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-participating policies.²

1.2.1 Universal Life

Universal life policies are a type of permanent life insurance and are usually, but not always, non-participating. Universal life policies account for over 95% of the life insurance policies transacted in the life settlements markets and represent the majority of in-force life insurance policies in the United States (ACLI, 2008). Universal life policies can be described as combining a savings account (which we refer to here as the cash account) with a life insurance policy.

At this time, we should introduce a concept that may be new to those not experienced with life insurance terms - the cost of insurance, or “COI”. Generally, the owner of a life insurance policy will describe the cost of that policy in terms of the amount of premium that he or she pays to the carrier, be it annual, semi-annual, quarterly or monthly. The uninitiated might assume, with some justification, that this premium is to compensate the carrier for agreeing to pay the net death benefit upon the death of the insured - indeed, the amount of the first year’s premium payment is often the deciding factor when it comes to selecting the carrier for a new life insurance policy. In the case of a universal life policy, however, the premium is paid into the cash account and that cash account balance (the account value) then attracts interest at a given rate (the current crediting rate). The current crediting rate is set by the carrier based upon the performance of its investments, which, in the case of universal life policies, are usually long-term fixed interest assets, e.g., higher rated corporate and government debt instruments. The carrier then debits the cash account to meet expenses, typically an administrative charge on each premium payment and further monthly charges to meet the cost of maintaining and administering the policy. The carrier also debits the cash account with the COI - a specified amount of money that reflects the mortality risk assumed by the carrier (i.e. the risk that the insured dies earlier than the carrier expected, causing the carrier to lose money on the policy). For this reason, in calculating required premium payments, the carrier will apply the COI to the net amount at risk - the amount by which the contractual death benefit payment exceeds the account value that has been built up in the policy. The higher the account value, the less the carrier has at risk (as the carrier retains all of the account value upon the death of the insured). The distinction between premium payments and the cost of insurance is critical to the correct evaluation and pricing of a policy for a prospective life settlement, for reasons that will be explained in subsequent chapters.

We referred earlier to the cash surrender value of the policy, being the amount that a carrier will typically pay out were the owner to surrender the policy. The cash surrender value of a universal life policy is always less than or equal to the account value (it may be reduced by the amount of any surrender charges that are applied to the policy). Carriers typically impose surrender charges on newly issued policies during the first few years of issue (potentially as long as 15 years, depending upon the product). These surrender charges are imposed to offset the costs incurred by the carrier in issuing the policy - processing the application, underwriting the insured(s) and paying commission to the producer (the life insurance agent who introduced the new owner/insured to the carrier).

Universal life policies typically have a policy maturity date, which is defined by reference to the date on which the policy was first issued (the policy issue date). The policy maturity date is typically the first anniversary of the policy issue date (a policy anniversary) after the insured’s 100th birthday. Policies issued before 2001 will occasionally have an earlier maturity date - for example, the policy anniversary after the insured’s 99th, 97th, 95th or even 90th birthday.³ If the insured survives beyond the policy maturity date, coverage under a universal life policy typically ceases, and after this time the carrier may be obliged to make no payment on the death of the insured, or may only pay out the cash surrender value.

The amount paid by the carrier upon the death of the insured depends on the terms of the policy. It may be a fixed amount (referred to as level death benefit) or a variable amount. If variable, it may be described as increasing death benefit (in which case it usually equals the fixed amount stated on the policy plus the then current account value) or in the case of policies issued recently, as return of premium (ROP), in which case the death benefit payable at any time is a function of a stated amount plus the total amount of premium payments made up to that date. Policies with a ROP component typically have a limit on the total amount to be paid out, such that the ROP component stops within a few years of issue, with the policy usually reverting to a level death benefit payout.

Accrual of interest on the account value for a universal life policy is generally tax free in the United States, making this a good policy for estate planning.

1.2.2 Variable Universal Life

Variable universal life policies - also a type of permanent life insurance - have many of the same characteristics as universal life policies. The difference arises in the management of money in the cash account. As mentioned, cash account balances in universal life policies are typically invested by the carrier in long-term, fixed rate instruments with minimal credit risk. Accordingly, the current crediting rate on those policies tends to be reasonably low albeit - it is to be hoped - relatively stable. Variable universal life policies introduce an element of discretion for the owner as it is possible to invest the balance in the cash account across a number of different sub-accounts, managed by the carrier. These sub-accounts will have exposure to different investment strategies and asset classes, potentially including short-, medium- and long-term fixed rate instruments, equities, commodities and corporate credit. The opportunity to vary the mix of investments creates a greater potential rate of return, albeit with higher volatility.

Universal life and variable universal life policies have flexible premiums and for that reason are often described as flexible premium adjustable life policies.

1.2.3 Term Insurance

Term insurance is frequently used for “key man” policies and for policies purchased to support a fixed term mortgage loan. The phrase describes a policy with a fixed term, which pays out a prescribed amount to the beneficiary following the death of the insured within that term. There is no accumulated account value for term insurance and the insurance coverage is terminated at a specific date with no further payment if the insured survives beyond this date. Owners of term policies pay premiums based solely on what the carrier determines is required to cover the risk of the insured’s death during the term, given the insured’s age and medical history (as underwritten just prior to issue of the policy) based upon a fixed death benefit amount. As a result, younger persons and shorter terms will generally attract lower insurance premiums.

1.2.4 Endowment Insurance

An endowment policy has a fixed term, like a term policy, but unlike a term policy it pays a defined amount in the event that the insured survives to the end of the fixed term. Premiums are higher - often substantially higher - than term insurance contracts, as there is certainty that an amount will be paid out by the carrier. However, the amount to be paid is frequently uncertain, as it is usually dependent upon the performance of investments made by the carrier.

Endowment policies were commonly issued in the UK to support interest-only mortgage loans. Such policies were often sold to UK homeowners during the 1990s on the basis that the endowment would increase in value over the term of 15, 20 or 25 years such that it would repay the principal amount due on the mortgage loan at its maturity. Poor performance of the underlying investments and a litany of mis-selling complaints, as well as a change in the tax treatment, caused endowment policies to fall out of fashion and very few have been issued in the UK in the last five years (ABI, 2008).

The widespread use of endowment policies in the UK created one of the first secondary markets for insurance instruments - the traded endowment policies, or “TEPs” market. TEPs were bought and sold at auctions conducted by specialist endowment brokers. Such auctions continue today, although compared to the US life settlements market, the value and number of the endowment policies traded is very low.

1.2.5 Whole Life

Whole life insurance is the generic name for a policy that continues until the death of the life assured. Such policies have increasing accumulated value as the insured ages. The premium payments are structured to “overpay”, such that the account value will build up to the contractual death benefit amount by a defined age (usually 100), progressively reducing the carrier’s net amount at risk.

The most common type of policy sold in the USA is the whole life policy. Here the policy holder pays a fixed annual premium over his or her life in exchange for a whole life policy with specific death benefits or face amount as stated on the policy. The beneficiary of the policy receives full benefit from the policy regardless of the date of death. Premiums are usually constant, based upon the average actuarial premium amount needed to cover claims for the policy holder’s entire life - as a result premiums are larger than needed to cover the mortality risk in the early years. The excess premium is invested at a pre-stated rate and as this cash surrender value grows it can be used for other possibilities.

Whole life insurance combines features of both term insurance (where the premiums are fixed) and permanent life insurance (where a cash value accrues within the policy and payout of the cash value is assured at expiration of the policy). In the life settlements market, participating policies are most often whole life policies rather than universal life policies.

1.2.6 Policy Riders

Carriers will frequently offer extra options with their insurance products, to be added at issue. These are commonly known as “riders”, such as:

• Extended Death Benefit Rider: In this case, if the insured lives past a certain date (typically the first policy anniversary after he or she has attained the age of 100), no further premium payments are due but the carrier remains obliged to pay the net death benefit (or some other amount, depending on the terms of the rider) if the insured dies before a later policy anniversary date, e.g. age 105, 100, 115 or 125.

• Term Rider: If the insured dies within a short time after issue of the policy (say 5 or 10 years), the death benefit payment is increased by a fixed amount, equivalent to owning a separate term life insurance policy on the insured.

Figure 1.1 A comparison of insurance products

Riders may be offered as incentives to purchase insurance from a particular carrier or offered as a “bolt-on” to a policy when first issued. We will look in later chapters at how riders can affect policy pricing. Figure 1.1 compares some characteristics of the different policy types.

1.3 DEVELOPMENT OF THE VIATICAL SETTLEMENT AND LIFE SETTLEMENT MARKETS

1.3.1 History and Inception

Although the secondary market for life insurance is relatively new, the judicial ruling in the Supreme Court case of Grigsby v. Russell in 1911 declared the policy owner’s right to transfer legal ownership and beneficial interest to a third party at his or her own discretion.

The first of such transactions occurred amidst the devastating impact of the AIDS epidemic in the mid-to-late 1980s, when life insurance policies were purchased from terminally ill individuals, for an amount made up of a percentage of the policy face value. A key driver for this change was the requirement of vast sums of capital by terminally ill AIDS patients to primarily finance expensive health care fees. Subsequently, this type of transaction was given the term “viatical” and the viatical settlements industry was born.

However, it was only after the Health Insurance Portability and Accountability Act (HIPAA) was signed into law in 1996 that the life settlements market emerged. Aside from imposing a series of administrative, physical and technical safeguards on the storage and use of protected health information, HIPAA essentially confirmed the right of the owner of the life policy to transfer ownership/beneficial interest to a third party having no insurable interest in the life of the originally insured party, while determining the tax treatment of the corresponding gain. This effectively allows third party investors to freely purchase life insurance policies at the discretion of the policy owner and beneficiary, hence, creating a market for life settlements.

1.3.2 Negative Sentiments

The life settlements industry has had more than its fair share of negative sentiment. Early transactions in viatical settlements involved the sale of policies insuring the lives of AIDS patients to some retail investors, with the promise that the returns would be extremely high and realized in a very short period as long as the investors continued to pay the required premiums over this period. The “magic bullet” effect caused by the availability of highly active antiretroviral therapy (Palella et al., 1998) to combat AIDS resulted in the insured individuals living much longer than the investors had been led to expect, leading to losses and the inevitable lawsuits from state and federal regulators. ⁴ Increasing regulation - as insurance is regulated at state level in the USA one is transacting in 50 separate markets rather than one - and the cross-over of insurance methodologies and experience has led to most of the bad apples being weeded out. However, the “headline risk” continues, with an enforcement action against a significant market participant brought by Eliot Spitzer⁵ in 2006, resulted in a claim for $2.1 billion in triple damages under the federal RICO statute (Racketeer Influenced and Corrupt Organizations Act of 1970).⁶

The life insurance lobby has used these “bad apples” in support of its campaign to promote regulation that will effectively eliminate the life settlements industry, through the implementation of legislation at state level and via the National Association of Insurance Commissioners (NAIC) Model Act drafting process.⁷ The life settlements industry has responded to this pressure through lobbying for appropriate regulation at state level - supporting consumer choice through maintaining the availability of life settlements in as many markets as possible.

1.3.3 Market Size

Two recent surveys have estimated that the available market size will grow from an estimated $13 billion in 2004 to $161 billion over the next few decades; through a combination of population ageing and increasing market penetration (penetration is currently estimated at around 3% - see Bernstein Research (2005, 2006)). The face amount that cleared through the market grew from around $10 billion in 2005 to $12 billion in 2007.⁸ In common with other asset classes, the life settlements market contracted significantly during 2008, as institutional investors fight to repair the damage to their balance sheets. However, life settlements is attracting a much wider audience within the investor community than was the case even two years ago, and once investor activity picks up again, growth in life settlements activity should be much more rapid than in other, more traditional, asset classes.

1.3.4 Institutional Involvement

The bad press dealt to the life settlements industry might explain the historical lack of capital markets interest in what should be an attractive asset class - after all, credit derivative swap (CDS) pricing was derived from life insurance underwriting methodologies, so credit traders should feel that they understand the risks extremely well. Intensive regulatory and compliance requirements, the lack of market transparency and efficiency and extremely high barriers to entry have historically tended to turn most investors away from the product. In March 2007, the Institutional Life Markets Association (ILMA) was formed by six leading investment banks (Bear Stearns, Credit Suisse, Goldman Sachs, Mizuho International, UBS and West LB) to promote legislative initiatives and best practices in the life settlements and premium finance industry. ILMA is endeavouring to develop and agree higher standards of market practice and to enhance transparency in the industry through fee disclosure and standardized documents.

1.4 THE PARTIES INVOLVED IN A LIFE SETTLEMENT TRANSACTION

directindirect