Issues InIssues In Life Settlement SecuritizationLife Settlement Securitization

A.M. Best CompanyA.M. Best Company

Emmanuel ModuEmmanuel Modu

Managing Director & Global Head of Structured FinanceManaging Director & Global Head of Structured Finance

A.M. Best WebinarA.M. Best Webinar

May 8, 2008May 8, 2008

Copyright Copyright © © 2008 by A.M. Best Company, Inc., Ambest Road, Oldwick, NJ 08858. ALL RIGHTS RESERVED. No part of this document may be distributed in 2008 by A.M. Best Company, Inc., Ambest Road, Oldwick, NJ 08858. ALL RIGHTS RESERVED. No part of this document may be distributed in any electronic form or by any means, or stored in a database or retrieval system, without the prior written permission of the A.M. Best Company.any electronic form or by any means, or stored in a database or retrieval system, without the prior written permission of the A.M. Best Company.

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A life settlement is an insurance policy sold by the owner for: an amount less than the face value of the policy; and greater than the surrender value.

Purchaser pays: future premiums; and collects death benefits.

Life expectancy (LE) generally ranges from 3-12 years.

The insured generally is older than 65.

Definition/Characteristics of Life Settlements

33

The life settlement market is acknowledged to have begun in earnest in 1998/1999 after the viaticals market came to a stand still.

Size and market growth figures are elusive.

A.M. Best is studying market size – most commonly quoted figure for 2007 is $12B to $15B.

Size of Life Settlement Market

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Types of Insurance Policies Involved

• Generally universal policies but can include whole life, term, etc.

• Universal policies can have cash values that can be used to change the premium payments.

• Investors generally reduce premium payments to the minimum level necessary to keep the policy in force.

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Supply Chain To Investors

Policy OwnersPolicy Owners

Insurance AgentsInsurance Agents

BrokersBrokers

ProvidersProviders

INVESTORSINVESTORS

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More institutional investors have been considering participating in the market – more are joining the crowd at every industry conference.

Financial institutions are looking into how to reduce transaction costs by eliminating intermediaries.

Policy supply will remain scarce and expensive, causing more industry participants to buy policies in contestability period and/or get involved in premium finance transactions.

Emerging losses by investors in funds originated 5 or 6 years ago will lower return expectations of new market participants.

Loan Programs Supported by Insurance Companies Will Increase

Loan programs in which insurers can offer loans to policyholders in an amount greater than the policy’s cash surrender value (Access Plus loan program by New York Life – see April 28, 2008 issue of BestWeek)

Loan programs such as Legacy Loans offered by an independent funding group, Legacy Funding Group, to insureds.

NAIC is considering the feasibility of a model law that would allow insurers to offer loans to policyholders in an amount greater than the policy’s cash surrender value.

Market Situation

77

Effective regulatory oversight.

The emergence of new initiatives supported by the life insurance industry to provide alternatives to the secondary market for life insurance policies.

Adoption of model guidelines from the NAIC and NCOIL regarding life settlements.

Emerging data on mortality trends in existing portfolios.

Pricing transparency, market efficiency.

Transparency of general methods employed by medical examiners for estimating life expectancies.

Securitization.

Factors That Will Influence Growth of Market

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Simplified Definition The process of transferring risk through the issuance of

securities to the Capital Markets.

General Hallmarks of Securitization Segregation of homogenous assets in bankruptcy-remote

special purpose vehicles (SPVs). Certification of a “true sale” of assets to the SPVs.

Predictability of the cash flows associated with the assets.

Creation of one or more tranches of securities sold to investors.

Securitization Definition

99

Simplified Securitization Transaction Diagram

Policy SuppliersLicensed Originators

of Life Settlement Policies/Policyholders

InvestorsNotes:

Tranche A...

Tranche Z

Life Policies Sold to Issuer Issuer

Bankruptcy-Remote Special Purpose

VehiclesCash from Issuer to

Suppliers or Insureds

Interest & Principal

Funding

Insurance Cos.

Death BenefitsPeriodic Premiums

Reserve Fund

Liquidity Facility

Payments From or To Liquidity Facility For Funding Shortfalls

in Premiums, Interest or Principal Payments.

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Providers: Licensed entities that facilitate the purchase of insurance policies in the secondary market – they are

also responsible for making sure that all sale documentation packages conform to applicable laws.

Medical Examiners: They generally review medical records in order to provide a mortality rating and/or life expectancy for

each insured.

Attorneys: They can help ensure that all sales and transaction documentations are complete, that the seller of a

policy has insurable interest in the life of the insured, that the providers used in the transactions are licensed, and privacy laws are observed.

Collateral Managers: They generally determine the policies that will be included in the transaction. In addition, they confirm

that the eligibility criteria has been met; perform policy optimization, deliver the sale documentation to the trustee; and are responsible for determining what actions to take (within the scope of the transaction’s legal documents) to avert a liquidity crisis.

Actuaries:

They can help assess the reasonability of the assessments provided by medical examiners; perform an underwriting review of medical examiners; and determine the appropriate mortality tables that should be used for the transactions.

Tracking Agents: They periodically check to see if the insured is alive or dead.

Critical Service Providers(See Methodology for Complete List and Full Description)

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• Pure viatical securitization:• Dignity Partners Funding Corp. I – $35mm in 1995.

• Pure life settlement securitizations:• Tarrytownsecond LLC – $63mm in 2004 (indicative rating, later

withdrawn). • RRLST III, LP – $166mm in 2006 (indicative rating, later withdrawn).

• Life settlement/annuity arbitrage securitizations:• Life Insurance and Life Annuity Based Certificates (LILACS) – Various

transactions averaging about $200mm in rated securities, totaling approximately $1.2 billion in rated securities from 2003 to 2004.

• Legacy Benefits Life Insurance Settlements 2004-I LLC – $70mm in 2004.

Rated Securitization Efforts So Far

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A.M. Best’s credit evaluations, which are primarily based on the first dollar of loss, comes in the form of:

Preliminary Assessment. A private assessment of a transaction collateralized by a projected collateral pool and a proposed

transaction structure.

Indicative Rating. A public rating based on a collateral pool that is 80% formed and a transaction structure.

Debt Rating. A public rating based on a completely formed collateral pool and a transaction structure.

A.M. Best’s Credit Assessment Categories

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General Eligibility Criteria(See Full Policy Eligibility Criteria in Methodology)

• Insurance company must have a “B+” rating or higher.

• Face value of the policy or policies related to one insured should not exceed 3.33% of the total face value of the pool.

• Face value of the policy or policies issued by a single insurance company should not exceed 15% of the total face value of the pool.

• Life expectancies should be issued by two medical examiners.

• Purchase of fractionalized shares of policies generally are not permitted.

• There must be confirmation that the policy has no outstanding debt.

• There must be confirmation from the insurance company that the policy is in force and not within the grace period.

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Regulatory/legal risks (insurable interest, fee disclosure issues).

Extreme market inefficiency (exorbitant transaction costs).

Lack of transparency of general methods employed by medical examiners for estimating life expectancies.

Longevity risk.

Ramp-up risk.

Correlation risk.

Credit risk of insurers.

Structural risk (e.g., no liquidity facility, reserves, etc.).

Risk Factors Faced by Investors

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Insurable interest doctrine says that the beneficiary of a life insurance policy must have:

a relationship by blood or by law to the person being insured; and

an economic interest in having the life, health or bodily safety of the individual insured continue.

An individual has unlimited insurable interest in his or her own life – therefore he/she can sell his/her own policy to anyone.

Insurable interest may not exist in certain trusts set up to hold insurance policies.

Risk Factors Faced by InvestorsRegulatory/Legal Risks– Insurable Interest Tenet

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Fee structure.

Example — Undisclosed fees, particularly when fees may be perceived to be excessive, may invite regulatory scrutiny.

Tax obligations.

Suitability issues:

Example — Inducing insureds to dispose of perfectly good policies and to buy others for the sole purpose of generating commissions will invite regulatory scrutiny.

Risk Factors Faced by InvestorsRegulatory/Legal Risks – Miscellaneous

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We crudely gauge market efficiency by measuring transaction cost as the difference between Market Value and Economic Value.

• In general, transaction cost can be as high as 50%-70% of the payment to insureds – in some cases, such a cost can be over 100%.

• High transaction cost is not conducive to an efficient securitization.

Extreme Market InefficiencyRisk Factors Faced by Investors

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Policy OwnersPolicy Owners

Insurance AgentsInsurance Agents

BrokersBrokers

ProvidersProviders

INVESTORSINVESTORS

Risk Factors Faced by Investors Extreme Market Inefficiency (cont’d)

Intermediaries Intermediaries Receive 50% of Receive 50% of Economic ValueEconomic Value

Assume Insureds Assume Insureds Receive Receive

Economic ValueEconomic Value

Investors Pay Investors Pay Market Value = Market Value =

150% of 150% of Economic ValueEconomic Value

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Risk Factors Faced by InvestorsLack Of Transparency in Life Expectancies

• Medical examiners use a “debit” and “credit” system that quantifies how an insured’s health deviates from standard mortality.

• Example: If an insured assigned a debit of 50%, this means that his/her mortality is 50% above “standard mortality,” i.e., 150% of standard – this factor (150%) is commonly referred to as the mortality multiplier.

• The system requires that the medical examiner establish a reference mortality experience – a mortality table that represents a combination of risks that are preferred, substandard and standard. (See 5th edition of Brackenridge’s Medical Selection of Life Risks, Chapter 5 ).

• The mortality multiplier is applied to that mortality table to arrive at the life expectancy of the insured.

2020

• Life expectancy based on a standard mortality table such as VBT 2001 is 13.8 years for a 75-year-old male non-smoker;

• Life expectancy for same insured based on impaired mortality multiplier of 150% is 11.8 years.

Lack Of Transparency in Life Expectancies (cont’d)

Survival Probability by YearCohort of 75-Year-Old Non-Smoker (150% Mortality Rating)

Standard Mortality Table is 2001 VBT

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

Year

Cu

mu

lati

ve S

urv

ival

Pro

bab

ilit

y

Survivorship Based on Standard Mortality Table (LE=13.8yrs)

Survivorship Based on Impaired Mortality Table (LE=11.8yrs)

Risk Factors Faced by Investors

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• Medical examiners typically provide a mortality multiplier and a life expectancy – insufficient data for evaluating the mortality risk of an insured.

• For proper analysis, one needs the standard mortality table used by the medical examiner.

• However, users of medical examiner mortality ratings and life expectancies generally assume that medical examiners use the 2001 VBT (or a derivative, thereof) as their standard table. (Use of 2008 VBT may be on the horizon).

Lack Of Transparency in Life Expectancies (cont’d)Risk Factors Faced by Investors

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There are significant differences between life expectancies from one medical examiner to another.

909 life expectancies issued by 3 medical examiners on exact same lives: ages 75 to 79 and male/female split of 66%/34%.

After averaging life expectancies for each medical examiner, the largest difference in average life expectancies issued by any pair of medical examiners was 24 months, and the smallest difference was 8 months.

Differences in life expectancies can be due to different methodologies used by the various medical examiners, systematic mis-estimation of life expectancies by medical examiners, etc.

Assumptions about life expectancies can have a dramatic impact on the internal rate of return (IRR) of a portfolio of life settlements.

Risk Factors Faced by InvestorsLongevity Risk & Mis-Estimation of Life Expectancies

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Effect of LE on IRR -- A Real Portfolio Consisting of 150 Life Settlements

Increase in LE (Months) IRR (%)

0 (Base) 12.4

3 11.6

6 10.7

9 10.0

12 9.2

15 8.5

18 7.8

21 7.1

24 6.5

27 5.9

30 5.3

33 4.7

36 4.3

Risk Factors Faced by InvestorsLongevity Risk & Mis-Estimation of Life Expectancies (cont’d)

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• The standard mortality table(s) used to estimate life expectancies.

• The various changes in methodologies or procedures.

• The results of any experience studies and how changes in methodology are accounted for in the studies.

• Source materials such as reinsurance manuals and clinical studies used to determine mortality ratings or life expectancies.

• How is co-morbidity handled?

• Are mortality improvements factored into mortality ratings or life expectancy figures?

• Is “age near” or “age last” the applicable age used for the evaluation?

• Are flat extras used? If so, for what diseases?

General Issues/Questions To Be Addressed by Medical ExaminersRisk Factors Faced by Investors

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Ramp-Up Risk

A sizeable portfolio of life settlements is necessary for stable economic A sizeable portfolio of life settlements is necessary for stable economic value.value.

Investors are competing with other investors for scarce policies – Investors are competing with other investors for scarce policies – especially policies with low life expectancies.especially policies with low life expectancies.

““Hit ratio,” the number of policies an investor bids on and wins versus the Hit ratio,” the number of policies an investor bids on and wins versus the total policies he/she sees can be as low as 1%-3% depending on the IRR total policies he/she sees can be as low as 1%-3% depending on the IRR hurdle rate.hurdle rate.

Risk Factors Faced by Investors

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Distribution of Portfolio Economic ValuePortfolios of 100, 200, 300, and 400 Policies with LE of 9.6 Years

Mean Economic Value = 19% of Total Death Benefits

0%

5%

10%

15%

20%

25%

5% 7% 9% 11%

13%

15%

17%

19%

21%

23%

25%

27%

29%

31%

33%

Portfolio Economic Value as a Percentage of Total Death Benefits

Fre

qu

ency

Dis

trib

uti

on

100

200

300

400

400 Policies400 Policies

100 Policies100 Policies

Issues Faced by InvestorsRamp-Up Risk – Portfolio Size (cont’d)

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Life Expectancy Range(Months)

Frequency Distribution

Cumulative Probability

<=24 0.30% 0.30%

>24 <=48 1.80% 2.10%

>48 <=72 5.60% 7.70%

>72 <=96 10.70% 18.40%

>96 <=120 15.90% 34.30%

>120 <=144 16.70% 51.10%

>144 <=168 16.90% 67.90%

>168 <=192 14.50% 82.40%

>192 <=216 9.60% 92.00%

>216 <=240 5.00% 97.00%

>240 <=264 2.20% 99.20%

>288 0.80% 100.00%

Issues Faced by InvestorsRamp-Up Risk – Scarcity of Short Life Expectancies

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Issues Faced by InvestorsCorrelation Risk

Lives can be correlated if there is a cure that affects all individuals with Lives can be correlated if there is a cure that affects all individuals with similar diseases – HIV/AIDS for example.similar diseases – HIV/AIDS for example.

While cures are good for the afflicted and good for society, they diminish While cures are good for the afflicted and good for society, they diminish investment returns because they can extend life.investment returns because they can extend life.

It is difficult to measure the likelihood of cures for diseases and the effect It is difficult to measure the likelihood of cures for diseases and the effect on mortality.on mortality.

Diversity of diseases is the best way to hedge against correlation of lives.Diversity of diseases is the best way to hedge against correlation of lives.

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Disease Or Category Examples Maximum Limits

Cardiovascular Coronary Artery Disease, Arrhythmia,Other (e.g. Heart Valve Disease)

50%

Cerebrovascular Stroke, Carotid Artery, Transient Ischemic Attack

20%

Dementia Alzheimer, Multi-Infarct 20%

Cancer Lung, Prostrate, Breast, Hematological, All Other Cancers

25%

Diabetes 10%

Respiratory Diseases Emphysema, Asthma, Sleep Apnea, Chronic Obstructive Pulmonary Disease

20%

Neurological Disorders (Excluding Alzheimer)

Parkinson’s Disease, Lou Gherig’s Disease (ALS)

15%

Other Renal failure, Peripheral Vascular, etc.

20%

No Disease 100%

Multiple 40%

HIV/AIDS 0%

Issues Faced by InvestorsCorrelation Risk (cont’d)

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Best’s Idealized Default Rates of Insurers*

(Financial Strength Ratings Based on the Issuer Credit Rating Scale)

aaa aa+ aa aa- a+ a a-

Years              

1 0.034% 0.064% 0.113% 0.162% 0.212% 0.231% 0.270%

2 0.105% 0.318% 0.437% 0.556% 0.674% 0.736% 0.888%

3 0.199% 0.576% 0.761% 0.945% 1.130% 1.252% 1.509%

4 0.315% 0.838% 1.085% 1.332% 1.579% 1.758% 2.131%

5 0.449% 1.103% 1.409% 1.715% 2.021% 2.253% 2.752%

6 0.602% 1.371% 1.733% 2.094% 2.456% 2.738% 3.369%

7 0.772% 1.643% 2.057% 2.470% 2.884% 3.213% 3.981%

8 0.956% 1.918% 2.380% 2.843% 3.306% 3.677% 4.585%

9 1.154% 2.196% 2.704% 3.212% 3.720% 4.131% 5.179%

10 1.363% 2.479% 3.028% 3.578% 4.128% 4.575% 5.762%

11 1.583% 2.764% 3.352% 3.941% 4.529% 5.009% 6.331%

12 1.812% 3.053% 3.676% 4.299% 4.923% 5.432% 6.884%

13 2.048% 3.345% 4.000% 4.655% 5.310% 5.845% 7.419%

14 2.289% 3.641% 4.324% 5.007% 5.690% 6.247% 7.935%

15 2.535% 3.941% 4.648% 5.356% 6.063% 6.639% 8.428%

aaa aa+ aa aa- a+ a a-

Issues Faced by InvestorsCredit Risk

Derived from: Derived from: A.M. Best’s Idealized Default MatrixA.M. Best’s Idealized Default Matrix, December 5, 2007, December 5, 2007

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Regardless of medical examiner used, A.M. Best imposes a floor on LEs.

Get the Standard Mortality Matrix based on the 2001 VBT* for all the lives in the life settlement pool and calculate the life expectancy for this pool (LEstandard).

Get the Impaired Mortality Matrix for all the lives in the pool based on the mortality multiplier issued by the medical examiner and the 2001 VBT and calculate the life expectancy for this pool (LEimpaired).

If the quotient LEimpaired/LEstandard >=80%, use the Impaired Mortality Matrix as the Intermediate Mortality Matrix for the analysis.

If the quotient LEimpaired/LEstandard < 80%, adjust the Impaired Mortality Matrix by a multiplier such that the quotient LEimpaired/LEstandard = 80% -- the adjusted Impaired Mortality Matrix is the Intermediated Mortality Matrix used in the analysis.

Adjustments to Life ExpectanciesSecuritization Mechanics

*2008 VBT May Be Used In The Future*2008 VBT May Be Used In The Future

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Given the Intermediate Mortality Matrix, each mortality array in the pool associated with policy face value greater than or equal to $2mm is scaled down linearly from 80% (for face value of $7mm or more) to 100% (for face value of $2mm or less).

The new mortality matrix is the Final Mortality Matrix which is used for the base scenario in the analysis.

Adjustments to Life Expectancies (cont’d)

Securitization Mechanics

3333

The Final Mortality Matrix provides the probability of death for each life in the pool for each year.

Default risk and recoveries are assigned to each insurance company in the pool ( see Best’s Idealized Default Rates of Insurers).

Correlations are assigned or mortality ratings are decreased if concentration of diseases is excessive or not provided.

Monte Carlo simulations are performed to determine death benefit cash inflows, premium cash outflows, and other cash outflows associated with the waterfall.

Probability of ruin is calculated – i.e. probability that securities do not receive promised payments during the term of the transaction and at the maturity of the transaction.

Probability of ruin is tied to Best’s Idealized Default Matrix (see next page) to help determine the ultimate rating of the securities.

Securitization MechanicsModeling the Transaction

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Best’s Idealized Default Matrix

aaa aa+ aa aa- a+ a a- bbb+ bbb bbb-

Years                    

1 0.026% 0.034% 0.043% 0.053% 0.064% 0.113% 0.162% 0.212% 0.231% 0.270%

2 0.076% 0.105% 0.135% 0.227% 0.318% 0.437% 0.556% 0.674% 0.736% 0.888%

3 0.142% 0.199% 0.257% 0.417% 0.576% 0.761% 0.945% 1.130% 1.252% 1.509%

4 0.221% 0.315% 0.408% 0.623% 0.838% 1.085% 1.332% 1.579% 1.758% 2.131%

5 0.314% 0.449% 0.585% 0.844% 1.103% 1.409% 1.715% 2.021% 2.253% 2.752%

6 0.419% 0.602% 0.786% 1.078% 1.371% 1.733% 2.094% 2.456% 2.738% 3.369%

7 0.534% 0.772% 1.009% 1.326% 1.643% 2.057% 2.470% 2.884% 3.213% 3.981%

8 0.660% 0.956% 1.251% 1.585% 1.918% 2.380% 2.843% 3.306% 3.677% 4.585%

9 0.795% 1.154% 1.512% 1.854% 2.196% 2.704% 3.212% 3.720% 4.131% 5.179%

10 0.937% 1.363% 1.789% 2.134% 2.479% 3.028% 3.578% 4.128% 4.575% 5.762%

11 1.087% 1.583% 2.079% 2.422% 2.764% 3.352% 3.941% 4.529% 5.009% 6.331%

12 1.242% 1.812% 2.381% 2.717% 3.053% 3.676% 4.299% 4.923% 5.432% 6.884%

13 1.402% 2.048% 2.693% 3.019% 3.345% 4.000% 4.655% 5.310% 5.845% 7.419%

14 1.566% 2.289% 3.012% 3.327% 3.641% 4.324% 5.007% 5.690% 6.247% 7.935%

15 1.733% 2.535% 3.337% 3.639% 3.941% 4.648% 5.356% 6.063% 6.639% 8.428%

aaa aa+ aa aa- a+ a a- bbb+ bbb bbb-

Source: Source: A.M. Best’s Idealized Default MatrixA.M. Best’s Idealized Default Matrix, December 5, 2007, December 5, 2007

Securitization MechanicsModeling the Transaction (cont’d)

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Mortality rates – especially in the first 3 years of the transaction.

Annual mortality improvements.

Premium payments – though increase in cost of insurance is rare, it does happen.

Time between death and collection of death benefits – it can take up to 3 months to collect death benefits.

Insurance company impairments – recoveries are extremely high but no one is sure how insurance regulators will look at recoveries to SPVs in the future.

The potential for challenges by insurance companies on payment of death benefits based on the insurable interest doctrine.

The A.M. Best Rating Committee, which is responsible for assigning ratings to transactions, may require additional stresses.

A.M. Best’s Major Portfolio StressesSecuritization Mechanics

3636

Fee disclosures up and down the chain from the insureds to the investors.

A.M. Best’s comfort level with the medical examiners used in the transaction.

The infrastructure set up by the transaction’s collateral manager to price, optimize and track policies.

The involvement of actuaries in understanding mortality profile of the lives in life settlement pools and understanding insurance policy structures.

The performance of consistency checks on each and every policy to ensure that the underwriting of the original insurance policy was done with accurate information.

The ability and willingness of the transaction’s sponsor to provide surveillance data on a timely basis for monitoring the transaction.

The existence of back-up servicers (tracking agent, collateral manager).

The extent to which attorneys have certified the existence of insurable interest associated with each and every insurance policy.

A.M. Best’s Major Qualitative IssuesSecuritization Mechanics

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Emmanuel ModuEmmanuel ModuManaging Director & Managing Director &

Global Head of Structured FinanceGlobal Head of Structured Finance

+1-908-439-2200 x5356+1-908-439-2200 x5356emmanuel.modu@ambest.comemmanuel.modu@ambest.com

A.M. Best’s methodology, Life Settlement Securitization, published on March 24, 2008 can be downloaded from: http://www.ambest.com/ratings/methodology.html