life settlement-backed securities

fugui Financial Career Workshop

(lsbs)

LIFE SETTLEMENT- BACKED SECURITIES

NOVEMBER 2010

An emerging market backed by $15 trillion and growing life insurance assets

© 2010 by R. Brezeck Wang, fugui Financial Career Workshop. All Rights Reserved. http://fuguifinancial.com

This is for reference only Investors should consider the investment objectives, risks, charges, and expenses carefully before investing

© 2010 fugui Financial Career Workshop All Rights Reserved

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Contact Information

R. Brezeck Wang Analyst

+1 206 601 7853 [email protected]

William Li Strategist

+1 626 202 9836 [email protected]

fugui Financial Career Workshop fuguifinancial.com

fugui Financial Career Workshop (fFCW) is a student-run financial career & research workshop established

in 2010 by two dedicated students, William Li ’12, University of California, Irvine, and Brezeck Wang ’14, Hobart College. Backed by powerful technologies and

resources, fFCW conducts research on global economy, stocks, and financial derivatives including options and

asset-backed securities.



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Contents Introduction ..................................................................................................................................... 3

Understanding Life Settlement ....................................................................................................... 4

History of Life Settlement............................................................................................................ 4

How Does It Work ....................................................................................................................... 4

Current Condition of the Market ................................................................................................. 5

A Critical Analysis on LSBS ............................................................................................................... 7

Definition of LSBS ........................................................................................................................ 7

The Framework of LSBS ............................................................................................................... 7

Possibility of Securitization of Life Settlements .......................................................................... 8

Comparison with Mortgage-backed Securities ........................................................................... 9

Valuation of Life Settlement-backed Securities ............................................................................ 10

Conclusion: The Future of Life Settlement-backed Securitization ................................................ 11

References ..................................................................................................................................... 12

Goldman Sachs Group, Inc.

200 West Street, New York, NY



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Introduction In January 2004, the first life settlement-backed security (LSBS) was underwritten by Tarrytown

Second, LLC. It was a $63 million, class A Life settlement securitization backed by $195 million

face value of life insurance policies. In April 2004, Legacy Benefits settled another deal with $70

million face value, in which $61.5 million was rated as A1 by Moody’s. But life settlement and its

securitization are unknown by most people. This report briefly talks about the life settlement

business and the securitization of settled life insurance policies – the framework, possibility,

valuation process, features and risks.

Life settlement business is derived from the former viatical settlement services during 1980’s for

HIV infected individuals at that time. Life settlement (a.k.a. senior life settlement) is, different

from viatical settlement, a new option for senior policy holders to jump out of the policy with a

considerable amount of cash, a lot more than cash surrender value paid by the insurers. LSBS is

backed by these settled insurance contracts, so it is crucial to analyze this secondary market

before we step into its securitization market.

As a kind of asset-backed security, life settlement-backed security is much different from those

other ABSs, for example the most famous mortgage-backed securities (MBS). This difference

both contributes to its favorable characteristics, and at the same time causes its sluggish

development over time. We will talk about the features and risks of life settlement-backed

securitization, with a comparison to mortgage-backed securitization. Then, we will analyze the

unknown future of this newly born type of securities. Finally, we introduce the concept of

valuation of LSBS.



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Understanding Life Settlement

History of Life Settlement The conceptual origin of this secondary market of life insurance can date back to the 1911 U.S.

Supreme Court case of Grigsby v. Russell, in which Justice Liber Wendell Holmes stated that life

insurance should be "transferable without limitation" by the policy owners. The reasoning was

that life insurance is one of the best recognized types of investment, fulfilling requirements for a

transferable property such as like bond and stock. This idea was once practiced as viatical

settlement during 80’s and 90’s when AIDS was incurable. Men diagnosed with AIDS were

usually homosexual, without worries about distributing fortune to wives and kids, while they

needed an amount of cash to cover the medical expenditures. They could then sell their life

insurance policies to brokers and instantly generate a large amount of cash. But this idea was

not favored by investors because of the small number of these cases. Also, the medical science

community has learnt a lot more about this disease since then. Infected individuals’ life

expectancies are extended and some of them are even cured.

Today, the concepts of viatical settlement and life settlement are separated. The former only

deals with people diagnosed with AIDS and other terminal ills, while the latter is also known as

senior life settlement, describes purchasing life insurance policies from elderlies. But in practice,

life settlements also involve policy holders who are diagnosed with terminal diseases like cancer.

How Does It Work In one word, trading life insurance policies is betting on the early death of insured individuals,

which is not tasteful to investors.

However, the truth is that most insurance contracts, especially those high-value senior life

policies ever eventually go to lapse (see Exhibit 1). As one gets older, a policy is likely to become

more and more unnecessary to her, or he just could not afford the annual premiums anymore.

In contrast to the amount generated from a life settlement deal, the cash surrender value seems

really dim, which is usually only three or four percent of the benefit. The life settlement brokers

seize the opportunity to make profit from life insurances of the old.

The life settlement business works as an investor takes out a high-value policy from the insured

person at a pleasant price, which could be three to four times as the surrender value, according

to the premium rate and the insured’s life expectancy. The investor will then have to pay all the

future premiums to keep the contract active. The investor could obtain the death benefits as

payoffs when the insured dies. Then the return spread should be:

Return = Death Benefit – (Premiums + Purchase Price)

From the spread formula, we can tell that the longer the insured individual lives, the less profit a

life settlement could yield.



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Exhibit 1: Surrender/Lapse Ratio in Life Insurance Industry (Source: ACLI Fact Book 2009)

Current Condition of the Market As the life settlement business grows, more and more policies could be traded within the

secondary market. Several hundred high-value senior life insurance policies could be pooled and

securitized into what we are talking about next: life settlement-backed securities. 2004 was a

milestone for life settlement-backed securitization. In January that year, Tarrytown Second, LLC

underwrote a $63-million, class-A life settlement security backed by $195 million face value of

life insurance policies; soon in April, Legacy Benefits settled another one with $70 million value.

Meanwhile, most LSBSs are small and private, without being rated by major rating agencies or

even known by most investors.

Still, we have to analyze the situation of life settlement market before stepping into its

securitization. Employer-sponsored retirement benefits have disappeared in the U.S. for a long

time. As we said, the premium rate of a life insurance can be too high for a senior policyholder,

whereas many elder policyholders need cash to maintain life or to cover medical expenses..

Major players in life settlement market argue that it is totally legitimate and good to senior

policyholders who need money, while the opponents, majorly insurers, criticize this business as

it cut the lapse/surrender ratio of life insurance policies and erode these firms’ profits.

Fast growth of this market also is companied with ever-increasing domestic life expectancy.

According to the latest data from U.S. National Center for Health Statistics, life expectancy at

birth keeps going up to 77.9 years in 2007. While life expectancy is longer, death rate also

dropped significantly as the death rate of seniors over 65 decreased by over 2%. Society of

Actuaries (SOA) also decreased the mortality rates of all ages in the latest 2008 Valuation Basic

Table. Yet, the estimates among insurance agencies seemingly do not catch up with the actual

2004 2005 2006 2007 2008

Lapse rate 5.40% 4.90% 4.90% 5.10% 6.10%

by amount 5.90% 5.60% 5.80% 5.50% 6.80%

Surrender rate 1.60% 1.70% 1.40% 1.30% 1.50%

by amount 1.10% 1.30% 1.10% 1.10% 1.10%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

Surrender/ Lapse rate by face & amount



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figure. This misestimate can cause unreasonably high premiums for life policies and boost up the

development of life settlements. But life extension is not always a good signal for life settlers –

longer life expectancy often erodes the profitability of life insurance transactions, as we

mentioned earlier.

How fast is this secondary market growing? In October 2008, Conning Research estimated that

life settlement transactions totaled up to approximately $12 billion in face value during 2007,

from $6.1 billion in 2006. During the meltdown over the last two years, this market did not

shrink like other parts of the financial system. Dramatically, during the time of credit crunch and

tightened budget, selling the life insurance policy would be a perfect solution for extra cash.

Conning estimated that the size of the market will approach $21 billion by 2012 and in 2017 this

figure will fly to $177 billion, whereas fFCW sees even more in long term due to the new wave of

baby boom. Still, the secondary market is very small comparing to the primary market –

according American Council of Life Insurers (ACLI)’s Fact Book 2009, major insurers hold over 10

trillion dollars insurance assets, while fFCW estimates that the size of the entire U.S life

insurance market exceeds $ 15 trillion.

Overall, the prospect of life settlement is fairly positive. And the high growth rate of this market

brightens the possibility of securitization of life settlements.



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A Critical Analysis on LSBS

Definition of LSBS Sometimes called longevity derivatives, mortality bonds, or death bonds, life settlement-backed

securities (LSBS) are asset-backed securities (ABS) which are collateralized by life insurance

policies, linked to this fast-growing life settlement business. Before analyzing the securitization,

we want to discuss more about its framework.

The Framework of LSBS Exhibit 2: The Flow Chart of Life Settlement-backed Securitization

The securitization of Life settlements involves a collection of life insurances purchased from

senior policyholders. The originator pools policies and securitizes the cash flows of the death

benefits and premiums of policyholders, the insured. Then the originator will sells the securities

to asset management firms and hedge funds. During this process, the originators will ask

evaluation agencies to evaluate each policy and perhaps the medical records of the former

policyholders. Larger-sized securities might be structured by investment banks. In order to



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DEATHS

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receive the death benefits paid by insurance companies, the holder of the security must

guarantee the associated premiums until the death of the insured.

Possibility of Securitization of Life Settlements To analyze the possibility, we should first know about the features and risks of LSBS.

The biggest risk of life settlement and the securitization is, apparently, the unpredictability of

the time of deaths. It is not like mortgage or other assets which have detailed records to analyze.

Betting against life insurances is by all means betting against deaths, which is not very tasteful.

Even though we might be able to analyze the insured individual’s health conditions, it is

impossible to estimate when the insured will die, especially specified to a certain day. But

securitization combines several hundreds to thousands of policies purchased from people with

different health conditions, ages, and other factors. And if we look into this we could find that

the deaths over time are nearly normally distributed, enabling us to analyze quantitatively:

Exhibit 3: Expected Annual Mortalities (Male at age of 50, totally 1,000 people)

We use the mortality rate in SOA’s 2008 Valuation Basic Table (SOA 2008 VBT) and adjusted the

table according to the data from U.S. National Center for Health Statistics and our own estimate.

The reality here is, again, American elderlies live a lot longer than SOA and insurers assume, and

the premium rate is unreasonably high. In other words, the market of life insurances is not

efficient, where information and reality could not instantly affect the value and price of assets in

this market. This situation enables investors to engage arbitrage in a pool of almost-30-trillion-

dollar assets. As life settlement business booms, the securitization of insurance policies could be

favored by alternative investors.



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Backed by life insurance policies, the securitization is by all means also collateralized by the

insurer’s ability to pay back. While major insurers usually do not have problem paying excessive

death benefits (life settlements can actually cut surrender values for insurers, which is five times

more than benefit expenses every year), small insurance firms would face this awkward

situation. If the securitization grows to a considerable size, it would definitely change the profit

curve of life insurance industry. Thus, LSBS has insurer default risks.

Another risk would be regulatory risk. The regulation on life settlement is on state-basis. As of

January 2009, 42 states have regulations over life settlements. Usually these regulations require

life settlement brokers to obtain the license to engage in this business, with a concern of the

controversy of life settlements and the securitization. SEC starts to notice this fast-growing

market now and a national regulation on life settlement is likely to be advanced soon. Over-

regulation and the absence of government support would definitely slow down its development.

Other risks and dangers include the unsavory business – stranger-oriented life insurance (STOLI),

morality, ethnics, and reputation risks.

As the market is growing really fast, securitization experts will keep focusing on the highly

controversial but lucrative asset class. After all, the future of life settlement-backed securities

finally depends on the consensus within the investment community.

Comparison with Mortgage-backed Securities To further understand the distinct features of LSBS, we find it useful to compare it with MBS.

The majority of mortgage-backed securities are issued by U.S. Government and government-

sponsored enterprises (GSE), including Ginnie Mae, Fannie Mae, and Freddie Mac. The sellers

are major banks that issue mortgages. After September 2008, Fannie Mae and Freddie Mac are

all controlled by the government. Along with Ginnie, the three GSEs and their bonds are now

explicitly guaranteed by the U.S. Government. While there are $14 trillion mortgage debts all

over the country, the size of mortgage-related securities is over $8.9 trillion. These mortgage-

backed securities are collateralized by the mortgages and the borrowers’ monthly payments,

generating monthly interest rate cash flow.

However, as we introduced, most life insurance policies are settled by private entities, so are

the securities backed by the policies. The total value of life insurance policies is similar to that of

mortgage debts, but the size of life settlement-backed securities is only $12 billion. The sellers

are senior individuals who want to sell their policies for cash. These securities are not

guaranteed by U.S. Government, however, collateralized by the insurers’ abilities to pay death

benefits. One significant feature of LSBS is that these securities do not generate periodical

interests, but the bond holder must pay yearly premiums. Security holders, however, can collect

death benefits after the deaths of insured people.

Generally, LSBS is much safer than MBS. But it is so much different from the more popular MBS

so whether it will be accepted by investors or not is still a question.



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Valuation of Life Settlement-backed Securities Although we have not come up with a detailed valuation model for LSBS, we do want to

introduce the idea of the valuation of LSBS.

Suppose a pool of life settlements to be securitized initially has settlers. Equation (1)

describes the settlers left in the pool over time by deducting the sum of deaths over time t.

∑ (1)

As showed in Exhibit 2, the cash flow of the securitization consists of the premiums of all settlers

left in the pool and the one-time benefits of all deaths. We could look into the cash flow from

individual policies. Assume the premium rate is P, and the benefit would be B. And for simplicity

we assume that B and P are equal for each settler over time. Then,

……

(2)

Then the value of the securitization, V, would be the sum of all cash flow generated, discounted

by risk-free rate, . Then, Equation (3) then gives the most basic valuation model for life

settlement-backed securities.

∑ ⁄

(3)



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Conclusion: The Future of Life Settlement-backed Securitization The future of the security is based on the future of life settlement market. With a new wave of

baby boom, life insurance, one of the most fundamental investment tools will definitely see a

huge boom in future not far from us. Meanwhile, the average age of U.S. citizens is becoming

older and older – last generation of baby boom is going into their twilight years. In addition, the

life expectancy of American people is increasing in the same rate with the average rate, beyond

consensus of insurer community, making the premium rates unreasonably high. With all these

factors, life insurance policies can be a burden when people become old. Life settlement, as a

legacy of viatical settlement in 70’s, becomes a considerable option for these elderlies.

While securitization of life settlements has nothing to do with these insured, it is a financing

approach for companies investing in life settlements. Securitized pool of policies gives these

investors opportunities to reallocate the life settlements and the life extension risks behind

them, just like mortgage-backed securities. However, different from MBS, LSBS is backed by the

life insurance market, which is much more stable less influenced than most other markets, for

example, mortgage, which is greatly affected by the situation of economy.

We believe that the biggest challenge for the securitization of life settlements is not life

extension risk. However, this emerging market faces two major problems:

1. The obstinate resistances from insurance giants like MetLife, New York Life, ING, etc.

They claim that life settlement would erode their profitability. In our opinion, life

settlements, if appropriately utilized, can actually benefit major insurers. First, the

amount of surrender value paid to policyholders is almost 5 times that of the benefits

paid to beneficiaries. Life settlements can decrease this expenditure, and investors are

more interested in trading securities than holding it and waiting for the death benefit.

Second, AIG owns a huge amount of life settlements in order to hedge its portfolio of

policies. Life settlement could be beneficial to insurers in some ways;

2. Trading life insurance policies, fundamentally, is betting on early deaths. This does not

sound very tasteful but this is the truth. Whether life settlements and the securitization

will be accepted by most security specialists is questionable. More terribly, if not well-

supervised, unsavory actions like STOLI will happen which is detrimental to the life

settlement market, the investors and the whole financial industry, destroying the

reputation of Wall Street.

But overall, life settlement-backed securitization has a lot to be expected. Today, if only ten

percent of the surrendered policies are instead settled, there would be almost $100 billion flow

into the market of life settlement. We are going to keep track of this upbeat market and conduct

more in-depth research on it.



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References

Stone, Charles A., Anne Zissu. “Securitization of Senior Life Settlements: Capturing Value from

Early Death”. The Journal of Derivatives. Vol. 13, No. 3: pp. 66-72. New York: Institutional

Investor Journals. Spring 2006.

DBRS, Inc. “Selected Commentaries: Life Settlement ABS Developments”. New York: DBRS, Inc.

June 2008.

Bhuyan, Vishaal B. Life Markets: Trading Mortality and Longevity Risk with Life Settlements and

Linked Securities. Hoboken: John & Wiley Sons, Inc., 2009.

American Council of Life Insurers (ACLI). Research Report: ACLI Life Insurers Fact Book 2009.

Washington D.C.: American Council of Life Insurers, 2009.

Fasano, Michael. “Securitization of Life Settlement Cash Flows” Washington D.C.: Fasano

Associates. October 31, 2008.

Xu, Jiaquan, Kenneth D. Kochanek, Sherry L. Murphy, Betzaida Tejada-Vera. “Deaths: Final Data

for 2007”. National Vital Statistics Reports. Vol. 58, No. 19. Atlanta: National Center for Health

Statistics. May 20, 2010.

Society of Actuaries (SOA). 2008 Valuation Basic Table. Schaumburg: Society of Actuaries.

Revised, June 16, 2009.

The Securities Industry and Financial Markets Association (SIFMA). “US Bond Market

Outstanding (2010 Q2)” New York: SIFMA. October 15, 2010.

PIMCO. “Bond Basics: Mortgage-Backed Securities” Newport Beach: PIMCO. February 2009.

life settlement-backed securities

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