It is important to distinguish whether an underwriting
report provides a 50 percent median life expectancy or an actuarial mean life expectancy. Many investors do not understand
this distinction, and the actuary must interpret data to model
cash flows properly. This element alone can produce material
adjustments to the implied internal rate of return for a case.
Underwriting always has been problematic for life settlements because it is what drives the embedded value of a life
insurance policy. During 2008, the life settlement industry
saw many underwriters make significant adjustments to their
tables, which tended to increase life expectancies for most underwriting opinions. These shifts in life expectancies caused a
ripple throughout the market, since the assets now were yielding less than what was originally expected.
Some underwriters currently have accumulated enough
mortality data on previously underwritten cases to define
reasonable early-duration mortality rates matched to the
underwriting process. They constantly are revising their methodologies and periodically adjusting their mortality tables to
become more accurate. At least one state requires periodic filing of A/E ratios with an actuarial certification.
Because of the newness of the market, the first three to five
years of each underwriter’s mortality curves are the most important when performing an A/E analysis. But data may exist for up
to 10 or more years. Each underwriter uses his or her own proprietary mortality tables, and the slope of these mortality tables will
affect any A/E analysis, along with projected policy values. Assuming two underwriters produced the same actuarial life expectancy
for a common block of insureds, their A/E results still would differ
because of differences between their mortality tables.
From the point of view of the investor, the cash flow
from a life settlement includes:
■ ■ The purchase price of the life insurance policy;
■ ■ The life insurance policy premiums paid while the
insured is alive;
■ ■ The death benefit received at the time of the insured’s
Following the 2008 shift in underwriting, there’s been new
interest for documented best practices for underwriting. In November 2009, an actuarial committee was formed by the Life
Insurance Settlement Association to define a mortality table
that is better suited to the risks seen in the life settlement market. Actuaries will need to maintain an active role in evaluating
market experience and in translating risk assessment processes
to expected mortalities for proper evaluation of policies.
Changing regulations always have the potential to affect the future value of a portfolio. It is important to recognize that laws
and regulations vary by state and that further constraints may
be placed on the market through the Securities and Exchange
Commission (SEC) and other federal agencies.
The legality of life settlements is well established and not an
issue. Regulation has dealt more with process and issues related to insurable interest. An example of a regulation focused on
insurable interest is the National Association of Insurance Commissioners’ Model Regulation that creates a five-year ban on
settlement of new policies, subject to various exceptions. This
regulation is designed to reduce or eliminate issuance of stranger-originated life insurance policies (see Page 22).
The Government Accountability Office and the SEC most
recently have recommended that the life settlement market be
subject to SEC rules because life settlements function as an investment product. While debate continues on these issues, changes of
this type certainly will transform portions of the market.
To mitigate policy-related risks, an appropriate amount of
due diligence is performed whenever a fund closes on a policy
to ensure that the fund can become the rightful owner and beneficiary under the policy. A legal review considers issues such as
insurable interest, right to transfer the policy, and compliance
with applicable laws and regulations. An actuarial review focuses on financial data and adjustments for existing cash values,
premiums paid to date, and other factors affecting the policy’s
value at the time the sale was closed. Reputable law firms and actuarial firms generally are retained to provide these services on
an independent basis for funds that are accumulating policies.
Investors also need to ensure that funds are constructed using the most efficient tax structure. This work usually requires
a reputable law firm with solid experience in life settlement
taxation and, often, in international tax agreements. Actuarial
models should consider potential tax obligations based on the
fund’s jurisdiction and structure.
Because of the possibility of someone living longer than expected, life settlements carry an asset extension risk. This often
has been underestimated by mortality models used in the life
settlement market. One reason is the common market practice
of applying level mortality multiples over the entire mortality
curve. For many ailments, this approach does not give an appropriate representation of mortality. The life settlement actuary
needs to rely on mortality research and expertise to make appropriate adjustments for the pricing and valuation of policies.
It’s also important for the actuary to understand a policy’s
sensitivity to life expectancy extension and to account for this
appropriately in evaluating policy value. If life expectancy is
extended 10 percent, it will reduce the return on the policy.