If you’re not yet familiar with so-called life settlement securitisations – or death bonds – never fear. In a comprehensive primer released on Tuesday, Standard & Poor’s has answered all the questions you never thought to ask.
S&P kicks off with something of a hedge, noting that while it has not rated any of these securities, “we provide our view on the attendant risks and difficulties in securitizing a pool of these assets.”
Here’s S&P’s take, any emphasis FT Alphaville’s:
What is a life settlement securitization?
Life settlements, sometimes referred to as senior or elder settlements, involve the purchase of life insurance policies from individuals, typically age 65 and older, who have various ailments or suffer from a particular disease and whose projected life expectancy is typically between two and 10 years. An investor trust buys the policies and assumes the responsibility to pay the policy premiums when due and the right to receive the policy benefit when the covered individual dies. The insurance policies are pooled and then repackaged as bonds and marketed to investors. The benefits of the policies go toward paying principal and interest on the bonds. (Life settlements differ from viatical settlements, which are policies purchased from individuals with terminal illnesses; though viatical settlements were once securitized.)
What are Standard & Poor’s concerns about life settlement securitizations?
Standard & Poor’s first concern is with the actuarial assumptions underlying a transaction. In our view, the small number of lives, usually only a few hundred (but typically around 100), included in a transaction is not sufficient to assure statistical credibility. When dealing with a limited sample as opposed to a population, the originator’s ability to make statistical inferences is lessened, and small errors in underwriting can have a material impact on the performance of the transaction. Since the payment of debt service on the rated instruments would be linked to the projected mortality of the policyholders, this potential cash flow mismatch would, in our opinion, create too much uncertainty in the required payments to investors. In our view, statistical credibility is unlikely to be achieved with a pool of less than 1,000 lives. In a potential securitization the key components describing the insured in the pool would generally be age, smoking status, and gender. If we were to apply the mortality table to a small number of people, we would need to address whether we can properly apply it to the unique characteristics of that specific pool; otherwise, the analysis could be missing the real risk entirely. For example, as between two pools with similar distributions of age, gender, and smoking status, the individuals in the two pools having different family histories/genetic predispositions, occupational histories, or having lived in different environments (e.g. urban versus rural) could have a material impact on each pool’s actual mortality. Therefore, when evaluating a block of life policies, it seems reasonable to run cash flow testing under certain extremely adverse mortality scenarios.
Our second concern relates to insurable interest, which can be generally defined as the interest the beneficiary of a life insurance policy has in the covered individual being alive, because the death of that individual would cause the beneficiary a loss, financial or otherwise. Spousal and parental relationships usually meet this threshold, as do certain business relationships. By law, an insurable interest must exist when the life insurance is purchased. However, in a life settlement securitization, noteholders who do not have insurable interest in the lives covered by the pool of policies become the ultimate beneficiaries of the policies. This could be viewed as an abuse of insurable interest, which could affect the enforceability of the policy, and therefore the payment of the death benefit. In order to rate structured settlement securitizations, we would have to obtain comfort that applicable insurable interest laws have not been violated. To date, court decisions in some states have validated the need for investors in such transactions to have insurable interest in the covered lives, while in other states courts have taken the opposite stand. In a number of states, however, the courts have not rendered opinions and so the legal status is uncertain.
A third concern is the accuracy of independent medical reviews that originators may use in these securitizations. In mortality underwriting, it’s expected that insurers will misunderwrite a very limited portion of their policies, but across the life insurance industry, the large pool of individuals minimizes the impact of misunderwriting. In the case of life settlements, we believe the situation is not as clear. Various medical underwriters usually re-underwrite these policies, and their incentives are not necessarily in alignment with investors’ interests. Typically, these medical underwriters get a flat rate for each policy written. Because no physical is required, only a review of the insured’s medical file is undertaken, there is a greater potential for underwriting errors. This, combined with the limited number of policies in the securitized pool, can have dramatic effects on cash flows. In addition, because there is limited historical data comparing the projected mortality versus the actual mortality rates, it is difficult to assess the accuracy of these third-party medical reviews. Given the importance of the accuracy of the predictions of life expectancy to the performance of these securitizations, being able to review underwriters’ established track record of performance is key to evaluating the risks of these transactions.
A fourth concern is that most life settlement originators that buy these policies have either limited or no track record. They often buy the pools using leverage, and after securitizing the pools retain a small residual equity position in the transaction. They’re paid a commission, but the risk they retain is minimal. Consequently, the bondholders are assuming the lion’s share of the risk, and the originators are in a position to focus more on their growth than on potential underwriting problems. Having reputable participants in the industry with longer track records as well as a reasonable alignment of interest with bondholders would likely provide increased qualitative strength to a potential transaction, which we would view positively.
One final issue is the timing of the cash flows. Upon the death of a policyholder, there is a statutory period for payment from the life insurance company, while the notes have predetermined payment dates. This could create a cash flow mismatch resulting in a missed payment and an event of default. In a situation where the insured is missing, and the insurer cannot verify the death of the insured, it is not obligated to make a benefit payment until potentially years after the disappearance. While at some point in the future if the insured remains missing, the insurance company will make the payment, this delay may result in a missed interest or principal payment. Social Security records are the primary means of confirming the death of an insured, but the diligence of the servicer in combing through these records is important to the timely payment of benefits. If the servicer does not have sufficient financial interest in the timely reporting of deaths, then the investors may be at greater risk.
Given the uncertainties, why are investors still interested?
Some investors believe that these bonds offer portfolio diversification and that those already immersed in more traditional fixed-income investments can use these bonds to balance their holdings. For example, similar to how some investors perceive natural peril catastrophe bonds, investors do not believe there is a significant correlation between mortality and the condition of the economy, though there is correlation between the condition of the economy and the credit quality of the insurance providers. There are also the potential benefits from the high payment priority of policies and the state guarantee fund in the event the regulator takes control of the insurance company. However, regulators have a tremendous amount of flexibility in these actions and there could be some uncertainty as to how the regulator would treat these policies.
What would it take for Standard & Poor’s to begin rating life settlement securitizations?
To date, Standard & Poor’s has not rated a life settlement transaction. The concerns outlined above would need to be addressed in order for us to rate these transactions. In addition, we would first create and publish criteria for rating securitizations of this asset class. Analyzing these transactions, with their unique set of risks, requires a collaborative effort between Standard & Poor’s Structured Finance and Insurance ratings groups, as applicable.
Morbidly fascinating.
Related links:
Life Settlement ‘Hit Hard’ by Recession, Conning Says – Bloomberg
Hedge Funds Buy Life Insurance Policies to Ply New Profit Path – Bloomberg (2005)