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Senior Life Settlements: a Cautionary Tale

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Senior Life Settlements: a Cautionary Tale Senior Life Settlements: A Cautionary Tale n recent years, Wall Street 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 stock 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 securitization market can only be achieved with a favorable rating from 0 2002 2003 2004 2005 2006 2007 2008 a credit rating agency. However, rating Years life settlement securitizations 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 security (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.
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