Techniques to Create Efficiencies in the Secondary Market for Life Insurance

1. Techniques to Create Efficiencies in the Secondary Market for Life Insurance By Hui Shan, ASA, MAAA, Ph.D Candidate University of Connecticut

2. Table of Contents • Background • Current Inefficiencies • Challenges • Solutions for Investors • Solutions for Insurance Companies • Solutions for Reinsurers • Conclusion

3. Background • Definition of the secondary market for life insurance • Involves the active trading of life insurance policies after they have been sold • Started in the late 1980s with the AIDS epidemic when individuals cashed out their policies for expensive medical treatment • Involves transfer of ownership • Takes advantage of the difference between the cash surrender value and the policy fair value due to the impairment in the policyholder’s health status • Many names associated with transactions in the secondary market, such as Life Settlements, and target population has changed over time • The total life insurance face amount transferred in 2006 was estimated to be about $6.1 billion, which reflects more than 30 percent compound growth from 2002. • Who are the players in this arena? • Investors • Life settlement companies • External underwriters • Insurance companies • Reinsurers

4. Current Inefficiencies • Tax inefficiency due to transfer of ownership in transaction • Policyholder • Investor • High transaction fees • Current transactions short change policy owner’s estate need • Life settlement assets not liquid • Poor ratings due to difficulty in obtaining coverage for the risk of policyholder living too long (tail risk coverage) • Hard to distinguish between a well constructed portfolio and a speculative one • Underwriters tend to understate life expectancy (LE) and life settlement companies tend to use the lower life expectancy in the bidding process to make their price more competitive in the market

5. Challenges • Challenges for Investors • How to quantitatively measure the risk of a portfolio • How to comply with FAS 157 in ongoing valuations • Lack of tail risk coverage at an affordable price • Challenges for Insurance Companies • How to meet evolving needs of the consumers • Revisit lapse and mortality assumptions built into the insurance pricing? • Concern that those policies which otherwise would lapse are now persisting because of life settlements • Challenges for Reinsurers • Current price offered by reinsurers for tail risk coverage is prohibitively high due to incorporation of a significant provision for adverse deviation. • Difficult to find buyers for this coverage • Difficult to control the underwriting misstatement risk since it is non-diversifiable

6. Solutions for Investors

7. Policy Fair Value Pricing: Current Approach • Prospective formula: where Pn– Premium payment at the beginning of the n-th period DB – Death benefit – Conditional death probability, probability that an individual age x dies between x+n-1 and x+n. – Cumulative persistency probability, probability of surviving through the n-th period. – The discount factor for the n-th period.

8. A Snapshot of 2001 VBT Tables • Base mortality rates in this research are from the 2001 Valuation Basic Tables.

9. Rates used in PFV Calculation • Derived from base mortality rates: cumulative persistency probabilities and conditional death probabilities

10. Improvement in Fair Value Pricing • An appropriate mortality slope can be assigned to policyholder based on re-underwriting LE and specific policyholder health impairments • A Provision for Adverse Deviation (PAD) in mortality is calculated to incorporate: • the underwriter misstatement risk • the statistical volatility risk of maturities after LE • The life settlement price is determined using the mortality slope plus PAD and an appropriate return on capital to discount cash flows

11. Portfolio Management • Modeling tools include the following: • Monte Carlo cash flow projections of premiums and maturities based on re-underwriting mortality information at time of settlement, or adjusted mortality information based on the “unlocking” process • Probability distribution of the ending portfolio value and internal rate of return, and the expected cost of the extension risk • Sensitivity analysis based on different LE misstatement scenarios • Risk-return measures of a portfolio of life settlement assets include the following: • Mortality duration of the portfolio • Sharpe ratio • Coefficient of Variation

12. Portfolio Value Simulation

13. Return Rate Simulation

14. Sensitivity Analysis If the true LE varies from the expected:Return Rate Distribution - Portfolio Value Distribution -

15. Observations • The risk-return measures and modeling tools allow an investor to do the following: • Assist the investor in determining the proper price to pay for new contracts to be added to the portfolio, and the fair market price for contracts to be sold off by the investor • Re-evaluation of the fair value and risk-return profile of the current portfolio to take into account more updated underwriting information

16. Asset Valuation: Current Approach • The initial fair value equals the purchase price of the life settlement asset • Portfolio valuation at any subsequent point in time involves the following: • Projection of future minimum premiums to keep existing policies in force • Use of mortality assumptions derived at the time of settlement • Use of a discount rate which equals IRR calculated at the time of settlement

17. Asset Valuation: New Approach • Develops a formal two-step process to adjust (“unlock”) future mortality assumptions based on historical mortality experience • Determination of whether there is a statistically significant deviation in underlying mortality assumptions. If the deviation in mortality experience is not significant, then: • The original LE will not change, and the future mortality assumptions will be appropriately adjusted to recognize an acceleration or deceleration of future deaths • Fair value of assets for the existing in force is calculated • If the deviation in mortality experience is significant, then: • Future mortality assumptions are unlocked to increase/decrease original LE assumptions, using a credibility weighting process, which gives more weight to actual experience as the portfolio ages.

18. Observations • The new valuation methodology conforms more closely to FAS 157, the governing regulation for life settlements valuation • The formal “unlocking” process is based on sound statistical and actuarial principles • The new valuation methodology results in a smoother pattern of annual earnings rates, and more favorable risk-return measures • The new valuation methodology is a better measure of the portfolio asset value because it distinguishes between short term fluctuations which are not statistically significant, and long term trends which reflect shifts in the underlying mortality experience of the portfolio

19. Solutions for Insurance Companies

20. Lapse Assumption Revisit? • Ongoing study on lapsed mortality based on data from a major insurance company suggests that lapsed policies tend to be more healthy and hence would not be targeted by life settlements companies. Hence, the existence of the life settlements industry should not impact the lapse assumptions or profitability of insurance companies.

21. Revolution • Some insurance companies have entered the secondary market by setting up a sub-company that purchases policies • Insurance companies could offer a loan product to meet the evolving needs of the consumers that • Avoids transfer of ownership • Allows for balance between liquidity need and estate need of the policyholder

22. Loan Strategy • The loan can range from the cash surrender value of the policy to the policy fair value • The policy serves as a collateral. Upon death of the insured, the beneficiary receives a residual death benefit, which is the policy death benefit minus the accumulated loan plus any expenses, if this is positive • Modeling results have shown that the insurers make a stable return with less volatility, while providing the consumers a far more transparent product that meets both liquidity need and estate need

23. Solutions for Reinsurers

24. Reinsurance: Current Approach • Reinsurance coverage in the life settlements market helps the investors • Cover the tail risk (longevity risk) • Improve the rating of their life settlements portfolio • Reinsurance coverage for the tail risk is not readily available • Price is prohibitive to cover underwriter misstatement risk of understating true life expectancy (LE) of policies • Not enough experience in this market place for reinsurers to provide coverage with any degree of confidence • Life settlements market is inefficient and it is hard to distinguish between well-constructed portfolios and speculative portfolios • Examples exist where reinsurers have been hurt by providing this type of coverage • Reinsurance charge for providing policy premium coverage beyond LE+2 years ranges from 5% to 7% of the face amount.

25. Reinsurance: New Approach • Methodology is based on the following: • Initial reinsurance charge based on actuarial cost of coverage assuming re-underwriting LE is correct with no PAD • At each portfolio valuation, methodology utilizes statistical confidence bands to determine if deviations of actual to expected mortality are significant • A credibility weighted formula is developed to adjust re-underwriting LE if deviations are statistically significant. • Based on the adjusted re-underwriting LE, turning point when the reinsurance coverage begins will be appropriately refined.

26. Observations • Reinsurance charge is reasonable and fair for both investors and reinsurers • Properly managed portfolios will end up paying a fair price for the reinsurance coverage • Risky portfolios will be protected for normal statistical fluctuations in mortality experience, but will have to bear some of the cost for the underwriter misstatement risk • The new reinsurance approach provides the highest Sharpe ratio compared to no reinsurance coverage or current reinsurance approaches

27. Conclusion

28. Conclusion • Life settlements is a valuable asset class to include in a portfolio of fixed income assets • Uncorrelated with market and interest rate fluctuations • Favorable risk-return ratios compared to other fixed income assets • Several ideas in this research are currently being implemented or being considered by players in the secondary market for life insurance. • The secondary market is continuing to grow and expand into other financial areas and all the techniques we have discussed for greater efficiencies and risk control are very relevant.