Are Life Settlement Securitizations the New Trend?

OCTOBER 2009

INVESTING IN DEATH: ARE LIFE SETTLEMENT SECURITIZATIONS THE NEW TREND?

By John P. Cleary, Esq. plummet because the risk was Procopio, Cory, Hargreaves & Savitch diversified. Of course, sponsors of these LLP securities did not account for a nationwide meltdown in housing prices Although Wall Street is still littered with and tightening of credit for even the the aftermath of the mortgage disaster, most qualified borrowers needing to investment bankers already anticipate a refinance. When that happened, return to the heady days of hefty fees investors lost hundreds of billions of through securitization and trading of a dollars. new asset class – life settlements. To be Whether securitized life settlement sure, these investments are a bit contracts will take off may depend on macabre because a favorable return on how credit rating agencies measure the investment is dependent upon the level of risk. As with any securitized untimely death of another human being. bond, a credit agency must rate the However, they are legal and their bond. The less predictable the outcome popularity is on the rise. Investment JOHN P. CLEARY of the investment, the tougher it is to advisors and broker‐dealers have rate. Investment banks structuring noticed increased interest in life these pools of risk and credit agencies settlement investments and large rating them will need to get a comfort investment banks have begun the expectancy, the investor may receive a higher return. If the insured lives longer level on issues such as the average process of creating life settlement‐based human lifespan, factors contributing to derivative securities. than expected, the return will be lower. In sum, the purchaser is hoping and remission from disease, treatment WHAT IS A LIFE SETTLEMENT? banking on the insured's early demise. methodologies and drugs in the pipeline. To address this, life settlement Life settlements grew out of the viatical A RETURN TO THE GOOD OLD DAYS bonds likely will have policies from a industry that became popular in the Recently, the New York Times reported broad range of people with different 1980’s with many AIDS patients. A life diseases and varying ages. A life settlement is a secondary market there is now a strong demand for life settlement investments. Investment settlement bond with a mix of leukemia transaction on an insurance policy sufferers, those with heart disease and whereby an insured sells his insurance banks are planning to securitize life settlements in the same manner they individuals over 80 years old will policy to a third party investor for a provide a safer risk than, say, a bond lump sum purchase price. The key securitized mortgages before the collapse of the residential mortgage with a majority of breast cancer issues determining market value for a patients. This is because in the event a life insurance policy are the amount of securities market. Securitization is a financing method in which typically cure for breast cancer is found, the value the death benefit, the cost of premiums of the bond would sink. and the life expectancy of the insured. illiquid financial assets are pooled together and converted into securities In the face of increased interest in For the policy owner, a life settlement that may be offered and sold in the pooling life settlements, the insurance provides an alternative source of capital markets. Same as the industry is calling for tighter controls. liquidity to simply liquidating the policy securitization of mortgages, life Insurers understandably are concerned for the present cash value. Depending settlement securities will have different with a growing market for individuals on the age and health of the insured, an tranches representing different risk obtaining life insurance for the sole investor might pay 20 to 200 percent profiles. purpose of reselling it on the secondary more than the surrender value an Investment banks that sold residential market. Historically, a significant insurer would pay. The investor is percentage of policies have lapsed for obligated to continue paying the mortgage securities managed their risk by packaging individual mortgages into nonpayment of premiums, which avoids premiums on the policy and will receive payment of the death benefit. From the the death benefit upon the death of the tranches representing loans from different areas of the country and with insurers’ perspective, a hedge fund insured. The investor’s return depends sponsoring a pool of life settlements is upon the insured’s life expectancy and different borrower credit risks. The thinking was if the value of homes unlikely to let policies lapse, which will the actual date of death. If the insured lead to large payouts by insurers that dies before the estimated life declined in one area of the country, it would not cause the portfolio to might otherwise have been avoided.

LEGAL ISSUES WITH LIFE SETTLEMENTS However, the test failed on the third appropriately licensed to offer and sell element from W.J. Howey, that the securities. Last month, the Securities and Exchange investment be reliant on the “efforts of Commission (SEC) established a Life In connection with the solicitation of others.” The court found that the Settlements Task Force to examine policyholders to purchase their policies, investment did not involve a security emerging issues in the life settlements FINRA has identified certain necessary because the promoters’ efforts post‐ market. The Task Force is considering, disclosures such as unexpected tax purchase were to simply hold the policy, among other things, the application of liabilities, diminished insurable pay the premiums and wait for the the federal securities laws to life capacity, privacy issues and potentially insured to die. settlements, the issues relating to high commissions.3 FINRA is securitization of life settlements and Most courts have not followed the Life particularly concerned with brokers hedge fund offerings of life settlement‐ Partners ruling, either distinguishing the targeting policyholders who are based investments. Also, the Financial facts or explicitly rejecting the notion vulnerable to abusive sales practices, Industry Regulatory Authority (FINRA) that the post‐purchase efforts are including the elderly and seriously ill. It recently issued a Notice to Members in merely ministerial in nature. Also, in has warned brokers that their duties which it warned brokerage firms and 2004, the D.C. Circuit sided with the SEC include discussing alternatives to the fund managers of the regulatory and in shutting down a $1 billion offering by sale of their insurance policy if there is a compliance issues with life settlement a viatical settlement company, expressly need for cash, including borrowing investments. rejecting the Life Partners ruling. against the policy or invoking other contract features. Because many life Are Life Settlements Securities? In 2006, FINRA issued Notice to settlements may be securitized, brokers Members 06‐38 which stated that, at The question whether life settlement should ensure that a policyholder least for FINRA’s purposes, life investments meet the definition of a acknowledges and appreciates that their settlements involving variable insurance “security” under federal and state medical history and private health policies are securities. In July 2009, securities laws is crucial. If the information may be shared with and FINRA reiterated and expanded on this investment is a security, the person or monitored by strangers. view in Notice to Members 09‐42. entity offering an investment in a life FINRA stated that its jurisdiction Also, the benefits to an insured of selling settlement must meet the offering reaches to “a security that is an interest a life insurance policy must be weighed requirements of the Securities Act of in a single life policy, or a group or a against the transaction‐related costs of a 1933, as amended, and is liable for pool of such policies, whether variable life settlement, which are often violations of the antifraud provisions of or not.” substantial. Under NASD Rule 2440 (as the Securities Exchange Act of 1934, as adopted by FINRA), a firm is prohibited amended. In addition, those Accordingly, it will be safer to assume from charging a customer more than a participating in the marketing and that federal and state securities laws do fair and reasonable commission in any selling of life settlement investments apply to the purchase and sale of securities transaction. In addition, would be bound by the broker‐dealer interests in life settlements. Whether under FINRA Rule 2010, a firm that registration requirements under state the transaction involves an interest in charges an unfair commission violates and federal law. Finally, hedge fund one policy or the sale interests in a pool the firm’s obligation to observe just and operators and investment advisers of life settlements, investment equitable principles of trade in the dealing in life settlements would be professionals must be aware of and conduct of the firm’s business. bound to comply with the expensive and advised on applicable securities laws as Similarly, any fees a firm charges a time consuming requirements of the they relate to the structuring, customer must be reasonable. Investment Advisers Act of 1940 and the marketing, offering and sale of these Investment Company Act of 1940. investments. As part of a firm’s suitability determination under NASD Rule 2310 As yet, the courts have not reached a Solicitation of Insureds for Life (as adopted by FINRA), the firm should uniform answer to this question. The Settlement Transactions ensure that policyholders understand first case, SEC v. Life Partners, Inc1., For brokerage firms considering life the tax treatment of the cash payment focused on whether participation in a settlement transactions, FINRA has when paid in a life settlement as life settlement investment is an taken the position this constitutes a compared to the tax treatment of the investment contract and therefore a material change in a firm’s business death benefit to the beneficiary. The “security” subject to the federal operations under NASD Rule 1011(k). policyholder also should understand securities laws. In that case, the As a result, prior to engaging in life that the sale could affect his or her investors were buying a fractionalized settlement transactions, a firm must file eligibility for certain public assistance interest in a particular life insurance a Continuing Membership Application programs, such as Medicaid. Also, if a policy. The court held that the offering and receive approval of the change in policyholder needs or desires to obtain involved (i) an investment of money (ii) business operations under NASD Rule replacement life insurance, he or she in a common enterprise, which satisfied 1017. The SEC Task Force has also should understand the impact that the the first two elements for a security warned that it will aggressively life settlement may have on the ability under the standard set by the Supreme investigate whether firms and brokers to obtain replacement insurance. Court in SEC v. W.J. Howey Co.2 soliciting policyholders are Finally, the policyholder should fully

appreciate and acknowledge that the status as an accredited investor under appreciate the risks related to the health buyer has a financial interest in his or Regulation D. Key disclosures include, and life expectancy of the insureds. her death. but are not limited to, information Although the SEC is also considering relating the structure of the transaction, how to balance the need for full Secondary Transactions in Life the mechanics for paying premiums on disclosure with the privacy rights of the Settlement Contracts the underlying policies and the risk of individual insureds, this will require The second part of the transaction – the changes in anticipated returns if transparency as to the individual lives purchase of a fractionalized interest in a assumptions and estimates used to on which the investment is based, their life insurance policy or a pool of policies value the policies prove to be health conditions, lifestyles and – is the focus of the SEC’s Life inaccurate. Because there are multiple prognoses. Settlements Task Force. The SEC’s parties involved in an investment

concern is that investors in securitized backed by life settlements (including the life settlements may not fully insured, the insurance company and the understand the complexities of the issuer of the securities), each of whom investment or appreciate the risks can adversely affect the value of the Mr. Cleary is an attorney with Procopio, involved. securities, disclosures must take into Cory, Hargreaves & Savitch LLP. consideration each of the principal Reach him at 619.515.3221 or As with any complex financial parties and their related risks. instrument, fund sponsors should [email protected]. provide full disclosure regardless of the Of particular importance is to ensure sophistication of the investor or her that investors understand and

1 87 F.3d 536 (D.C. Cir. 1996). 2 328 U.S. 293, 29899 (1946). 3 Notice to Members 0942.