Senior Life Settlements: A Cautionary Tale

n recent years, firms, the investor is betting on mortality by brokers and financial advisors taking a financial interest in another Ihave stepped up efforts to interest person’s demise. As morbid as this may consumers and investors in a unique sound, life settlements are a growing market segment - Senior Life Settle- market and have garnered considerable ments (SLS), which when packaged interest on Wall Street. into securities are sometimes known This article provides an overview of as “death bonds.” As outlined in this the development of the SLS market article, while these products may offer and discusses the risks associated brokers and other middlemen the with these transactions to financial opportunity for high commissions, institutions, investors, and consum- they carry significant risks to consum- ers, including the potential for fraud. ers and investors. Bankers should be In addition, a case study highlights an aware of the substantial risks associ- example where an FDIC insured insti- ated with any involvement with these tution’s involvement in SLS transac- products, and that absent specific tions contributed to its failure. authorization from their primary federal regulator any investment in them would be impermissible. Development of the SLS An SLS is a transaction in which Market an individual, generally between 65 In 1911, the United States Supreme and 79 years of age (Senior), sells Court case of Grigsby v. Russell1 estab- his or her life insurance policy to a lished that it was a policy owner’s right third-party investor, usually through to transfer an insurance policy, thus a broker, for an amount less than opening the door to life settlements. the policy’s face value, but greater Transfers of insurance policies grew than the net cash surrender value. significantly during the 1980s, when The investor becomes responsible for AIDS patients and other terminally paying the future premiums and, upon ill policyholders sold their life insur- the death of the Senior, receives the ance policies to obtain cash to offset policy’s death benefits. mounting medical bills and improve An SLS may appeal to a consumer the quality of life in their final days. who can no longer afford the premiums These transactions were known as or is strapped for cash. For an inves- viatical settlements, from the Latin tor, the potential profit depends on word viaticum or “provisions for a the purchase price and the amount journey.” However, over time, viaticals of future premiums paid to keep the became less profitable due to medical policy in force. If the death benefit advances that extended the life expec- exceeds the sum of the purchase price tancy of AIDS patients. In addition, plus the aggregate future premiums allegations of fraud relating to the sale and any other fees (all appropriately and marketing of these products were adjusted for the time value of money), widespread. Life settlement providers the investor will profit; if not, the then turned to a new group of policy- investor will suffer a loss. Essentially, holders – Seniors.

1 Grigsby v. Russell, 222 U.S. 149 at 156 (1911).

25 Supervisory Insights Winter 2010 Senior Life Settlements continued from pg. 25

As shown in Chart 1, the estimated the valuation of existing portfolios annual volume of life settlement trans- and further reducing investor interest. actions (policies changing hands) in However, life settlement providers and the United States rose from $2 billion trade groups predict a return of capital in 2002 to almost $12 billion in 2008, to the SLS market in 2010, although bringing the total outstanding to $31 investment banks may be playing a billion at the end of that year.2 The smaller role.3 According to a National rate of growth leveled in 2007, as Underwriter article, more regulatory the recession constrained cash avail- scrutiny, heightened consumer aware- able to fund policy purchases. Also, ness, and a return of buyers to the the major life expectancy underwrit- market are likely developments for the ers revised their methodologies and settlement business in 2010.4 assumptions, which resulted in longer As an investment tool, securitized life expectancies, casting doubt on SLS are touted as offering an attrac- tive investment feature: they are Chart 1: Annual Volume of Life Settlement Transactions Grew Rapidly from 2002 to 2007 / uncorrelated assets, meaning their Declined Slightly in 2008 performance is not directly tied to Life Settlement Market Estimated Annual Transaction Volume typical market influences. After all, death rates do not rise or fall based on the market. By purchasing a 14 securitized pool, the argument goes, 12 an investor can spread the risk over a large and diversified group of SLS 10 contracts. However, critics question 8 their investment viability due to the financial risks, lack of transparency, 6 and limited number of successful transactions. Also, some industry 4 $Billions observers believe significant growth in 2 the market can only be achieved with a favorable rating from 0 2002 2003 2004 2005 2006 2007 2008 a rating agency. However, rating Years life settlement presents many challenges, and in fact very few Source: Data Estimates by Conning Research & Consulting, Inc. have been rated.5

2 Data obtained from Conning Research & Consulting, an independent insurance industry analysis firm in Hartford, Connecticut. 3 In January 2010, Goldman Sachs shut down its life settlements provider (Longmore Capital) approximately one month after discontinuing its tradable mortality index (QxX). Credit Suisse downsized its Life Finance Group in February 2010. 4 “Feature: Experts See A Happy Year for Settlements,” by Trevor Thomas, published on the National Underwriter Web site only on January 11, 2010. National Underwriter is available at http://www.lifeandhealthinsurancenews. com/Exclusives/2010/1/Pages/Feature-Experts-see-a-happy-year-for-settlements.aspx?k=Life+Settlements. The Aite Group, LLC, Boston, MA, also has forecast a rebound in the life settlement business as noted by Trevor Thomas in a January 29, 2010 National Underwriter item available at http://www.lifeandhealthinsurancenews. com/News/2010/1/Pages/Aite-Group-Life-Settlement-Business-Will-Rebound.aspx?k=Life+Settlements. 5 News and industry reports show that only one life settlement securitization has been rated in recent years. In early 2009, American International Group (AIG) securitized a pool of life settlement policies with a face value of approximately $8.4 billion; this was an internal transaction between two units of AIG. A.M. Best Company, a credit rating organization serving the financial services industries, rated the securitization but did not publicly release the rating as this was a private transaction.

26 Supervisory Insights Winter 2010 In February 2010, the American life settlement contract for two years Council of Life Insurers issued a after the issuance of a policy. As a policy statement recommending that result, the application of the Kramer the securitization of life settlements decision is limited to policies in exis- be banned, largely because securi- tence before May 18, 2010. tizations could heighten fraudulent activity associated with Stranger Orig- inated Life Insurance (STOLI). STOLI Regulation of the SLS Market is the initiation of a life insurance SLS are complex financial transac- policy for the benefit of a person who, tions that involve both insurance and at the time of the policy’s creation, securities elements, and most states has no insurable interest. have enacted regulations governing Although SLS transactions present these products through their insur- a number of legal issues, insurable ance or securities regulatory enti- interest is paramount. In its simplest ties. The National Association of terms, an insurable interest means Insurance Commissioners developed that anyone who takes out a policy a model uniform law that has been must have an interest in the insured adopted in one form or another by 7 person staying alive (rather than at least 44 states. The law addresses hoping to cash in on the insured’s licensing requirements, requires death). The principle of insurable annual reporting, sets standards for a interest is a matter of state law. A reasonable return to the person sell- high-profile case in New York federal ing an insurance policy, and prohibits court frames the question as follows: certain practices such as paying find- Does state law prohibit an insured ers fees to an insured’s physician. from procuring a policy on his own However, although it provides sample life and immediately transferring the informational brochures for consum- policy to a person without an insur- ers and investors, the model regula- able interest, if the insured never tion does not prescribe their use. The intended to provide insurance for a Life Insurance Settlement Associa- person with an insurable interest? tion (LISA) provides an overview of On November 17, 2010, in a 5-2 deci- state laws on its Web site at sion, the court ruled that nothing in www.thevoiceoftheindustry.com. state law prevented such a practice Some SLS transactions fall under at the time the policies were sold.6 It the purview of federal securities laws is important to note that this deci- enforced by the U.S. Securities and sion applies only in New York and, Exchange Commission (SEC). If the effective May 18, 2010, New York life insurance policy being sold is changed its insurance laws regulating a (typically, a variable life permissible life settlement contracts insurance policy) or if the policy to prohibit STOLI. The new laws will be securitized, the SEC has also prohibit, with certain excep- jurisdiction. In July 2009, the Finan- tions, anyone from entering into a cial Industry Regulatory Authority,

6 Kramer v. Lockwood Pension Services, Inc, et al., 653 F.Supp2d 354, S.D.N.Y. September 1, 2009. (Question certi- fied to the New York Court of Appeals by the U. S. Court of Appeals for the Second Circuit, January 21, 2010.) The New York Court of Appeals heard oral arguments in the case on October 12, 2010. 7 Viatical Settlements Model Act and Viatical Settlements Model Regulation. Copies of the model laws are avail- able from National Association of Insurance Commissioners: http://www.naic.org/store_pub_legal.htm#model_ laws. A copy of the Viatical Settlements Model Regulation is available on the LISA Web site.

27 Supervisory Insights Winter 2010 Senior Life Settlements continued from pg. 27

Inc. (FINRA)8 published Regulatory Notice 09-42 reminding investment Risks to Investors firms that variable life settlements SLS transactions, when considered are securities transactions subject to purely as investments, present a federal securities laws and all applica- number of financial risks that must 9 ble FINRA rules. However, whether be understood by investors and other SLS transactions fall under consumers considering selling their federal securities laws is unclear, policies (see Table 1). and the courts have not reached a uniform answer. Special Risks to Financial Growth in the life settlement market and the potential dangers Institutions posed to consumers has resulted in A number of financial institutions additional regulatory and legislative report receiving applications scrutiny. In 2009, the life settlement from investors wanting to finance market was the subject of congressio- SLS transactions. Bankers also have nal hearings and an investigation by reported a few instances where they the U.S. Senate Special Committee have been approached with proposals on Aging.10 In addition, a Life Settle- to either hold SLS directly as securi- ment Task Force was established by ties or as part of a “troubled the SEC in September 2009 to under- for securitized SLS ” transac- stand the range of issues presented tion. Investments in SLS are specu- by the life settlements market and lative and have not been approved to partner with other regulators to as permissible by either the Federal ensure the existence of adequate Deposit Insurance Corporation or regulatory oversight and identify the Office of the Comptroller of the potential regulatory gaps.11 Currency. Any bank considering such an investment must apply for permis- sion prior to doing so12 and should expect significant questions about whether the risks could be suffi- ciently mitigated to granting such permission.

8 The FINRA, formed in 2007 as successor to the National Association of Securities Dealers, is the largest inde- pendent regulator for securities firms doing business in the United States. 9 The FINRA’s Regulatory Notice 09-42 is available at www.finra.org/Industry/Regulation/Notices/2009/P119547. 10 In April 2009, the U.S. Senate Special Committee on Aging held a hearing entitled, “Betting on Death in the Life Settlement Market – What’s at Stake for Seniors?” Details of this hearing can be found at www.aging.senate.gov/ hearing_detail.cfm?id=312228&, and details of the related Committee investigation are available at www.aging. senate.gov/letters/lifesettlementfindings.pdf. In September 2009, the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a hearing entitled, “Recent Innovations in Securitization.” Details of this hearing are available at www.house.gov/apps/list/hearing/financialsvcs_dem/ cmhr_092409.shtml. 11 The Life Settlement Task Force is discussed in SEC Chairman Mary L. Schapiro’s address before the Solutions Forum on Fraud, October 22, 2009, at http://www.sec.gov/news/speech/2009/spch102209mls.htm. 12 See Section 24 of the Federal Deposit Insurance Act; 12 C.F.R. Part 362 (Activities of Insured State Banks and Insured Savings Associations); 12 C.F.R. Part 1 (Investment Securities).

28 Supervisory Insights Winter 2010 Table 1 Risks to Investors in SLS Transactions Longevity Risk – The risk that the insured’s actual life span exceeds the projected life span. Longevity risk is affected by medical advances in the treatment of serious illnesses. The longer the life of the insured individual, the lower the investor’s return. Legal Risk – SLS transactions often involve complex legal structures and incorporate numerous documents that impact the legal validity of the underlying assets and appropriate conveyance of the death benefit to an investor. These structures also may require appropriate perfection of security interests in several state jurisdictions. Contestability Risk – The risk associated with the issuing insurance company’s right to rescind a policy within the two-year contestability period. Rescission Risk – This risk relates to the doctrine of insurable interest. An insurance company may rescind a policy when it suspects a lack of insurable interest. Funding Risk – The risk that the investor may have insufficient funding capacity to pay future premi- ums and other holding costs. Liquidity Risk – The lack of transparency in the SLS market creates difficulty in determining the fair value of a life settlement asset. The uncertainty in the market may hamper the ability of an investor to dispose of the investment at a reasonable price, if needed. Litigation Risk – The risk that the insured’s family members (heirs) or previous beneficiaries will file legal action and the potential financial impact to the investor. Regulatory Risk – The risk that new limitations or restrictions will be placed on SLS transactions, negatively impacting their value or marketability.

A financial institution that acts as an risk, which stems from a broker or investment advisor, whether through a settlement provider engaging in inap- networking arrangement, trust depart- propriate sales practices, and compli- ment or as a registered advisor,13 ance risk associated with consumer and recommends a SLS or any other protection regulations, such as Privacy financial product that performs below of Consumer Financial Information14 customer expectation or has an undis- and The Health Insurance Portabil- closed risk could create customer ity and Accountability Act of 1996 dissatisfaction or harm and potentially (HIPAA) Privacy and Security Rules.15 damage the reputation of the institu- The case study Bank Financing tion. In our judgment, the reputational of SLS Investments that concludes risks associated with this product are this article demonstrates the grav- unquantifiable but severe. Bankers ity of risks faced by institutions that should also be cognizant of third-party become involved in SLS transactions.

13 See Final Regulation R: Exceptions and Exemptions for Banks from the Definition of “Broker” (FIL-92-2007, Oct. 25, 2007), http://www.fdic.gov/news/news/financial/2007/fil07092.html and Securities Activities of Banks: Excep- tions and Exemptions for Banks from the Definition of “Broker” (FIL-89-2008, Sept. 10, 2008), http://www.fdic.gov/ news/news/financial/2008/fil08089.html 14 12 C.F.R. Part 332. 15 See U.S. Department of Health and Human Services Summary of the HIPAA Privacy Rule: http://www.hhs.gov/ ocr/privacy/hipaa/understanding/summary/index.html; see also FDIC Compliance Manual, VIII-6.8 – 6.11 (Fair Credit Reporting Act Examination Procedures, Section 604(g) Protection of Medical Information).

29 Supervisory Insights Winter 2010 Senior Life Settlements continued from pg. 29

consumer should ask when deciding to Risks to Consumers sell a life insurance policy, including: Financial institutions should be alert „„ Is the life settlement broker or to the aggressive marketing tactics provider licensed? A growing of some life settlement providers number of states require that life and brokers. As more life settlement settlement companies and brokers providers enter the market, competi- be licensed.18 tion to find policyholders increases. As incentive, commissions paid in „„ Is there pressure to make a quick connection with life settlements can decision? A legitimate invest- be quite high (up to 30 percent of ment professional will provide clear the purchase price). This incentive answers and allow ample time to has prompted some life settlement make an informed decision. providers to aggressively encourage „„ What are the transaction costs? financial service providers to canvass What is a fair and competitive their books of business for Seniors or sales price? There is no trans- other eligible customers who may be parent secondary market for life interested in selling their life insur- insurance policies, so it is difficult ance policies in the secondary market, to determine if a fair price is being regardless of whether they need to offered. Consumers should ensure sell or have previously considered bids are obtained from several SLS surrendering or allowing the policy to providers. lapse. Accordingly, in its August 2006 Notice to Members,16 the National „„ How will personal information Association of Securities Dealers be protected? When a life insur- (NASD) noted its concern that aggres- ance policy is sold, the insured is sive marketing tactics, fueled by high required to authorize the release of commissions, may lead to inappropri- medical and other personal informa- ate sales practices in connection with tion. The consumer should ensure these transactions. procedures are in place to protect the confidentiality of the data. Against this backdrop, financial advisors should encourage consum- „„ What is the impact on your survi- ers to carefully consider their ongoing vors? Carefully consider the need life insurance needs before entering for current income against the into SLS transactions, as their policy financial needs of survivors now and remains in force and may affect their in the future. Legitimate life settle- ability to obtain additional life insur- ment brokers/providers will require ance. The FINRA has issued an inves- the beneficiary to acknowledge and 19 tor alert17 that identifies questions a consent to the transaction.

16 The NASD August 2006 Notice to Members is available at www.finra.org/web/groups/industry/@ip/@reg/@ notice/documents/notices/p017131.pdf. 17 The FINRA investor alert is available at www.finra.org/Investors/ProtectYourself/InvestorAlerts/AnnuitiesAndIn- surance/P018469. 18 The National Association of Insurance Commissioners Web site at http://www.naic.org/state_web_map.htm contains information for consumers and investors by state, including licensing information. 19 As a general rule, in the absence of a court order (usually arising out of a divorce proceeding), there is no legal right to be named as a beneficiary in a life insurance policy or trust. Some State laws allow former beneficiaries or heirs to challenge the validity of the sale of a policy following an insured’s death, based on a variety of factors including lack of insurable interest, mental capacity of the insured, and applicable periods of contestability.

30 Supervisory Insights Winter 2010 „„ What are the tax consequences? strongly opposes STOLI, arguing it is Before entering into a life settle- fraud for a person to buy a policy with ment, a tax professional should be only a profit - and not insurance - consulted. motive. STOLI is prohibited or statuto- rily restricted in many states. Finally, given the risks involved, consumers should seek legal advice The Case Study discussed below before signing any agreements to demonstrates the negative impact that ensure a SLS transaction is in their the legal and other risks discussed best interest. above can have on a financial institution. The Potential for Fraud in SLS Transactions Bank Financing of SLS Investments - A Case Study The North American Securities Administrators Association (NASAA), This case study is based on actual which represents state securities events and involves a failed bank regulators, previously listed life settle- that granted loans secured by SLS ments among the top 10 investor contracts.22 Although SLS were not traps.20 The NASAA specifically iden- the sole cause of the institution’s fail- tifies Ponzi schemes, fraudulent life ure, this case study underscores the expectancy evaluations, inadequate significant risks associated with these premium reserves that increase inves- investments. tor costs, and false promises of large Big Venture Bank (Bank) was a profits with minimal risk. Other types $100 million rural community bank. of fraud identified in the SLS industry Bank officers and directors expanded are clean-sheeting (applying for a life the institution’s business strategy insurance policy without disclosing a to include a venture capital compo- life-threatening illness) and dirty-sheet- nent. Management converted its ing (when a healthy person provides parent company to a financial hold- false medical information indicating he ing company and established several or she has a life threatening illness). In subsidiaries to engage in venture capi- addition, in the case of wet-ink poli- tal financing activities. cies (new life insurance policies sold immediately after being issued – before One target investment was a local the ink is dry), the applicant commits manufacturing company, Big Moun- fraud on the application by claim- tain Manufacturing (Big Mountain). ing he or she needs life insurance for Big Mountain appeared to have a good estate planning purposes. One type of product; however, it did not have wet ink policy is STOLI.21 STOLI has funds to commence production, and many variations but only one purpose: the Bank previously had granted a to allow an investor without an insur- loan to the company in an amount able interest to initiate and profit from close to its legal lending limit. As a life insurance policy on a stranger. concern mounted over Big Mountain’s The mainstream insurance industry economic survival and the repayment

20 NASAA’s top 10 investor traps for 2009 are discussed on its Web site at http://www.nasaa.org/NASAA_News- room/Current_NASAA_Headlines/11129.cfm. 21 Also known as Speculator-Initiated Life Insurance (SPINLIFE). 22 All names in this case study have been changed.

31 Supervisory Insights Winter 2010 Senior Life Settlements continued from pg. 31

of its significant debt to the Bank, transferred from the family member Bank management began searching to the LLC. Each original trustee was for funding alternatives. They chose then replaced by a common trustee Senior Life Settlements. engaged by the Bank. This structure was used in an attempt to preserve The Bank’s plan was two-fold. As a insurable interest and facilitate the -term solution, the Bank would transfer of interest to an investor. Each extend a credit facility (aggregating 125 LLC granted the borrower an irrevo- percent of the Bank’s capital) secured cable security interest in all its assets by SLS contracts to five of Big Moun- (i.e., the beneficial interest in each tain’s directors at $3 million each. trust), which the borrower pledged to Twenty percent of the loan proceeds the Bank as collateral. (aggregating $3 million) were provided to the borrower group to inject into The five LLCs purchased 35 trusts Big Mountain. As a long-term solution, (and 35 policies) with an aggregate Bank management, with the aid of death benefit of $32 million. The Wall Street investment advisors, would policies were issued by 17 insur- underwrite and issue a $600 million ance companies to seniors residing SLS securitization transaction (consist- in 12 states. The LLCs, in an attempt ing of 500 policies with an aggregated to shelter their risks, subscribed to death benefit of $1.6 billion, includ- a master agreement which served ing the underlying policies associated as a profit-sharing mechanism. In with the Bank’s SLS loans). Once the the event any of the LLCs received deal closed, $15 million of the sales death benefits on policies in a greater proceeds from the securitization (part proportion than other LLCs, the of the securitization’s venture capital contracts would be shifted among the component) would be provided to Big LLCs to level the playing field. Mountain for operating capital and debt The proceeds of the Bank’s loans restructure, including the Bank’s direct were used to purchase the underly- loan. The plan was designed to make ing insurance policies, pay fees, inject the Bank whole on its loans, recognize capital into Big Mountain, and estab- large fee income from the securitiza- lish a three-year reserve for interest tion process, and sufficiently capitalize payments, fees, and future insurance the local manufacturing company. premiums. Table 2 summarizes the The structure of the credit facil- use of proceeds, including the sizable ity was a Series Limited Liability unfunded commitment. The loans Company (LLC) arrangement whereby were set up with seven-year maturi- a separate LLC was established for ties, with quarterly interest payments each of the five borrowers. Each LLC during the first three years followed owned seven trusts, and each trust by quarterly principal and interest owned one universal life insurance payments until maturity. policy on a senior individual. The In SLS transactions, active adminis- owner and beneficiary of the underly- tration of the collateral and continued ing policy was the trust. The original payment of policy premiums is critical beneficiary of each trust was the and requires a number of administra- insured’s family member. After the tive services.23 In this instance, these interest was purchased by the investor, services were provided by a Bank affil- the beneficial interest in each trust was iate (Service Company) for an initial

23 These administrative services include a tracking agent, collections manager, policy custodian, premium and claims administrator, and accounting services.

32 Supervisory Insights Winter 2010 Table 2 Big Venture Bank – SLS Loan Proceeds Percent of Purpose Amount Total Funded Portion Purchase Beneficial Interest of Trusts (Cost of Policies) $3,000,000 20.0 Fees Associated with the Purchase 60,000 0.4 Up Front Fees to Service Company under Servicing Agreement 625,000 4.2 Advance to Pay Current Premiums Due on Policies 325,000 2.1 Venture Capital Component for Investment in Big Mountain 3,000,000 20.0 Total Funded Portion $7,010,000 46.7 Unfunded Commitment Future Premium Payments on Underlying Policies (3 year reserve) $5,415,000 36.1 Interest Reserve on Credit Facility (3 year reserve) 2,025,000 13.5 Fees to Service Company under Servicing Agreement (3 year 550,000 3.7 reserve) Total Unfunded Portion $7,990,000 53.3 Total Credit Facility $15,000,000 100

up front fee and quarterly servicing independent legal opinions related fees, all of which were to be funded by to the structure of these transac- the loan proceeds. tions, perfection of the Bank’s collateral position in the various Loan Underwriting Deficiencies state jurisdictions, the contestability risk associated with the underlying The Bank’s SLS credit facility was policies (each policy was within the selected for review by FDIC examiners two-year contestability period), or due to its size and the unique char- the rescission risk related to insur- acteristics of the loan structure and able interest. Refer to Table 1 for underlying collateral. Examiners criti- information regarding these risks. cized Bank management for failing to perform the pre-funding due diligence „„ Unpredictable Cash Flow - necessary to understand the significant Cash flow in SLS transactions risks inherent in these transactions. depends on the amount of the The following loan underwriting defi- policy’s death benefits and can be ciencies were identified, all of which impacted by various risks, includ- impacted credit quality: ing longevity risk (the risk the insured individual will outlive „„ Inadequate Due Diligence of the life expectancy in the actu- Legal Issues - Management did arial model). Management did not not confirm that all transactions consider whether the 35 insured complied with state and federal individuals comprised a sufficiently regulations. Several critical docu- large pool to correlate with the ments tracing the transactions from actuarial tables and assumptions inception were missing or unavail- used in its actuarial model. able. Management did not obtain

33 Supervisory Insights Winter 2010 Senior Life Settlements continued from pg. 33

„„ Lack of Independent Mortality of the seniors with little consider- Analysis - Management did not ation given to the borrowers’ finan- perform a loan-level analysis that cial strength or cash flow, which considered the specific character- was nominal. The borrowers did not istics of each underlying policy, establish cash reserves to fund the including age of the insured, cost of holding the investment, and medical history, and condition. A no additional collateral was pledged. mortality profile that included a „„ Liquidity Risk - Management did summary of the pertinent medical not adequately analyze the avail- conditions and a determination of ability of a secondary market before life expectancy should have been engaging in these transactions. The conducted by a medical under- SLS market is still emerging, with a writer. The analysis also should limited secondary market (especially have included assumptions for for contestable contracts) and a lack medical advances that could impact of transparency, which posed signifi- mortality rates. Moreover, cash flow cant liquidity risk for the institution should have been stressed under and the borrowers should they want a number of reasonable mortality to dispose of the collateral. The scenarios to analyze longevity risk. lack of transparency in the pric- „„ Funding Risk – The carrying costs ing of life settlements and the fees (interest, premiums, and fees) asso- earned by intermediaries, coupled ciated with this structure is signifi- with the lack of standardization of cant. If cash flow was impacted the general methods for predict- by longevity risk, carrying costs ing life expectancies, contribute to would have significantly increased. capital markets uncertainties rela- Further, many of the underlying tive to the value of life settlement policies had premium structures transactions. Bank management that escalated as the insured aged. should have engaged independent, The unfunded portion of the credit licensed life settlement providers facility was sufficient to accommo- to determine an estimated market date the projected carrying cost for value based on the specific charac- only three years. teristics of the individual transac- tion. Management also should have „„ Borrowers Lacked Equity and ascertained the financial strength of Financial Capacity - Each borrower each insurance company. was essentially a passive participant with no equity in the structure. „„ Unrealistic Exit Strategy - The Repayment terms were extremely Bank’s ultimate repayment source liberal, as the borrowers were not - the proposed $600 million SLS required to make any out-of-pocket securitization – never materialized. payments for three years. Inter- The unique structure of the est payments, administrative fees, caused the underwriting process and premiums were all advanced to become severely protracted and on the line of credit. Moreover, the subject to continual delays and loans were primarily funded on the legal setbacks. projected cash flow from the deaths

34 Supervisory Insights Winter 2010 Regulatory Treatment and STOLI deals, and fraud cast a dark Impact on the Bank cloud over the SLS industry. Accord- ingly, bank and securities regulators The Bank failed to obtain regulatory continue to consider the application approval before establishing its SLS of additional federal and state laws credit facility. Given the highly specu- to life settlements and market inter- lative nature of these investments, mediaries. Bankers, investors, and legal risk, unpredictable cash flow, consumers being approached with funding risk, questionable collateral proposals to enter into life settlement position, liquidity risk, and numer- transactions should exercise caution ous other unmitigated risks, the SLS and carefully consider all risks associ- credit facility did not meet the test of ated with these transactions. Bankers a prudent extension of credit. Conse- should also consider whether such quently, once examiners became aware activity is likely to be permitted by of the activity, they adversely classified their supervisor, regardless of poten- the credit facility, placed each loan tial mitigating actions. on nonaccrual, required a significant allocation to the allowance for loan and Steven E. Chancy lease losses (ALLL), and instructed Examiner that any future advances, which were [email protected] previously contracted, be immediately charged-off through the ALLL. Deborah L. Thorpe, CFE Within an 18 month period, the Examiner write-downs associated with this [email protected] credit facility and other loan losses exhausted the Bank’s capital and Michael R. Tregle resulted in its failure. The FDIC as Counsel, Legal Division receiver of the Bank holds these assets [email protected] and is attempting to liquidate them. The authors acknowledge and thank Chad M. Wilgenbusch, Student Conclusion Intern, Legal Division, Memphis, Tennessee, for his valuable contribu- Substantial financial risks, aggres- tion to this article. Mira N. Marshall, sive and deceptive sales practices Chief, Compliance Policy Section, fueled by the opportunity for promot- Washington, D.C., also made substan- ers to collect high commissions, tial contributions to the article.

35 Supervisory Insights Winter 2010