This Month:
What's Happening in the Securitization of Life Insurance Contracts and the Life Settlement Market
Supply & Demand for Life Settlements in the global marketplace
Varying financing options - STOLI vs. traditional vs. hybrids
What's Happening in the Securitization of Life Insurance Contracts and the Life Settlement Market
by J. Alan Jensen, J.D.
J. Alan Jensen is a partner with the law firm of Holland & Knight, Portland, Ore. He can be reached at jalan.jensen@hklaw.com
Driven by a burgeoning life settlement market, the securitization of third-party purchased life insurance policies was inevitable. Purchasers or life settlement providers are now in turn selling policies to underwriters who are using them as security for marketable bonds. The life settlement market, which itself recently was created by investors giving insurance policyowners an alternative to surrendering the policies to the insurer or borrowing on the cash surrender value, will fuel the life securitization process.
In the securitization process, the ultimate purchasers of these insurance policies will package them as the underlying assets for marketable securities, which have been labeled "death bonds". One of the purported attributes of these bonds is that they are uncorrelated to many economic factors. The economic conditions that would affect the market value of death bonds are restricted to prevailing interest rates, the strength of the insurer and the accuracy of the analysis of the insureds' life expectancy. Other economic conditions that may figure large in market swings such as U.S. trade balances, unemployment rates and consumer spending will not, theoretically, affect death bonds.
The continued growth of the death bond market will need a growing supply of policies from the life settlement market. Not surprisingly, policies on older insureds (life expectancy under 12 years) are the most desirable because of their shorter life expectancies. As the demand grows so will the purchase of these policies, which will lead to a shortage of the most desirable life insurance contracts.
Two things have happened as a result of that growing shortage: life insurance contracts with greater life expectancies have been purchased and insurance agents and promoters have created an artificial supply of policies called stranger-owner life insurance contracts ("STOLI" or "SOLI"). Insureds/owners of these policies are persuaded to purchase them primarily for the anticipated profitable sale during the insured's lifetime rather than for permanent insurance protection. Usually the insureds/owners would sell the policies in the life settlement market two years following issuance at the end of the contestability period. This process has created market furor and incurred the wrath of insurers because of the skewing of lapse rates since STOLI policies probably will not lapse.
Properly structured STOLIs initially were legal in most states. However, various critics questioned whether these policies were valid at issuance because the owner (normally a trust) lacked an insurable interest. If the policy was issued to someone without an insurable interest, the contract was void and unenforceable.
Insurers are generally opposed to STOLIs. They argue these plans are antithetical to the basic need for life insurance, which is to provide permanent protection for the insured and his or her family. They are also alarmed by the hyperbole, if not basic fraud, surrounding the sale of many STOLIs. This disposable policy phenomenon developed in the life settlement market with little or no regulation.
There is currently a sea change occurring in the life settlement market. Litigation is now pending challenging the structure and the validity of STOLIs and asking the courts to determine that the promoters did not have an insurable interest in the policies. Such holdings would deprive the investors from receiving policy proceeds and instead would award them to the estate of the insured or allow the insurer to rescind the contracts and to return the premiums. There are three cases in various stages of litigation in New York and one in Connecticut over alleged invalid STOLI plans. Their outcomes could bring considerable restraint to the STOLI portion of the life settlement market.
All three cases involve the same basic scheme. An insured would agree to apply for insurance with the premiums paid by investors. Within a matter of days after the issuance of the policy to a life insurance trust crafted by the promoter with the grantor named as the exclusive beneficiary, the insured would assign all of his beneficial interest in the trust to the investor designee. In three of the cases, the insured died shortly after assigning his beneficial interest to the investors. The promoter argued that there was a valid assignment of the insured's interest after the policy had been issued. The promoters further argued that all the steps under the plan were independent of each other, and albeit occurring within days constituted independent legal acts that were valid in their own right.
In the first action, the court rejected the investors' motion to resolve the case on the pleadings, and the case is proceeding to trial. In denying the investors' motion, the court ruled that those alleged independent steps needed to be evaluated on the facts to determine if they were part of a single or integrated transaction. The net result of such a finding that they were part of a single plan would determine that the policy had in fact been issued to the investors. Since the investors did not, under New York law, have a valid insurable interest, the insurance contract would be void from inception. In this lead case, the insurer had paid the proceeds, thus leaving the two claimants (the deceased's family and the investors) contesting ownership of the $10,000,000 death proceeds.
The other two cases involve the same plan, and in both the insured died shortly after the issuance of the policy. The insurers in these two cases have not paid the proceeds. One insurer has brought an action in superior court in Connecticut alleging that there was no insurable interest on the part of the insured and, therefore, the contract was void. Were the court to determine that the insurer was right in that assertion, it would result in the excusal of the insurer from paying the proceeds after returning the premium.
In addition to the pending litigation, there are two model acts governing life settlements that many state legislatures are now considering. The National Association of Insurance Commissioners (NAIC) has proposed a revised Viatical Settlement Act that has been expanded to include not only the sale of policies by the terminally ill (life expectancy of two years or less), but also life settlement sales by those who are not terminally ill. The National Conference of Life Insurance Legislators (NCOIL) has promulgated an act, a species of which is known as the Life Settlement Consumer Protection Act of 2008 now pending in the California legislature.
States need to address the life settlement market with legislation. They will most likely use the model acts proposed by NAIC and NCOIL to bring comprehensive treatment to the life settlement market. Today, for example, life settlement brokers have no licensing requirement or duty to disclose the economics of the transaction to their clients who are seeking to sell policies in the life settlement market. Nor do brokers have explicit responsibility to serve only the seller of the policy or disclose commissions that might be paid to the broker on the sale of the policy.
All this will change significantly, particularly if the NCOIL proposal is adopted. The NCOIL proposal now pending before the California legislature would impose comprehensive regulations on a basically unregulated area. Life settlement brokers and providers would have to be licensed with the Insurance Commissioner. Brokers would have to provide complete and significant disclosure to the seller/owner of the insurance, including fees and commissions the broker would realize on the sale. Brokers and providers must attend CLE programs to ensure a level of competence for professionals in the field. All forms and promotional material that the broker and provider furnish to the insured/owner must be filed with the Commissioner, who is given authority to require modification.
STOLIs, which are defined quite broadly as policies the issuance of which were "initiated" for sale to anyone who does not have an insurable interest in the insured at the issuance of the policy, are declared to be fraudulent and void. Had this absolute prohibition been adopted in New York and Connecticut, it would compel the courts to resolve in favor of the estate of the insured or the insurer in those pending cases discussed above.
The California NCOIL proposal imposes a fiduciary relationship upon the broker with the insured/owner and prevents the broker from representing prospective purchasers as well. The seller is given 30 days after execution to rescind the sale. No policyowner may sell it within two years of issuance with notable exceptions, such as the illness of the insured, sale of a closely-held business, spouse's death and other illustrated exceptions.
The Commissioner of Insurance is given the power to intervene if that office determines that there has been a violation of the Act. Consequently, the Act takes both the position that the life settlement is a security and places the Commissions in loco parentis with respect to violations of the Act. The California Act, if adopted, would be effective January 1, 2009.
Given the development of aggressive legislation in this area, the landscape in the coming year will be much different than it is today. The sanitization of the market will undoubtedly occur quite rapidly and will be overall a boon to the consumer. The substantial compliance requirements will result in a winnowing of those brokers and providers currently in the market periodically doing one-off transactions. The remaining brokers, because of the licensing and educational requirements, should be a much more knowledgeable group that will be instrumental in the growth of the life settlement market. The excesses and indeed outright fraud that have occurred should see a decline, if not an eradication.
Supply & Demand for Life Settlements in the global marketplace
by Clifford M. Brown
Clifford M. Brown works with Maple Life Financial, based in Bethesda, MD. He can be reached at 240-333-2482 or at cbrown@maplelf.com
In less than a decade the life settlement business has exploded from a small domestic industry characterized by simple organizations into a complex market driven by sophisticated companies striving to meet the needs and requirements of institutional investors around the world. The resiliency of the life settlement business in the wake of industry-specific scandals and turmoil in the global capital markets confirm that life settlements are widely accepted as legitimate and desirable financial assets that belong in institutional investment portfolios. The tipping point for this asset class has been reached.
The entire industry quotes the enormous growth experienced over the past nine years, estimating that the face amount of policies purchased increased from $0.2 billion in 1998 to almost $12 billion in 2006. Growth is projected to continue as the pool of potentially eligible policies, driven by aging 'baby boomers' swells to as much as $161 billion in constant dollars by the year 2030.
Statistics citing the billions of dollars of face value sold or 'settle-able' simultaneously highlight and obscure some interesting truths. First is that the actual amount of money invested is a fraction of the face amount purchased (probably about 25 percent on average when factoring in all costs). Second is that that penetration (amount purchased relative to amount available) is actually quite small.
While the overall potential market size (defined by face amount) will be driven by the pure demographics of the nation's aging population, the growth in actual cases closed will be a function of both global demand for investments and increased awareness by domestic policy holders that the marketplace actually exists.
Global Demand
That capital may now flock to this asset class should come as no surprise. The market is benefiting from the convergence of several forces that virtually ensure its continued development.
Institutional investors constantly seek ways to obtain an optimal mix of risk and return in their portfolios. Truly diversified life settlement portfolios will likely generate total rates of return in the nine to 12 percent range with reasonable underwriting. While that may seem modest compared to industry rumors, it is robust for what would essentially be low risk fixed-income portfolios.
More importantly, returns from life settlements are largely uncorrelated with returns on other asset classes. Adding life settlements to an investment portfolio therefore will enhance the efficiency of the portfolio because the volatility of the expected returns from the portfolio will be reduced. This has enormous value to portfolio managers.
The need for assets like life settlements and the attractiveness of the stability they may provide is highlighted by the current turbulence in the global capital markets. While virtually all kinds of securities are being negatively impacted, market prices for life settlements have been largely unaffected.
With the collapse of the mortgage industry, Wall Street, which is always looking for new and innovative ways to make money, has begun to deploy billions of dollars of capital in an effort to develop multiple ways for investors to get exposed to the asset class. Products that have been or are expected to be developed will enable institutions to go long or short exposure to mortality or longevity risk and will do so in both cash and synthetic forms and in equity and debt structures.
As Wall Street develops these products, it will need to sell them. And they will be sold to investors on every continent. The process of selling these products will result in increasing awareness of the asset class among institutional investors. The fractionalization of products and the availability of synthetic exposure to the asset class will mean that small institutions that cannot afford to build large portfolios will be able to gain exposure.
Increased demand for the asset class will ensure that at least some of the alternative structures being developed by Wall Street will be widely accepted, resulting in a phenomenon seen with many other financial assets-the volume of synthetic and derivative securities tied to the asset class will dwarf the actual cash market.
The development of synthetics and derivatives will, however, require the cash market to continue expanding. Global demand for the asset class is likely to continue to exert downward pressure on rates of return which means higher prices for consumers.
Local Supply
Several recent developments portend the continued rapid expansion of policy supply for many more years. Broadly speaking these developments fall into the categories of insurance company embrace of the industry, compensation disclosure and fee compression and direct-to-consumer marketing. Current trends regarding these issues represent a full scale assault against some of the forces that have worked to restrain the advancement of the industry.
Insurance companies are setting up their own life settlement operations. They will be buyers of the assets that many of them have worked diligently to legislate out of existence. Also, insurance companies are realizing that they cannot keep their agents and affiliates from educating clients and policy holders about the options that exist for the policies that they own. More education and awareness will increase supply.
Regulation, investor demand and fear of litigation are resulting in an increase in transparency to consumers regarding compensation and fees involved in transactions. This trend will not stop until there is universal acceptance of standard documentation and all fees and expenses are disclosed on every settlement, just like consumers receive when they get a mortgage. Disclosure results in fee compression (which means higher prices for sellers) and increased consumer comfort and, leading to an expansion of policy supply.
Industry observers estimate that the average face value of policies actually bought over the past several years exceeded $1,500,000 . But the average face value of policies outstanding is only about $97,500. In order for that $161 billion market to be meaningfully penetrated the industry needs to efficiently obtain and process "small-face" policies. Many "direct-to-consumer" programs have been developed to penetrate this market segment. The success of these initiatives is critical if the supply of policies is to reach its full potential.
Life settlements are here to stay. The investment thesis is too compelling for professional money managers to ignore. Driven by Wall Street, capital from around the world will continue to flow to the sector as long as people can actually deploy their money. Increased demand for cash and synthetic products will require more policy supply. Irreversible trends to increase the number of policies put up for settlement exist. Nevertheless, the question of whether or not the local supply of policies can meet the global demand for policies remains open.
Varying financing options - STOLI vs. traditional vs. hybrids
by Wm. Scott Page
Wm. Scott Page is president and CEO of The Lifeline Program, a life settlement provider company. He can be reached at at 800-252-5282 or at www.thelifeline.com
One of the most talked about aspects of the life settlement industry is called stranger originated life insurance (STOLI), a scenario that enables an investor to finance premium payments for an insurance policy which can then be sold into the secondary market dominated by life settlement companies. These arrangements are being challenged by regulators and in the courts across the country. Unfortunately, traditional premium financing and new "hybrid" options are being cast aside at the same time. For agents, it is critical to understand the differences.
For some in the life settlement industry, "premium finance" and STOLI were interchangeable terms that often created confusion. As things have begun to shake out, clear differences have emerged between traditional premium finance and STOLI, often called non-recourse premium finance.
For those with a long history in the life settlement industry, it is not news to learn that STOLI policies have fallen out of favor. Because the insurable interest of such policies is sometimes questionable, many provider companies and their institutional backers will not purchase them. Some providers continue to buy them but at steep discounts.
In a traditional premium financing arrangement, a policyholder takes out a loan to make the premium payments, and this loan is backed by some form of collateral such as a letter of credit, land, securities, or even expensive personal property such as an art collection. The policyholder must eventually pay back the loan or the collateral is jeopardized.
In a STOLI situation, the policyholder takes out a non-recourse loan to make the premium payments on a life insurance policy. With these arrangements, an agent or financial planner typically initiates the life insurance process, and the insured is often advised to create a vehicle such as an irrevocable life insurance trust (ILIT), a limited partnership or a limited liability company to own the policy. Instead of the policy owner paying the policy premiums, a lender provides funds to the policy-owning entity to pay premiums for the first several years. As a result, the lender obtains a collateral assignment on the policy, this is where the "stranger" comes into play.
Because it is non-recourse, the policyholder is not required to pay the loan back and the only collateral for the loan is the policy itself. Several legal jurisdictions have questioned whether or not insurable interest exists in such a transaction, and many life settlement providers have chosen not to purchase policies with STOLI characteristics.
At the heart of this situation is insurable interest. While individual state definitions vary, insurable interest must be demonstrated in order for a life insurance policy to be valid. It must exist at the time of issue or the policy is void as a matter of law.
With traditional premium financing, because the policyholder has put up as collateral some of his own assets to back the loan, presumably the insurable interest requirement has been met. Such policies do exist in the marketplace, and a number of institutional players will purchase these policies in the secondary market as part of a life settlement.
Traditional premium financing and STOLI are the two most prevalent types of financing arrangements, but a third option exists which is something of a "hybrid."
In these transactions, the policyholder receives a loan to pay premiums but also puts up a personal guarantee for a portion of the loan, which is renewable each year. In addition, the trust paperwork is approved by the insurers in advance, so the carriers have essentially agreed that insurable interest is present and that the policy will not be rescinded in the future for this reason.
For example, an individual receives a loan to pay $100,000 in first year premiums for a life insurance policy. The individual is required to put up a personal guarantee equal to 25 percent of the loan balance (in this case $25,000) and show that they have assets of at least this amount available. The guarantee must be verified and validated by an accountant, and this 25 percent might be cash, savings or other form of collateral.
In addition, the personal guarantee must be renewed each year, so the amount of the guarantee will increase as the size of the loan increases when the next year's premiums are paid. At the time of issue, the trust agreement is presented to the insurance carrier for approval to theoretically eliminate the threat of future contesting or rescission.
Because these hybrid arrangements include a policyholder personal guarantee and carrier approval, it is believed by many that policies that are financed in this manner will ultimately be eligible for a life settlement and sale into the secondary market after the two-year contestability period has ended.
These hybrid arrangements haven't been challenged by the court or regulators, but some in the industry believe that a hybrid will not face the same scrutiny as prior schemes. Others are wondering if this is non-recourse in disguise. It is indisputable that the life settlement industry will continue to purchase policies which are financed by traditional and legitimate means. For life agents, knowing the differences among financing options for life insurance policies is more critical than ever.