self-compelled saving.” This opinion placed the ownership rights in a life insurance policy on the same legal footing as more traditional investment property such as stocks and bonds. As with these other types of property, a life insurance policy could be transferred to another person at the discretion of the policy owner.

This decision established a life insurance policy as transferable property that contains specific legal rights, including the right to:

  • Name the policy beneficiary
  • Change the beneficiary designation (unless subject to restrictions)
  • Assign the policy as collateral for a loan
  • Borrow against the policy
  • Sell the policy to another party

A second milestone occurred in 2001 when The National Association of Insurance Commissioners (NAIC) took a crucial step by releasing the Viatical Settlements Model Act defining guidelines for avoiding fraud and ensuring sound business practices. Around this time, many of the life settlement providers that are prominent today began purchasing policies for their investment portfolio using institutional capital. The arrival of well-funded corporate entities transformed the settlement concept into a regulated wealth management tool for high-net-worth policy owners who no longer needed a given policy. Strong demand for life settlements policies is driving a rapid market expansion that continues today.

Life Settlement History

Although the secondary market for life insurance is relatively new, the market was more than 100 years in the making. The life settlement market would not have originated without a number of events, judicial rulings, and key individuals.

Life Settlement Hedge Funds – Structural Considerations

Because life settlements are a unique investment which has characteristics not associated with other types of investments creative managers can choose to structure a life settlement hedge fund in many different ways. This will detail (i) the potential life settlement hedge fund structures, (ii) life settlement investment program considerations, and (iii) a brief overview of life settlement taxation issues.

Potential Life Settlement Fund Structures

Hedge fund structure – the hedge fund structure with net asset valuations on contributions and redemptions is a common structure but it might not be the best structure unless a valuation mechanism is put in place. Because life settlements are not traded on an established exchange the manager will need to develop some valuation policy which might include using outside appraisers or “marking to model.” The method of valuation will need to be appropriately constructed and will be based on the needs of the funds structure.

Private equity fund structure – the private equity structure gets around the valuation issue but also presents a problem if the fund will own a large amount of policies and/or policies which have widely different expected maturities. The private equity fund structure will require and good understanding of the cash management issues for the fund to make sure that the IRR is satisfactory over the life of the fund. (The central issue being how to redeploy capital from an early maturity.) Such funds may choose to have quarterly distributions of profit after a certain date.

Hybrid fund structure – some managers may choose some sort of hybrid between the above two structures which avoids valuation periods, but allows inflows and redemptions. Usually this would be accomplished through side pocket accounts. However, managers should note that these structures may present accounting issues; we therefore recommend that the manager discuss the proposed program with all of the service providers (attorney, administrator, auditor) prior to finalization of the program.

Debt structure – the offering could be structured as a debt offering. There are many different ways that the debt structure could work, including: (i) the fund could pay the investor a variable coupon based on the fund’s returns, (ii) the fund could pay the investor a fixed coupon which is payable yearly or quarterly after a certain amount of time, or (iii) the fund could pay the investor a fixed coupon which is payable at the end of the life of the fund. There are many issues with the debt structure including the possibility of unattractive returns for the management company if the life settlements do not pay off according the actuarial schedule. There also may be some “phantom income” issues with some of these debt strategies.

All of the structures above contemplate a robust back office of the management company as well as an administrator which is able to deal with the specific issues attributable to these funds (note: many administrators will not be able to handle the administration of these funds).

Description of the Investment Program

The manager should understand his life settlement program will work. A business plan may be helpful in thinking through some of the issues which will arise. Additionally, the following questions should probably be addressed in the description of the investment program or within the offering documents.

  1. What types of policies (whole, term, variable, etc.)?
  2. What are life expectancies of the insureds? How old will the life expectancy reports be?
  3. How old can the insured be?
  4. Cash management policies for the premium payments.
  5. Will all policies be past the contestability period?
  6. Will there be required insurance company ratings? Will there be reinsurance?
  7. Will there be diversification criteria for the policies (carriers, life expectancies, etc.)?
  8. Will the program (i) buy and sell policies, (ii) buy and hold policies to maturity or (iii) a combination of the two?

The above list is not a full list of the potential issues which will need to be addressed. The manager’s hedge fund attorney will be able to identify areas which need greater clarification or information.

Taxation of Life Settlements

Practitioners can disagree as to the tax treatment of life settlement policies and oftentimes the tax treatment will be dependant on the facts of the particular situation. As a general matter, though, if a fund holds a life settlement policy to maturity then the gain will likely be ordinary income; if a fund sells a life policy before maturity then the gain would likely be capital gain. Prospective managers are urged to discuss this issue in depth with their formation attorney.

Additionally, while many hedge funds allow IRA investments, life settlement hedge funds probably should not allow investments from IRAs. This issue should also be discussed in depth with the attorney.

Life Settlement Funds

Currently Hedge Funds are holding Billion of dollars of Life Settlements on their books, part of the problem of the big growth area of 2008 until today in this industry is that the spreads on the valuation of the acquired life settlements, has widened due to updated mortality table’s and valuations by the actuaries .This is great news for the contingent capital Industry looking to access these hedge funds with large portfolios for a secondary use. Industry, with tighter lending and credit markets many were waiting to see how funds would react continue to purchase and invest in life insurance settlements.

As the stock market continues its tumultuous run, interest in Life insurance settlements is an institutional investment has been at a an all-time high over the last three years according to executives at The Lifeline Program®. A number of factors are contributing to this increase, but the investment category’s status as an asset non-correlated to the stock market is proving to be attractive to institutions.

According to W. Scott Page, life settlements are gaining momentum for the following reasons:

Non-correlated assets can generate an attractive yield. The markets have little effect on life settlement yields. One of the key aspects of a life settlement is that the investor earns a payout on the demise of the policyholder. The strength or weakness of the stock market does not impact the life settlement arena.

Life settlement assets are backed by highly rated financial institutions. Life settlements are performed on policies held by carriers with A.M. Best ratings of “A” or better, so the payouts are regulated and solid.

Trading platforms exist. Several “household name” institutions have developed or are developing platforms to trade life settlement policies and portfolios.

Securitization is on the horizon, which means that Contingent Capital “plays” are now a viable option for extra yield for hedge Funds holding large portfolios of these assets. Though it may not be this year, securitization is definitely in the future for life settlements. Portfolio analysis comprising the past several years proves that life settlement portfolios will perform predictably and generate consistent cash flow.

Third party tracking, servicing and underwriting simplify the investment. In a sign of a maturing industry, life settlements are not necessarily managed by one-stop shops anymore. The size and scope has made it profitable for third party companies to manage tracking, servicing and some underwriting, thus easing entry by financial players. The contingent capital industry will be able to add in the region of 350 basis points in revenue to the Hedge Funds Holding portfolios of $100 million or greater making this secondary securitization play and attractive proposition to specialized Hedge funds holding these assets.

The Contingent Capital Securitization Process

Hedge Funds Holding high quality portfolios of Life Settlement will now be able to access the Securitization market place in order to develop a secondary trade / market for their product. Industries interested in this area are companies wishing to enhance their balance sheets, the Mid Cap Insurance companies being a typical example . The initiator normally a SPV based in a off shore jurisdiction would have a portfolio of potential clients looking for contingent capital . This being capital that they need in addition to their normal regulatory capital requirements in order to grow their business and potentially attract a higher rating from the rating agencies .Effectively a Hedge Fund administration company would be used for valuing the portfolio / in conjunction with the actuarial firm assigned to the portfolio and administrating the process , possibly assisting in the bi- monthly valuations of the underlying Life settlement portfolio support the contingent capital trade each trade / transaction would be over collateralized depending on the quality and duration of the individual life settlements being used . A rule of thumb being for every $10 million of Contingent Capital be pledged the transaction would be over collateralized by two times or $20 million to support $10 million in contingent capital this could be as high as 3 to 1 depending on the underlying valuation of the portfolio . Normally entities such as Towers Watson will do bi- monthly valuations, so a conservative buffer in the over collateralization process would be needed.

The Process

Once a Hedge Fund is engaged in provided contingent capital to the SPV either a Fund and or individual transactions can be contemplated. Lets take for example a mid cap Insurance company in Licensed in three US domiciled States, the company has assets of $40 million and Surplus of $10 million (surplus being the calculation of the total amount of assets and cash by which assets exceed liabilities ) wishes to increase their surplus to say $30 million , so $20 million of additional surplus as contingent capital is contemplated . The SPV and its agent, basically puts together a structure that allow the contingent capital to go in as equity rather then debt which would be problematic with most Insurance Departments. In contract $20 million would be exchanged for newly issued proffered shares in the value of $20 million being swapped for the contingent capital thus allowing the capital to go in as equity rather then debt. The SPV has a contract with the company out lining the expectations of the contingent capital, namely in this case that it will be the last asset to be liquidated and or drop down as primary capital , after all underlying equity/surplus along with inuring reinsurance that the company has purchased has been exhausted .