Life Settlements and Longevity Structures

Pricing and Risk Management

Geoff Chaplin, Jim Aspinwall, Mark Venn

• Publisher: Wiley
• Year: 2009
• Print ISBN: 9780470741948
• eBook ISBN: 9780470684856
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Recent turbulence in the financial markets has highlighted the need for diversified portfolios with lower correlations between the different investments. Life settlements meet this need, offering investors the prospect of high, stable returns, uncorrelated with the broader financial markets.

This book provides readers of all levels of experience with essential information on the process surrounding the acquisition and management of a portfolio of life settlements; the assessment, modelling and mitigation of the associated longevity, interest rate and credit risks; and practical approaches to financing and risk management structures. It begins with the history of life insurance and looks at how the need for new financing sources has led to the growth of the life settlements market in the United States.

The authors provide a detailed exploration of the mathematical formulae surrounding the generation of mortality curves, drawing a parallel between the tools deployed in the credit derivatives market and those available to model longevity risk. Structured products and securitisation techniques are introduced and explained, starting with simple vanilla products and models before illustrating some of the investment structures associated with life settlements. Capital market mechanisms available to assist the investor in limiting the risks associated with life settlement portfolios are outlined, as are opportunities to use life settlement portfolios to mitigate the risks of traditional capital markets. The last section of the book covers derivative products, either available now or under consideration, that will reduce or potentially eliminate longevity risks within life settlement portfolios. It then reviews hedging and risk management strategies and considers how to measure the effectiveness of risk mitigation.

 

1

Life Insurance: Primary and Secondary Markets

INTRODUCTION

This chapter explores the background to the development of the market for life settlements - the sale of life insurance policies to financial investors. It describes the parties involved in a typical life settlement transaction and the associated process. It concludes with a review of some of the legal and practical issues associated with life settlements.

1.1 HISTORY, APPLICATION AND TERMINATION OF LIFE INSURANCE POLICIES

1.1.1 History: Early Life Insurance

Risk protection has been a primary goal of humans and institutions throughout history. Protecting against risk is the reason for insurance. One of the first records of life insurance was in Rome, where burial clubs were formed, known as Fratres. These clubs were set up by the poor to pay for the funerals of their members and to help the surviving family members financially.

Following the fall of Rome most types of insurance were abandoned. Around 450 AD, guilds began to be established for the various types of highly skilled trades. Accounts from that date suggest that these guilds helped their members with various types of insurance, including life and disability.

Insurance in Asia can be traced back to the Vedas, the oldest sacred texts of Hinduism. For instance, Yogakshema, the name of Life Insurance Corporation of India’s corporate head-quarters, is derived from references within the Rigveda, one of the texts. It is suggested that a form of “community insurance” was prevalent in India around 1000 BC, practised by the Aryans.

1.1.2 Modern Insurance

Illegal almost everywhere else in Europe, life insurance came into its own in England, where it was vigorously promoted in the late seventeenth century. During this time, insurance began to be transacted at Edward Lloyd’s Coffee House in Tower Street, London, where ship owners and underwriters (known as “backers”) met to put together insurance contracts and other shipping and merchant-related business.

While serving as a means of risk avoidance, life insurance also appealed strongly to the gambling instincts of England’s burgeoning middle class. Gambling was so rampant that when newspapers published names of prominent people who were seriously ill, bets were placed at Lloyd’s Coffee House on their anticipated dates of death. Reacting against such practices, 79 merchant underwriters broke away in 1769 and two years later formed a “New Lloyd’s Coffee House” that became known as the “real Lloyd’s”. Making wagers on people’s deaths ceased in 1774 when Parliament forbade the practice in the Life Insurance Act of that same year.

Slightly more tolerably - as one assumes they had at least some vested interest in the survival of the individuals in question - those same gamblers had made use of mortality information drawn from John Graunt’s Observations on the Bills of Mortality¹ (published in 1662) to bet on the survival rates of those captains to whom they entrusted their ships. The tables published in Graunt’s book are often cited as the first recorded example of a population mortality table and his work led to his election as a Fellow of the Royal Society - no mean feat for a haberdasher, at a time when those engaged in trade were largely ignored by this august body.

Life insurance is not gambling, but its development has spurred the growth of the mathematical science of probability. Today this science has been refined through actuarial studies and has become the foundation of pricing technology for credit default swaps (CDSs).

1.1.3 Insurance Moves to America

The US insurance industry was built on the British model. The year 1732 saw the birth of the first insurance company in the American colonies in Charleston, South Carolina, providing fire insurance. In 1759, the Presbyterian Synods in Philadelphia and New York sponsored the creation of the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers - the first life insurance corporation in America established for the benefit of ministers and their dependents. The first recorded issue of a life insurance policy for the general public in the United States occurred in Philadelphia, on 22 May 1761.

1.1.4 Summary

Life insurance was originally dominated by the mutual life insurance companies - companies owned by their policyholders, who therefore received a pro rata share of the company’s profits from underwriting life insurance. Similar to the mutual life insurance companies were fraternal life insurance companies, which were started by the various trade associations and fraternal orders to assist their members, the first example being the Ancient Order of United Workmen, organized in 1868 in Meadville, Pennsylvania (Zelizer, 1983). These should be distinguished from stock life insurance companies where the profits are made for the benefit of the stockholders.

Today life insurance has become a major industry across the globe, with many different types of policies available for the consumer and offered by a multitude of insurance carriers. However, most development of structured life insurance products has been driven by the US market, primarily owing to its size. By the end of 2007, total life insurance coverage in the USA reached US$19.5 trillion, including corporate and individual cover (ACLI, 2008).

Companies such as Lloyd’s have been keeping statistics on life expectancies since the late nineteenth century. Actuarial estimation of life expectancies in the general population has therefore become a very exact science. The challenge for an investor is to apply this science to the much smaller populations involved in life settlements.

1.1.5 Applications of Life Insurance

An individual might have several reasons for taking out a life insurance policy on his or her life. Examples of these reasons include:

1. to provide financial support to dependents in the event of the early death of the breadwinner;

2. to pay for funeral expenses, death and/or inheritance taxes;

3. to facilitate other financial contracts - for example, many mortgage lenders require that a life insurance policy be taken out as a precondition to a mortgage loan;

4. to provide compensation for the disruption to a business in the event of the death of a senior employee or director (known as “key man” insurance); and

5. as a means of saving (often tied to retirement).

The reason for taking out life insurance will often drive the selection of the type of policy. Some policy types will be appropriate for one situation but not for another. For example, a policy that pays out only on death is appropriate for (2) above whereas a policy that pays out at a certain age, if the insured survives to that age, is appropriate for (5) above. Similarly, a term life policy (under which the policy terminates with no payment if the insured lives longer than the specified term) might be appropriate for (3) above but is unlikely to provide appropriate cover for (1) or (4).

With the spread of company-sponsored and private pension schemes, insurance to provide coverage for dependents (item (1) above) is now often part of a pension scheme and may also be included in the benefits package offered by some employers.

1.1.6 The Parties Involved in a Life Insurance Policy

Several parties are involved in the issue and maintenance of a life insurance policy and each has different roles, responsibilities and interests in the process.

The owner of a life insurance policy (also described as the policyholder) is the person responsible for making premium payments under that policy. This person is often - but not always - the same as the insured, the individual whose life is the subject of the life insurance policy. On occasion, the owner of a life insurance policy may be a trust or a corporation (a so-called “non-natural person”), which is typically the case in policies issued for retirement or tax planning and, of course, for “key man” policies which are usually owned by the employer company.

There may be more than one person insured under a life insurance policy (see “Life Insurance Products and Underwriting” below for a discussion of “first-to-die” and “second-to-die” policies). There will also be at least one (and potentially more than one) beneficiary. The beneficiary receives the payout on the policy if it matures through the death of the insured(s) during the prescribed term. The owner has the right to designate the beneficiary of the policy and to change the beneficiary at any time. The company that has issued the life insurance policy is referred to as the carrier or the insurer. As life insurance is heavily regulated in most jurisdictions, the carrier will need to be licensed to issue life insurance in the relevant territory. In the United States, a carrier wishing to underwrite life insurance throughout the nation will require licensing in each of the fifty states and Washington DC as well as territories such as Puerto Rico.

In many cases - certainly in the case of “traditional” life insurance policies - the owner and the insured will be the same person and the beneficiary or beneficiaries will be dependents of the owner/insured. It is also possible for the owner and the beneficiary to be the same person - for example, where the dependent son takes out a life insurance policy on his parent in order to meet funeral expenses or where a company takes out a life insurance policy on several of its key employees. It is theoretically possible for the same person to be owner, insured and beneficiary under a life insurance policy, but this is rarely seen. It is, however, important to remember that the same person may play two roles in respect of a life insurance policy, as will be seen when considering the process involved in a life settlement.

1.1.7 Life Insurance and Life Assurance

In the United Kingdom, insurance market participants may refer to “life assurance” - not a term that exists in the United States. Assurance policies are designed to provide a payout upon the occurrence of an event which is certain, but where the timing is uncertain - hence the term “life assurance”, as death is a certainty but the timing of death is uncertain. By contrast, insurance policies are designed to provide a payout upon the occurrence of an event which is uncertain, for example, buildings insurance or contents insurance where it is not certain that your house will collapse or that you will suffer a loss as a result of fire, flood or burglary. In this book we will refer to insurance policies throughout - the distinction between assurance and insurance being irrelevant to life settlements, securitization and/or derivatives.

1.1.8 Termination and Surrender of Life Insurance Policies

There are many reasons why the owner of a life insurance policy may find that policy surplus to requirements. The owner may have taken out insurance in relation to a house purchase or his or her own business. At a later date the policy may no longer be required: the house may have been sold, or the related mortgage loan paid down as the owner’s income rose; dependents may have grown up or the insured’s marriage may have broken down; a company may have evolved to a point where “key man” insurance is no longer appropriate; or the owner may be seriously ill and may need to realize investments to pay for medical expenses. A variety of reasons can exist for selling an asset and - except to the extent that the insured’s state of health affects the value - these reasons should be irrelevant to the calculation of that sale price.

Until recently (the late 1980s), the only option was to surrender the policy to the life insurance company. This involves returning the policy to the carrier - literally, surrendering the right to receive payments under the policy - in exchange for a cash payment, known as the cash surrender value. Calculation of this cash surrender value is based upon the specific terms of the policy, but it will certainly depend upon the total amount of premiums paid into that policy since inception (among other factors). The cash surrender value may, in some cases, be zero (if, for example, the policy has only recently been issued and it is therefore subject to high surrender penalties). The cash surrender value will not take account of the health status of the insured; its calculation is prescribed in the policy document and the carrier is required to treat all owners of the same policy equally. This goes some way towards explaining why cash surrender values are low. Because the carrier cannot take into account the health status of the insured in calculating the cash surrender value, it must be conservative and therefore assume that it has given up a significant asset - the right to receive ongoing premium payments for many years to come - in exchange for being released from an insignificant liability such as the obligation to pay out the net death benefit at some date, potentially many years in the future. Simply discounting the respective asset and liability flows will show why it is rational for the carrier to be reluctant to surrender the right to receive those ongoing premium payments.

While the carrier is proscribed from incorporating current insured health status in the calculation of its cash surrender values, third parties are not so proscribed. Accordingly, in the late 1980s early 1990s, investors began to consider the risks and rewards of owning life insurance policies and found the returns to be highly significant, even on a risk-adjusted basis - as we will see when we look at the development of the viatical and life settlements markets later.

1.2 LIFE INSURANCE POLICY TYPES AND UNDERWRITING

There are several types of life insurance products that may feature in a secondary market transaction. The type of product is usually more relevant to physical transactions (such as the sale of legal and beneficial interest in a policy through a life settlement) rather than a derivative transaction (such as the assumption of longevity risk through an index swap, of which more later). The purchase of a physical policy exposes the buyer to all of the terms and conditions of ownership of that policy (including, for example, the risk that the carrier defaults upon its obligations under the policy), whereas the majority of derivative contracts focus more on the transfer of longevity risk as we will see in later chapters. It is important to note that very rarely are any two life insurance products created equally. Carriers have a vast range of policy options available, and as the design of a life insurance product is not usually based upon ease of access to the secondary market, it is vital to review the terms of each policy in detail before making a buying decision.

Policies can be divided into permanent insurance and term insurance. Permanent insurance policies continue for the duration of the insured’s life (subject to a contractual maturity date, generally after what would be the insured’s 100th birthday). Permanent insurance policies generally accrue a cash value. Payout of the accumulated cash value is assured at the end of the policy, and as long as the policy is kept in force the carrier pays out the contractual death benefit upon the death of the insured and retains the accumulated cash value. Term insurance, by contrast, only pays out the death benefit in the event that the insured dies during the specified term of the policy, and no cash value accrues to the owner. It is often possible to convert term insurance into permanent insurance, by following a procedure laid out in the policy document.

Policies can also be divided into participating and non-participating. A participating policy allows the policyholder to share in the carrier’s surplus - the policy owner receives a dividend representing that portion of the carrier’s premium income that is not needed to cover death benefit payments, additions to reserves or administrative expenses. It is very similar to participating in the carrier’s investment returns. The vast majority of individual life policies purchased today are non...

Table of contents

• Dedication
• Title Page
• Copyright Page
• Introduction
• Chapter 1 - Life Insurance: Primary and Secondary Markets
• Chapter 2 - Mortality and Credit Structures, Valuation and Risk
• Chapter 3 - Structured Products and Securitization
• Chapter 4 - Examples of LSP Securitization: Principal Protected Fund
• Chapter 5 - Capital Markets Products: Principal Protection
• Chapter 6 - Structured Financing: Guaranteed Loan Repayment
• Chapter 7 - Life Settlement Derivatives
• Chapter 8 - Hedging
• Appendix
• Bibliography
• Index