More Than You Ever Wanted To Know About Death Bonds

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If you are not yet familiar with what are called life securitizations – or death bonds – fear not. In a comprehensive primer released on Tuesday, Standard & Poor’s answered all the questions you never thought you’d ask.

S&P kicks off with a hedge of sorts, noting that while it hasn’t rated any of these securities, “we are giving our view on the risks and the difficulties that come with securitizing a pool of these assets.”

Here is S&P’s view, all focus on FT Alphaville:

What is a life securitization?

Lifetime settlements, sometimes referred to as elderly or elder settlements, involve the purchase of life insurance policies from people, usually aged 65 and over, who suffer from various ailments or suffer from a particular disease and whose the projected life expectancy is usually between two and 10 years. . An investor trust purchases the policies and assumes responsibility for paying the policy premiums at maturity and the right to receive the policy benefit on the death of the covered person. Insurance policies are bundled together and then repackaged into bonds and marketed to investors. The benefits of the policies go to the payment of principal and interest on the bonds. (Viatical settlements differ from viatical settlements, which are policies purchased from people with terminal illnesses, although viatical settlements have previously been securitized.)

What are Standard & Poor’s concerns about life settlement securitizations?

Standard & Poor’s first concern relates to the actuarial assumptions underlying a transaction. In our view, the small number of lives, usually only a few hundred (but usually around 100), included in a transaction is not sufficient to ensure statistical credibility. When dealing with a limited sample as opposed to a population, the originator’s ability to make statistical inferences is reduced, and small underwriting errors can have a significant impact on trade performance. Since the payment of debt service on rated instruments would be linked to the projected mortality of policyholders, this potential cash flow mismatch would, in our view, 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 elements describing the insured in the pool would typically be age, smoking status and gender. If we were to apply the life table to a small number of people, we would need to determine if we can apply it correctly to the unique characteristics of that specific group; otherwise, the analysis could miss the real risk entirely. For example, between two pools with similar distributions of age, sex, and smoking status, individuals from the two pools with different family backgrounds/genetic predispositions, different occupational backgrounds, or having lived in different environments (e.g. urban versus rural) could have a significant impact on the actual mortality of each pool. Therefore, when valuing a block of life insurance policies, it seems reasonable to perform cash flow tests under certain extreme adverse mortality scenarios.

Our second concern relates to the insurable interest, which can be generally defined as the interest that the beneficiary of a life insurance policy has in the fact that the person covered is alive, because the death of this person would cause the beneficiary a loss, financial or otherwise.. Marital and parental relationships generally meet this threshold, as do some business relationships. By law, an insurable interest must exist at the time the life insurance is purchased. However, in a life settlement securitization, noteholders who have no insurable interest in the lives covered by the policy pool become the ultimate beneficiaries of the policies. This could be considered an abuse of insurable interest, which could affect the enforceability of the policy, and therefore the payment of the death benefit.. In order to value structured settlement securitizations, we should obtain assurance 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 an insurable interest in the lives covered, while in other states courts have taken the opposite position. In a number of states, however, the courts have not rendered an opinion and the legal status is therefore uncertain.

A third concern is the accuracy of independent medical examinations that originators may use in these securitizations.. In the area of ​​death underwriting, insurers are expected to mistakenly underwrite a very limited portion of their policies, but in the life insurance industry, the large number of individuals minimizes the impact of poor underwriting. In the case of life settlements, we believe the situation is not as clear. Various medical underwriters typically re-write these policies, and their incentives are not necessarily aligned with investor interests. Typically, these medical underwriters get a flat rate for each policy purchased. Since no physical examination is required, only a review of the insured’s medical records is undertaken, there is a greater risk of underwriting errors. This, combined with the limited number of policies in the securitized pool, can have dramatic effects on cash flow. Additionally, since there is little historical data comparing projected mortality to actual mortality rates, it is difficult to assess the accuracy of these third-party medical examinations. Given the importance of the accuracy of life expectancy predictions to the performance of these securitizations, being able to examine the established performance track record of underwriters is essential to assess the risks of these transactions.

A fourth concern is that most life insurance claimants who purchase these policies have limited or no track record.. They often purchase the pools using leverage and, after securitizing the pools, retain a small residual equity position in the trade. They receive a commission, but the risk they retain is minimal. As a result, bondholders bear the lion’s share of the risk and originators are able to focus more on their growth than on potential underwriting issues. Having reputable industry participants with longer track records as well as a reasonable alignment of interests with bondholders would likely provide increased qualitative strength to a potential transaction, which we would view positively.

A final issue is the cash flow timing. On the death of a policyholder, there is a legal deadline for payment from the life insurance company, while 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 required to pay a benefit until potentially years after the disappearance. Although at some point in the future, if the insured remains missing, the insurance company will make payment, this delay may result in default of payment of interest or principal. Social Security records are the primary means of confirming an insured’s death, but the servicer’s diligence in going through these records is important for timely benefit payments. If the servicing agent does not have a sufficient financial interest in the timely reporting of deaths, investors may be at greater risk.

Given the uncertainties, why are investors still interested?

Some investors believe that these bonds provide portfolio diversification and those already immersed in more traditional fixed income investments can use these bonds to balance their holdings. For example, similar to how some investors view natural catastrophe bonds, investors do not believe there is a significant correlation between mortality and the state of the economy, although there is a correlation between the state of the economy and the credit quality of insurers. There are also the potential benefits of the high policy payment priority and the state guarantee fund in case the regulator takes control of the insurance company. However, regulators have enormous flexibility in these actions and there could be some uncertainty as to how the regulator would deal with these policies.

What would it take for Standard & Poor’s to start rating settlement-life securitizations?

To date, Standard & Poor’s has not rated any life settlement transactions. The concerns described above should be resolved before we can assess these transactions. In addition, we would first like to create and publish rating criteria for securitizations of this asset class. The analysis of these transactions, with their unique set of risks, requires a collaborative effort between Standard & Poor’s structured finance and insurance rating groups, as appropriate.

Morbidly fascinating.

Related links:
Regulation of life ‘hit hard’ by recession, says Conning – Bloomberg
Hedge Funds Buy Life Insurance Policies for a New Path to Profit – Bloomberg (2005)

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