Life Settlement

We study the effect of the life settlement market on the structure of long term contracts offered by the primary market for life insurance, as well as the effect on consumer welfare, using a dynamic model of life insurance with one sided commitment and bequest-driven lapsation. We show that the presence of life settlement affects the extent as well as the form of dynamic reclassification risk insurance in the equilibrium of the primary insurance market, and that the settlement market generally leads to lower consumer welfare. We also examine the primary insurers’ response to the settlement market when they can offer enriched contracts by specifying optimally chosen cash surrender values (CSVs).

In this paper, we comprehensively analyze open-end funds dedicated to investing in U.S. senior life settlements. We begin by explaining their business model and the roles of institutions involved in the transactions of such funds. Next, we conduct the first empirical analysis of life settlement fund return distributions as well as a performance measurement, including a comparison to other asset classes. Since the funds contained in our dataset cover a large fraction of this relatively young segment of the capital markets, representative conclusions can be derived. Even though the empirical results suggest that life settlement funds offer attractive returns paired with low volatility and are virtually uncorrelated with other asset classes, we find latent risk factors such as liquidity, longevity and valuation risks. Since these risks did generally not materialize in the past and are hence largely not reflected by the historical data, they cannot be captured by classical performance measures. Thus, caution is advised in order not to overestimate the performance of this asset class.

A life settlement is a financial transaction in which the owner of a life insurance policy sells his or her policy to a third party. We present an overview of the life settlement market, exhibit its susceptibility to longevity risk, and discuss it as part of a new asset class of longevity‐related securities. We discuss pricing where the investor has updated information concerning the expected life expectancy of the insured as well as perhaps other medical information obtained from a medical underwriter. We show how to incorporate this information into the investor's valuation in a rigorous and statistically justified manner. To incorporate medical information, we apply statistical information theory to adjust an appropriate prespecified standard mortality table so as to obtain a new mortality table that exactly reflects the known medical information. We illustrate using several mortality tables including a new extension of the Lee–Carter model that allows for jumps in mortality and longevity over time. The information theoretically adjusted mortality table has a distribution consistent with the underwriter's projected life expectancy or other medical underwriter information and is as indistinguishable as possible from the prespecified mortality model. An analysis using several different potential standard tables and medical information sets illustrates the robustness and versatility of the method.

We analyze the prevailing valuation practices in the life settlement industry based on a sample of 11 funds that cover a large portion of the current market. The most striking result is that a majority of asset managers seem to substantially overvalue their portfolios relative to the prices of comparable transactions that have recently been closed. Drawing on market‐consistent estimates with regard to medical underwriting, it is possible to trace back the observed discrepancies to inadequately low model inputs for life expectancies and discount rates. The main consequences are a dissimilar treatment of investor groups in open‐end funds structures as well as an unduly high compensation for managers and third parties. To address this predicament, we suggest defining life settlements as level 2 assets in the fair value hierarchy of IFRS 13, improving transparency and disclosure requirements, and developing new incentive‐compatible fee schedules.

We analyze how the life settlement market – the secondary market for life insurance – may affect consumer welfare in a dynamic equilibrium model of life insurance with one-sided commitment and overconfident policyholders. As in Daily et al. (2008) and Fang and Kung (2010), policyholders may lapse their life insurance policies when they lose their bequest motives; but in our model the policyholders may underestimate their probability of losing their bequest motive, or be overconfident about their future mortality risks. For the case of overconfidence with respect to bequest motives, we show that in the absence of life settlement overconfident consumers may buy “too much” reclassification risk insurance for later periods in the competitive equilibrium. In contrast, when consumers are overconfident about their future mortality rates in the sense that they put too high a subjective probability on the low-mortality state, the competitive equilibrium contract in the absence of life settlement exploits the consumer bias by offering them very high face amounts only in the low-mortality state. In both cases, life settlement market can impose a discipline on the extent to which overconfident consumers can be exploited by the primary insurers. We show that life settlement may increase the equilibrium consumer welfare of overconfident consumers when they are sufficiently vulnerable in the sense that they have a sufficiently large intertemporal elasticity of substitution of consumption.

We use data from a large US life expectancy provider to test for asymmetric information in the secondary life insurance—or life settlement—market. We compare the average difference between realized lifetimes and estimated life expectancies for a sub-sample of settled policies relative to the entire sample. We find a significant positive difference indicating private information on mortality prospects. Using non-parametric estimates for the excess mortality and survival regressions, we show that the informational advantage is temporary and wears off over five to six years. We argue this is in line with adverse selection on an individual’s condition, which has important economic consequences for the life settlement market and beyond. JEL classification: D12; G22; J10

The last 12 months have been very active in the life settlement industry. The life settlement market continued to expand in 2006 and, by some estimates, approximately $15 billion in face amount of policies were sold. Synthetic structures have also become available as a means to invest in life settlements without actually purchasing the physical life insurance policies. In addition to purchasing life settlements, lending into the life settlement market, and providing synthetic investment opportunities, in the past year a number of financial institutions have become part owners of life settlement providers. As further evidence of a maturing market, a number of exchanges, similar to commodities exchanges, are currently in operation, and more may be on the way. Life settlements are governed on a state-by-state basis, with 28 states having enacted laws to govern life settlements and several states having proposed legislation. The primary legislative guide for life settlement regulation has been the Viatical Settlement Model Act, promulgated by the National Asssociation of Insurance Commisioners in 2001. In May 2006, a movement to amend the Model Act began to gather momentum. In an effort to end the so-called stranger-originated life insurance (STOLI) or investor-originated life insurance business segment, the Life Insurance and Annuities (A) Committee proposed a prohibition on the sale of a life insurance policy during the first five years after the policy is issued. While the inexact nature of life expectancy determinations has been one factor that has delayed the arrival of securitization to this sector due to the difficulties encountered by the rating agencies in achieving a sufficient comfort level with life expectancy predictions, many believe that securitization presents the logical progression of the life settlement market.

Profiting from death may strike one as morally offensive, but the life settlement industry has created just such an opportunity. A life settlement is a transaction wherein an insured assigns the ownership interest (contract rights to the death benefit) of a life insurance policy to an investor for cash consideration. In other words, it is the sale of an economic interest in the death of the insured. As such, the industry has created a secondary market for what was once thought to be an illiquid asset: life insurance. While current market volatility makes an investment in death attractive, the life settlement industry is not without pitfalls. This Comment explores the evolution and legality of the industry as well as considerations for an individual contemplating a life settlement transaction.

Project Description: The purpose of this paper is to provide a general overview of the deterministic and probabilistic pricing methodologies, and the application of the common contributing factors in determining the price of life insurance policies for life settlements in the secondary market. This paper does not venture into an analysis or review of the internal economics provided by life insurance policies. Scope of Research/Methodology: The life settlement market has grown exponentially from its roots in the 1980’s as a viatical industry, to today’s multi-billion dollar life insurance secondary market. One of the principal facilitators of this expanding asset class is the evolution of more accurate and reliable pricing models used by institutional investors to value life insurance policies. Understanding the basics of these pricing models also helps policy owners and their advisors to be informed market participants. This paper underscores the two fundamental methodologies that are used today, Deterministic Pricing and Probabilistic Pricing, and examines the fundamental similarities and differences in these methods, and how those factors impact investors. In particular, this report scrutinizes the importance of the underlying mortality assumptions, and the internal rate of return that is calculated based upon those assumptions. Target Results/Benefits: Concisely describe the primary pricing methodologies that are utilized to value life insurance policies for life settlements. Timeline: Research/draft report from January, 2008 through March, 2008. Appendix, Data Sources: Insurance Industry Research Bernstein Research Call, Life Insurance Longview: Life Settlements Need Not be Unsettling (2005) Life Settlement Industry Resources The Art of the Deal: Pricing Life Settlements, Contingencies, Zollars, Grossfeld & Day (2003)

Connecting life insurance policyholders with potential investors (called Life Settlement Providers), Ashar Group plays a pivotal role in the industry. Its current position is however increasingly being challenged by consumer-direct models, led by major providers seeking to shortcut brokers. Ashar faces a strategic dilemma in cooperating --- but also competing --- with these providers. Maintaining a mutually beneficial dynamic with policyholders, downstream intermediaries and other actors thus constitutes a balancing act. The context of this case is an underdeveloped market whose reputation has suffered from broker misconduct. In light of the market's legacy issues and competing business models, this case study explores strategies Ashar may pursue to secure and enhance its market position. Discussions emerging from this case study have the potential to illuminate directions for market transformation.