Better off dead

Latest securitization scheme raises some eyebrows

By Michael J. Moody, MBA, ARM

The past several years have proven to be a major challenge for the world’s financial markets. It has become apparent that many of our financial touchstones have fallen from grace. One of those touchstones was a financial transaction known as “securitization.” As even a casual observer knows by now, many of the problems associated with subprime lending were driven by securitization, which turned out to be a much riskier process than either the issuers or the buyers expected.

While subprime issuances presented a variety of difficulties, time has shown that one of the most damaging was the “source of the money” issue. As the distance between the borrower and the ultimate lender increased, ultimate responsibility moved away from local lenders, with a resultant loss of motivation to protect the investment. The risk of fraud then increased, thanks in large part to a broad secondary market for mortgage loans via securitizations that were backed by the collateral of these mortgages.

Insurance industry securitization

The majority of securitization within the insurance industry was in the form of insurance-linked securities (ILS). Over the past 10 to 15 years, the property and casualty insurance industry found ILS to be an excellent source of capital because it gave the insurance industry the ability to gain direct access to the capital markets. And for their part, the capital markets were eager to become involved in ILS. Among the advantages offered were a significantly higher interest rate, a chance to diversify the investment portfolio, and an investment vehicle that was not tied to the stock market. All of these reasons had hedge fund managers eager to make investments in ILS instruments.

Initially, securitization that was associated with the insurance industry had been developed for the most part around catastrophic property exposures. And, according to Guy Carpenter, the ILS market consisted of several growing areas that included CAT bonds, industrial loss warranties, sidecars, and several forms of weather derivatives. They focused on areas that were typically difficult for the reinsurance market to deal with or provide high enough limits. While a number of forms of ILS had been gaining momentum prior to 2005, that momentum was slowed by the continuing soft market. Then the three sisters—Hurricanes Katrina, Rita and Wilma—brought about significantly more interest. More recently, however, the lack of available funds from large investors has served to slow the ILS movement once again.

Life insurers—late to the party

As was noted above, the property and casualty insurance industry has been using ILS for quite some time. Additionally, due to a lack of high-limit property insurance following Katrina, et al., the growth of the ILS market became brisk. Many industry experts believed that insurers/reinsurers would purchase additional ILS instruments as they continued to experiment with finding the most cost-effective approach to utilizing the capital markets.

Generally, the life insurance industry had not been participating in the movement to the ILS market. However, that all changed with Regulation XXX and Guideline AXXX. The result was that most life insurers had to set aside significant, additional reserves—redundant reserves—according to most of the life insurance industry. Projections provided by industry experts esti­mated that the new regulations would result in more than $150 billion in additional reserves over a 10-year period. Many insurers believed that this would result in higher rates and less competitive products.

Insurers began searching for a financial tool that could be used to provide some relief for these new, onerous capital requirements. One of the methods involved the use of ILS in concert with establishing a captive insurance company to fund the transaction. Growth of both the ILS and captive insurance companies for this purpose quickly spread. By using these captive insurance companies, or special-purpose entities as they are often called, life insurers found a viable method for gaining capital relief, while offering capital market investors returns that were not tied to the stock market. However, as with the rest of the ILS market, the current financial mess has pretty much dried up any available capital.

The next big thing?

Recently, Wall Street has come up with a new ILS idea, commonly referred to as securitization of life insurance settlements. In its most basic form, a life insurance settlement involves the sale of the rights to the death benefits associated with a life insurance policy. The sale of the proceeds of the life insurance policy is a transaction between the original policyholder to a third-party investor. The policyholder receives a lump-sum payment that reflects the net present value of the policy’s death benefit, after reducing the payment by future premium payments and any additional costs. While some aspects of this transaction are quite new, the core concept has existed in the life insurance industry for years. It was originally known as viatical settlements that were established for terminally ill patients who were facing costly medical procedures. This was seen as a way for these individuals to obtain additional funds without having to take the cash surrender value of the policy. Proceeds from the viatical settlements were significantly higher than the surrender value because the settlement was nearly always in excess of the redemption value offered by the insurer.

The life insurance settlement approach takes a similar path. The industry estimates that of the roughly $9.2 trillion in life insurance that is in force in the United States, about $416 billion is owned by individuals over the age of 65, considered to be the ideal candidates for this program. Further, because this age group is expected to increase over the next 20 years from about 37 million individuals to more than 72 million people, it has great potential for growth. In addition, many wealthy, older policyholders may wish to take advantage of an early cash payment. Older policyholders typically do not have the financial obligations that they did with growing families. When that is coupled with the fact that some have experienced a reduction in investment and real estate portfolios as a result of the housing bubble, insurers believe that many elderly policyholders would be interested in receiving an early settlement.

While there are a number of ways with which life insurance proceeds can be securitized, in essence there are three primary categories:

• Life settlements, in which invest­ors buy interests in established policies

• Premium financing for older policyholders, which typically operates independently of the secondary market

• Stranger-owned life insurance (STOLI). This latter category has generated most of the attention because it no longer involves the purchase of policies of critically ill policyholders.

The STOLI approach depends on attracting an older person to take out a large-limit life policy that is in fact purchased by an unknown investor. The insured’s only role is to consent to the purchase of insurance and then die; and the sooner he or she dies, the better it is for the investor. Groups of these types of policyholders are combined and the security is then sold to large hedge fund managers.

Obviously, the stranger-owned life insurance approach is coming under close scrutiny from many sources. First and foremost, many industry experts are concerned about the whole “insurable interest” issue. Proponents note that once the “stranger” has purchased the policy, he or she does in fact have an insurable interest. It would appear that the debate on this issue is far from over.

Currently most state regulators are reviewing this issue, and some have already outlawed the use of STOLI in their states. Additionally, the NAIC has taken this matter under review as well. The Securities and Exchange Commission and even Congress have also been reviewing the STOLI concept. And while Congress has strong concerns about the return to the “casino culture” that was the financial service sector a couple of years ago, they appear to have backed off for the time being. For the most part, Congress believed that there “does not appear to be any special issues in terms of consumer protection” from the STOLI approach. As a result, they indicated that the STOLI could be treated as any other securitization.

Conclusion

Will the life insurance settlement securitization be the risk-financing method of the future? Only time will tell; however, there appear to be some red flags that would suggest that the industry should proceed with caution. With the wounds still fresh from the subprime loans, there are several areas of concern. The originators of these securitizations will need to take special care to avoid the “source of money” issues that arose in the subprime loan area when you eliminate the traditional close working relationship between the local lender and the home owner. It became apparent that this totally changed the character of the relationship, and ultimately led to substantial increases in fraud.

Regardless of the final direction of the STOLI approach, it needs to be remembered that the primary purpose of life insurance is to provide a financial backstop for the beneficiaries in a time of need. Care must be taken to prevent life insurance from transforming itself into just another instrument that provides an investment opportunity for strangers. This would certainly be damaging to the entire insurance industry.