Sunday, October 18, 2009

Few Deals, Much Interest

The Oct. 13 release of a report on life settlement securitizations authored by Standard & Poor’s Corp., New York, is just the latest in renewed interest in life settlement securitizations. Like life insurance, mortgages or any other asset, these transactions pool policies, cut them up like a pie into bonds and sell pieces to investors.

The S&P report says that life settlement securitizations have “attracted investors’ interest in waves over time.” And, it continues, there is renewed interest expressed in the investment class. It goes onto say that investors and originators can see potential benefits such as a lack of correlation to the economy, but there are also inherent risks.

Among the risks and difficulties it cites are the accuracy of actuarial assumptions on the 100+ lives that underlie a transaction. The report, “Uncovering The Challenges In Rating Life Settlement Securitizations,” cites the potential for cash flow mismatch and the uncertainty it creates for payment to investors. S&P analysts Winston Chang and Gary Martucci write that statistical credibility is unlikely to be achieved with a pool of less than 1,000 lives. And factors examined including age, smoking status and gender is not broad enough. Factors including genetic information, occupational histories and living environments also need to be considered, according to Chang and Martucci.

S&P cites a second concern over the ‘insurable interest’ of policies which are sold to an investor and then packaged and sold again to investors who purchase securities. ’If there is an abuse of insurable interest can the policy be enforced?’ the rating agency asks.

The agency also cites a third concern: the accuracy of independent medical reviews used by originators in these securitizations. It goes on to explain that in mortality underwriting insurers “misunderwrite” a very limited portion of their policies and the law of large numbers minimizes that action. In the case of life settlements, the impact is less clear, according to S&P. It states that medical underwriters get a flat rate for each policy written and review the existing medical file rather than require a new physical exam, leaving open a greater risk for underwriting error. It also cites limited historical data comparing projected and actual mortality rates.

Chang and Martucci also raise the issue of the timing of cash flows, noting that a statutory period for payment of death benefits is not as defined as predetermined payment dates for notes. The potential cash flow mismatch could result in a missed payment and default, it added. It also cites a situation where the death of the individual cannot be verified, creating the possibility of years of delay in a payment of a death benefit.

S&P leaves open the possibility of rating these transactions after it addressed the concerns cited in the report and created and published criteria for rating securitizations of this asset class.

To get a better sense of where this market is going, I think it is also worthwhile to read testimony delivered on Sept. 24 before the House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises ( Several threads came out of that testimony: there have been only a handful of life settlement securitizations, there are a limited amount and type of policies that would be suitable for securitization, so the market’s growth may well be exaggerated; and this is a market that is only suitable for institutional investors.
So, the issue of whether life settlement securitizations ever grow big enough to become a cause for concern may never materialize.

And in theory, one would assume that the fact that institutional investors who are supposed to be conducting due diligence efforts would take care of some of the issues raised by the S&P report including how medical underwriting is done. Then again, given how much due diligence was done on RMBS, maybe that is too optimistic. But nevertheless, the institutional investors who package these transactions and the buyers of these bonds will for the most part be sophisticated investors, not your average investor.

On the issue of insurable interest, there is the potential that there are STOLI policies in the marketplace that could end up in these pools. But with efforts of the National Association of Insurance Commissioners, Kansas City, Mo. and the National Conference of Insurance Legislators, Troy, N.Y., legislation is popping up in states to attempt to tamp down stranger originated policies. Differences exist in the models developed by these organizations and there are differences in philosophy among trade groups weighing in on them including the American Council of Life Insurers, Washington, and the Life Insurance Settlement Association, Orlando, Fla., but the one commonality is the opposition to STOLI.

So, if a regulatory-legislative effort is successful, STOLI may not go away but may be diminished to the point that this could be scratched off S&P’s list of concerns.

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