Life Settlements

Life Settlement Underwriting - The Flip Side of The Coin
by Lance Wallach, CLU, CHFC, CIMC

Life settlements are fast growing into a staple of the insurance and financial planning world. Most financial professionals have heard of life settlements. It’s the sale of a life insurance policy of a senior (age 65 and over) for a lump sum that is greater than the policy’s cash surrender value but less than its death benefit. Policies that are viable for a life settlement are generally those beyond the contestability period wherein the insured has a life expectancy of between two to 15 years. Today life settlements are dominated by institutional funders and pension funds.  

Despite the continued growth in the life settlements market, the number of insurance or financial professionals who have actually completed a life settlement is surprisingly low. This can be attributed mainly to a lack of in-depth knowledge of life settlements. Considering that life settlements are relatively new for policyowners, many financial professionals have not had the opportunity to delve into the subject on a deeper level.   

Many policyholders come to a juncture wherein they continue to pay life insurance premiums on an unwanted policy in hopes of a gain at maturation or they hope to recoup some of the investment by trading the policy for its cash-surrender value. Corporate policyholders often face additional dilemmas when dealing with departing executives with key-man or split-dollar policies or insurance purchased as part of a buy-sell agreement.

With a life settlement, the policyholder realizes an amount much greater than the cash surrender value in exchange for the policy’s ownership. Term life insurance policies are also applicable when converted into permanent insurance. Life settlement transactions involving key-man or buy-sell policies can provide businesses with increased cash flow to solve immediate financial problems, while transactions concerning split-dollar policies usually involve retirement planning and charitable giving issues.

In short, life settlements offer policyholders of all kinds an array of options previously unavailable to them. This article will discuss the underwriting process related to life settlements, which is of paramount importance in the process, just as it is in life insurance itself, although there is a great deal of difference in the process for each respectively. 

Settlement amounts are determined by a multitude of factors that arrive at a net present value, which is the present value of future benefits from the death benefit minus the present value of future payments associated with sustaining the policy until maturation. These expenses include premium payments, cost of capital, and administrative costs.

This calculation enables the purchaser to factor in the desired profit from the investment and propose an offer to the seller of the policy. Because the investor will be sustaining the policy premiums until maturation, the insured’s life expectancy is critical in assessing the value or sale price of the policy. If the assessment of an insured’s life expectancy is too short, the purchaser will have paid too much and risks a financial loss. In contrast, the offer to the seller would be less if the assessment of an insured’s life expectancy were longer than their actual life span. The result is an undervalued sale for the policyowner. Institutional investors in life settlements generally get life expectancy reports from two or more independent life expectancy providers. Many of the larger institutions that invest in life settlements have proprietary underwriting personnel on staff.  Life expectancy reports can vary significantly based on interpretations, medical data on the insured, and the actuarial tables that are used.     

Differences In Underwriting Methodology  

Companies that provide life expectancy reports use actuarial and medical experts who apply probability theory, actuarial methodology, and medical analysis in calculating the probable mortality of an insured. Many life expectancy providers use experienced life insurance underwriters who work actuarial and medical experts. Several companies provide life expectancy reports. Among those most commonly accepted by institutional investors are: AVS, Fasano, 21st Services, ISC Services and EMSI.

These companies specialize in underwriting the senior segment (insureds above the age of 65) and have developed specified methods, underwriting manuals, and mortality tables.

The insurance industry customarily employs reinsurance underwriting manuals as the basis of its ratings for insurability. However, reinsurance manuals are gauged primarily for insurance applicants up to the age of 65 with insurable impairments up to 500%. These standards reflect the traditional demographic for life insurance. Conversely, life settlement underwriting is geared toward those above the age of 65 and can have impairment ratings much higher than 500%.

In order to cater to this market segment, adaptations were made to these underwriting manuals based on extensive research of current senior mortality data. They are scrutinized against recent medical advances and the treatment of diseases or disorders often associated with the elderly. In addition, companies that provide life -expectancy reports also draw from proprietary data accumulated from previous assessments. Generally, the underwriter uses a traditional debit and credit methodology to determine the overall rating of an insured, resulting in standard or substandard. Of course, this is an approximation since few impairments cause a uniform percentage increase in mortality.

The standard debit and credit method produces reasonable and quantifiable results. But, it’s not reliable for conditions, such as many forms of cancer. This is mainly due to the fact that the impaired mortality curve is significantly different than the standard curve. Companies that provide life expectancy reports have different ways to calculate these impairments. Some use the debit and credit approach, others apply extra deaths for a limited time span, and still others will use a combination of the two and apply them to the actuarial calculations. Clinical judgment may supersede the actuarial calculation for a policy with a high impairment and a short life expectancy. Life expectancy calculations use the underwriting assessment with the appropriate mortality table. However each life expectancy provider uses its own proprietary mortality tables based on sex, smoker or non-smoker status, impairment, and preferred class. The general understanding is that most life expectancy providers use the 2001 Valuation Basic Table (VBT), but it seems that most use a heavily modified version of the 2001 VBT or their own table altogether.

Individuals with medical conditions, such as Alzheimer’s disease, congestive heart failure, and other serious ailments would likely be declined for a life insurance policy. However, for the purposes of a life settlement, it is possible to estimate the life expectancy of an insured with these medical ailments.

For insureds with serious medical conditions, life expectancy assessments often take into account factors that contribute to healthy aging, such as regular physical exercise, social activities, the mental attitude of the insured, and their commitment to living a healthy lifestyle. Access to care givers and a support network, are also considered. All of these factors can add complexity to the underwriting process that will affect the final mortality calculation
 
Differences In Underwriting Requirements

When submitting an application for a large life insurance policy on an older person, the application needs to be accompanied by medical data as outlined in the insurance company’s requirement guidelines. This medical data usually includes a physical examination, blood profile, EKG and an attending physician’s statement. Many insurance companies also require functional assessments of an applicant, which include ability to carry out the activities of daily living. Often, financial underwriting is a part of this assessment of insurability. In contrast, life settlement underwriting is based on existing medical data and rarely requires any medical examination, EKGs, or blood work. A life settlement application should be accompanied by HIPAA and release of medical information forms.

The application is then followed by attending physician’s statements ordered from selected physicians by the company transacting the life settlement, which is usually a broker or provider.

This information is then forwarded to the company or companies providing life expectancy reports on the insured. After reviewing the attending physician’s statements and medical history, a life expectancy provider offers a detailed life expectancy report on the insured.

An institutional investor will prepare an offer on the policy based on the information in the life expectancy report and the profile of the life insurance policy. Occasionally, the company or companies providing the life expectancy report say that additional information from an attending physician could give them further insight into the insured’s life expectancy, which would affect the offers from institutional investors. In such a case, the life settlement broker or provider orders additional information from the appropriate physicians. When the insured has not seen a physician in two or three years, it could indicate that the person is not suffering from any chronic ailments. The company providing a life expectancy report is afforded little current data on which it can effectively base a life expectancy assessment.

In traditional underwriting, getting as low a mortality rating as possible on any medically impaired risk is preferred in order to obtain a lower cost of insurance. In contrast, for life settlements a higher impairment rating would result in a shorter life expectancy. Thus, the insured would receive a larger settlement for their policy.

Seller Beware

With life settlements growing at an astounding rate, more and more companies are seeking to enter this market. Many states have some form of regulation regarding life settlements, while others are unregulated or pending regulation. Some life settlements, such as those on a variable policy, are considered securities transactions. With all of these different -regulatory variables, it is important for insurance and financial professionals to work with a reputable company to facilitate a life settlement. When considering which life settlement company to work with, most of us look for the obvious: a company that will facilitate and expedite the policy with professionalism and get competitive bids from a number of institutional investors. What may be even more important is a company that can do the necessary record keeping to fulfill regulatory standards and has a compliance department that stays abreast with changing regulatory requirements and reporting. Most importantly, the company should have the applicable licenses in the states were it conducts life settlement transactions.

Not surprisingly, these various attributes tend to coincide. A reputable company will hold all of the applicable licenses needed or will refrain from activities in states in which it is not licensed. A compliance department that is also responsible for licensing and regulation oversee reporting and record keeping capabilities. These kinds of organizations generally have the manpower to process settlements with precision. Processing large numbers of settlements according to a high standard will give a company a preferred status and leverage with institutional investors, which might even result in higher offers on a given policy.

Be sure to ask the life settlement company if it is licensed and in which states. If it does settlements for variables, ask if these are cleared through a broker/dealer and what their relationship to that broker- dealer is. Use the Internet and other tools to research the company you plan on using for a life settlement. The issues may seem trivial today, but guess who’s left holding the bag three years after a life settlement with an unlicensed company that has fallen off the face of the planet.  
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Lance Wallach, speaks and writes extensively about retirement plans, estate planning, and tax reduction strategies.  He speaks at more than 70 conventions annually, writes for more than 50 publications, and was the National Society of Accountants Speaker of the Year. Contact him at 516-938-5007 or visit www.vebaplan.com.