Life Settlement Underwriting - The Flip Side of the Coin

Life settlements are fast growing into a staple of the insurance and financial planning world. Most financial professionals have heard of life settlements, which is the sale of a life insurance policy of a senior (age 65 and over) for a lump sum which is greater than the policy's cash surrender value but less than its death benefit. Policies which are viable for a life settlement are generally those beyond the contestability period wherein the insured has a life expectancy of between 2 and 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 that have actually completed a life settlement is surprisingly low. This can be attributed mainly to a lack of in-depth knowledge of life settlements on the part of these professionals. Considering that life settlements are a relatively new option for policy owners, many financial professionals, although having heard of life settlements, have still not had the opportunity to delve into the subject on a deeper level.

Many policy holders come to a juncture wherein they continue to pay life insurance premiums on an unwanted policy in hopes of a gain at maturation, or 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 typically involve retirement planning and charitable giving issues.

In short, life settlements offer policyholders of all kinds an array of options previously unavailable to them.

In a recent advisor survey, nearly half of the respondents had clients who had surrendered a life insurance policy, many of whom might have qualified for a life settlement transaction and subsequent lump sum cash payment.

In this article I will discuss in depth 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. Due to the fact that the investor will be sustaining the policy premiums until maturation, the life expectancy of the insured becomes 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. By contrast, should the assessment of an insured's life expectancy be longer than his or her actual life span, the offer to the seller would have been less than it could have been, thus resulting in an undervalued sale for the policy owner. Institutional investors in life settlements generally obtain life expectancy reports from two or more independent LE (life expectancy) providers. Many of the larger institutions investing in life settlements have proprietary underwriting personnel on staff. LE reports can vary significantly based on interpretations, medical data on the insured, and/or the actuarial tables used.

DIFFERENCES IN UNDERWRITING METHODOLOGY - Companies which provide LE reports use actuarial and medical experts who apply probability theory, actuarial methodology and medical analysis in calculating the probable mortality of an insured. Many LE providers employ the services of experienced life insurance underwriters who work in tandem with the actuarial and medical experts. There are a number of companies which provide LE 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 and scrutinized against recent medical advances and the treatment of diseases or disorders often associated with the elderly. In addition to this, companies that provide LE reports also draw from, and factor in, proprietary data accumulated from previous assessments. Generally, a traditional debit and credit methodology is used by the underwriter in determining the overall rating of an insured, resulting in either standard or substandard. Of course, this is an approximation due to the fact that few impairments cause a uniform percentage increase in mortality. Results using the standard debit and credit method produce reasonable and quantifiable results; however, for conditions such as many forms of cancer, the debit and credit methodology does not generate reliable results. This is mainly due to the fact that the impaired mortality curve is significantly different than the standard curve used in the absence of these impairments. Companies that provide LE reports employ different approaches in order to calculate these impairments. Some utilize 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. For a policy with a high impairment and a short life expectancy, clinical judgment may supersede the actuarial calculation. Life expectancy calculations utilize the underwriting assessment in tandem 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 VBT (Valuation Basic Table), 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 most 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 his or her commitment to living a healthy lifestyle. Access to care givers and a support network, are also variables that are taken into consideration. All of these factors can sometimes add a level of 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 individual the application needs to be accompanied by medical data as outlined in the insurance company's requirement guidelines. This medical data would usually include a physical examination, blood profile, EKG and an Attending Physician's Statement (APS). 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. By 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, usually a broker or provider. This information is then forwarded to the company or companies providing life expectancy reports on the insured. After review of the attending physician's statements and medical history, a life expectancy provider will provide a detailed LE report on the insured. Based on the information in the LE report and the profile of the life insurance policy, an institutional investor will prepare an offer on the policy. Occasionally, the company or companies providing the life expectancy report will indicate that additional information from an attending physician may give them further insight into the insured's life expectancy, which would possibly affect the offers from institutional investors. In such a case, the life settlement broker or provider will order additional information from the appropriate physician(s). In cases where the insured has not seen a physician in two or three years, which would seemingly be a good thing, indicating that the individual 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.

The principal difference in underwriting for life insurance and life settlements is that in traditional underwriting as low a mortality rating as possible on any medically impaired risk would be preferred in order to obtain a lower cost of insurance. By contrast, for life settlements a higher impairment rating would result in a shorter life expectancy. Thus, the insured would receive a larger settlement for his or her policy.

SELLER BEWARE - With life settlements growing at an astounding rate, there are more and more companies 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 make sure they 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: to wit, a company that will facilitate and expedite the policy with professionalism as well as acquire competitive bids from a number of institutional investors. However, perhaps of even greater importance to the professional, is a company that has an infrastructure that enables the record keeping necessary to fulfill regulatory standards, as well as a compliance department that will keep abreast with changing regulatory requirements and reporting. Most importantly, the company should hold the applicable licenses in the states were it conducts life settlement transactions.

Not surprisingly, these various attributes and characteristics tend to coincide with each other. A reputable company will hold all of the applicable licenses needed, or will refrain from activities in states in which it is not licensed. If they have the proper reporting and record keeping capabilities, this is usually overseen by a compliance department that is also responsible for licensing and regulation. Organizations such as these generally have built an infrastructure that has the manpower to process settlements with fastidious 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 what states. If they do 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 fast-forward three years after a life settlement with an unlicensed company that has fallen off the face of the planet and guess who's left holding the bag.