Life Settlement-Backed Securities

fugui Financial
Career Workshop
An emerging market backed by $15 trillion and growing life insurance assets
(lsbs)
LIFE SETTLEMENT-
BACKED SECURITIES
NOVEMBER 2010
© 2010 by R. Brezeck Wang, fugui Financial Career Workshop.

All Rights Reserved.
http://fuguifinancial.com
Contact Information
R. Brezeck Wang
Analyst
+1 206 601 7853
brezeck@gmail.com
William Li
Strategist
+1 626 202 9836
williamlee1988@gmail.com
fugui Financial Career Workshop

fuguifinancial.com
fugui Financial Career Workshop (fFCW) is a student-

run financial career & research workshop established
in 2010 by two dedicated students, William Li ’12,
University of California, Irvine, and Brezeck Wang ’14,
Hobart College. Backed by powerful technologies and
resources, fFCW conducts research on global economy,
stocks, and financial derivatives including options and
asset-backed securities.
This is for reference only

1 Investors should consider the investment objectives, risks, charges, and expenses carefully before investing
© 2010 fugui Financial Career Workshop All Rights Reserved
Contents
Introduction ..................................................................................................................................... 3
Understanding Life Settlement ....................................................................................................... 4
History of Life Settlement............................................................................................................ 4
How Does It Work ....................................................................................................................... 4
Current Condition of the Market................................................................................................. 5
A Critical Analysis on LSBS ............................................................................................................... 7
Definition of LSBS ........................................................................................................................ 7
The Framework of LSBS ............................................................................................................... 7
Possibility of Securitization of Life Settlements .......................................................................... 8
Comparison with Mortgage-backed Securities ........................................................................... 9
Valuation of Life Settlement-backed Securities ............................................................................ 10
Conclusion: The Future of Life Settlement-backed Securitization ................................................ 11
References ..................................................................................................................................... 12
Goldman Sachs Group, Inc.

200 West Street, New York, NY

Introduction
In January 2004, the first life settlement-backed security (LSBS) was underwritten by Tarrytown
Second, LLC. It was a $63 million, class A Life settlement securitization backed by $195 million
face value of life insurance policies. In April 2004, Legacy Benefits settled another deal with $70
million face value, in which $61.5 million was rated as A1 by Moody’s. But life settlement and its
securitization are unknown by most people. This report briefly talks about the life settlement
business and the securitization of settled life insurance policies – the framework, possibility,
valuation process, features and risks.
Life settlement business is derived from the former viatical settlement services during 1980’s for
HIV infected individuals at that time. Life settlement (a.k.a. senior life settlement) is, different
from viatical settlement, a new option for senior policy holders to jump out of the policy with a
considerable amount of cash, a lot more than cash surrender value paid by the insurers. LSBS is
backed by these settled insurance contracts, so it is crucial to analyze this secondary market
before we step into its securitization market.
As a kind of asset-backed security, life settlement-backed security is much different from those
other ABSs, for example the most famous mortgage-backed securities (MBS). This difference
both contributes to its favorable characteristics, and at the same time causes its sluggish
development over time. We will talk about the features and risks of life settlement-backed
securitization, with a comparison to mortgage-backed securitization. Then, we will analyze the
unknown future of this newly born type of securities. Finally, we introduce the concept of
valuation of LSBS.

Understanding Life Settlement
History of Life Settlement

The conceptual origin of this secondary market of life insurance can date back to the 1911 U.S.
Supreme Court case of Grigsby v. Russell, in which Justice Liber Wendell Holmes stated that life
insurance should be "transferable without limitation" by the policy owners. The reasoning was
that life insurance is one of the best recognized types of investment, fulfilling requirements for a
transferable property such as like bond and stock. This idea was once practiced as viatical
settlement during 80’s and 90’s when AIDS was incurable. Men diagnosed with AIDS were
usually homosexual, without worries about distributing fortune to wives and kids, while they
needed an amount of cash to cover the medical expenditures. They could then sell their life
insurance policies to brokers and instantly generate a large amount of cash. But this idea was
not favored by investors because of the small number of these cases. Also, the medical science
community has learnt a lot more about this disease since then. Infected individuals’ life
expectancies are extended and some of them are even cured.
Today, the concepts of viatical settlement and life settlement are separated. The former only
deals with people diagnosed with AIDS and other terminal ills, while the latter is also known as
senior life settlement, describes purchasing life insurance policies from elderlies. But in practice,
life settlements also involve policy holders who are diagnosed with terminal diseases like cancer.
How Does It Work

In one word, trading life insurance policies is betting on the early death of insured individuals,
which is not tasteful to investors.
However, the truth is that most insurance contracts, especially those high-value senior life
policies ever eventually go to lapse (see Exhibit 1). As one gets older, a policy is likely to become
more and more unnecessary to her, or he just could not afford the annual premiums anymore.
In contrast to the amount generated from a life settlement deal, the cash surrender value seems
really dim, which is usually only three or four percent of the benefit. The life settlement brokers
seize the opportunity to make profit from life insurances of the old.
The life settlement business works as an investor takes out a high-value policy from the insured
person at a pleasant price, which could be three to four times as the surrender value, according
to the premium rate and the insured’s life expectancy. The investor will then have to pay all the
future premiums to keep the contract active. The investor could obtain the death benefits as
payoffs when the insured dies. Then the return spread should be:
Return = Death Benefit – (Premiums + Purchase Price)
From the spread formula, we can tell that the longer the insured individual lives, the less profit a
life settlement could yield.

Exhibit 1: Surrender/Lapse Ratio in Life Insurance Industry (Source: ACLI Fact Book 2009)
8.00%
7.00%
6.00%
5.00%
Surrender/
Lapse rate 4.00%
by face &
amount 3.00%
2.00%
1.00%
0.00%
2004 2005 2006 2007 2008
Lapse rate 5.40% 4.90% 4.90% 5.10% 6.10%
by amount 5.90% 5.60% 5.80% 5.50% 6.80%
Surrender rate 1.60% 1.70% 1.40% 1.30% 1.50%
by amount 1.10% 1.30% 1.10% 1.10% 1.10%
Current Condition of the Market

As the life settlement business grows, more and more policies could be traded within the
secondary market. Several hundred high-value senior life insurance policies could be pooled and
securitized into what we are talking about next: life settlement-backed securities. 2004 was a
milestone for life settlement-backed securitization. In January that year, Tarrytown Second, LLC
underwrote a $63-million, class-A life settlement security backed by $195 million face value of
life insurance policies; soon in April, Legacy Benefits settled another one with $70 million value.
Meanwhile, most LSBSs are small and private, without being rated by major rating agencies or
even known by most investors.
Still, we have to analyze the situation of life settlement market before stepping into its
securitization. Employer-sponsored retirement benefits have disappeared in the U.S. for a long
time. As we said, the premium rate of a life insurance can be too high for a senior policyholder,
whereas many elder policyholders need cash to maintain life or to cover medical expenses..
Major players in life settlement market argue that it is totally legitimate and good to senior
policyholders who need money, while the opponents, majorly insurers, criticize this business as
it cut the lapse/surrender ratio of life insurance policies and erode these firms’ profits.
Fast growth of this market also is companied with ever-increasing domestic life expectancy.
According to the latest data from U.S. National Center for Health Statistics, life expectancy at
birth keeps going up to 77.9 years in 2007. While life expectancy is longer, death rate also
dropped significantly as the death rate of seniors over 65 decreased by over 2%. Society of
Actuaries (SOA) also decreased the mortality rates of all ages in the latest 2008 Valuation Basic
Table. Yet, the estimates among insurance agencies seemingly do not catch up with the actual

figure. This misestimate can cause unreasonably high premiums for life policies and boost up the
development of life settlements. But life extension is not always a good signal for life settlers –
longer life expectancy often erodes the profitability of life insurance transactions, as we
mentioned earlier.
How fast is this secondary market growing? In October 2008, Conning Research estimated that
life settlement transactions totaled up to approximately $12 billion in face value during 2007,
from $6.1 billion in 2006. During the meltdown over the last two years, this market did not
shrink like other parts of the financial system. Dramatically, during the time of credit crunch and
tightened budget, selling the life insurance policy would be a perfect solution for extra cash.
Conning estimated that the size of the market will approach $21 billion by 2012 and in 2017 this
figure will fly to $177 billion, whereas fFCW sees even more in long term due to the new wave of
baby boom. Still, the secondary market is very small comparing to the primary market –
according American Council of Life Insurers (ACLI)’s Fact Book 2009, major insurers hold over 10
trillion dollars insurance assets, while fFCW estimates that the size of the entire U.S life
insurance market exceeds $ 15 trillion.
Overall, the prospect of life settlement is fairly positive. And the high growth rate of this market
brightens the possibility of securitization of life settlements.

A Critical Analysis on LSBS
Definition of LSBS
Sometimes called longevity derivatives, mortality bonds, or death bonds, life settlement-backed
securities (LSBS) are asset-backed securities (ABS) which are collateralized by life insurance
policies, linked to this fast-growing life settlement business. Before analyzing the securitization,
we want to discuss more about its framework.
The Framework of LSBS

Exhibit 2: The Flow Chart of Life Settlement-backed Securitization
The securitization of Life settlements involves a collection of life insurances purchased from
senior policyholders. The originator pools policies and securitizes the cash flows of the death
benefits and premiums of policyholders, the insured. Then the originator will sells the securities
to asset management firms and hedge funds. During this process, the originators will ask
evaluation agencies to evaluate each policy and perhaps the medical records of the former
policyholders. Larger-sized securities might be structured by investment banks. In order to

receive the death benefits paid by insurance companies, the holder of the security must
guarantee the associated premiums until the death of the insured.
Possibility of Securitization of Life Settlements

To analyze the possibility, we should first know about the features and risks of LSBS.
The biggest risk of life settlement and the securitization is, apparently, the unpredictability of
the time of deaths. It is not like mortgage or other assets which have detailed records to analyze.
Betting against life insurances is by all means betting against deaths, which is not very tasteful.
Even though we might be able to analyze the insured individual’s health conditions, it is
impossible to estimate when the insured will die, especially specified to a certain day. But
securitization combines several hundreds to thousands of policies purchased from people with
different health conditions, ages, and other factors. And if we look into this we could find that
the deaths over time are nearly normally distributed, enabling us to analyze quantitatively:
Exhibit 3: Expected Annual Mortalities (Male at age of 50, totally 1,000 people)
DEATHS
60
50
40
30
20
10
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
Duration
We use the mortality rate in SOA’s 2008 Valuation Basic Table (SOA 2008 VBT) and adjusted the
table according to the data from U.S. National Center for Health Statistics and our own estimate.
The reality here is, again, American elderlies live a lot longer than SOA and insurers assume, and
the premium rate is unreasonably high. In other words, the market of life insurances is not
efficient, where information and reality could not instantly affect the value and price of assets in
this market. This situation enables investors to engage arbitrage in a pool of almost-30-trillion-
dollar assets. As life settlement business booms, the securitization of insurance policies could be
favored by alternative investors.

Backed by life insurance policies, the securitization is by all means also collateralized by the
insurer’s ability to pay back. While major insurers usually do not have problem paying excessive
death benefits (life settlements can actually cut surrender values for insurers, which is five times
more than benefit expenses every year), small insurance firms would face this awkward
situation. If the securitization grows to a considerable size, it would definitely change the profit
curve of life insurance industry. Thus, LSBS has insurer default risks.
Another risk would be regulatory risk. The regulation on life settlement is on state-basis. As of
January 2009, 42 states have regulations over life settlements. Usually these regulations require
life settlement brokers to obtain the license to engage in this business, with a concern of the
controversy of life settlements and the securitization. SEC starts to notice this fast-growing
market now and a national regulation on life settlement is likely to be advanced soon. Over-
regulation and the absence of government support would definitely slow down its development.
Other risks and dangers include the unsavory business – stranger-oriented life insurance (STOLI),
morality, ethnics, and reputation risks.
As the market is growing really fast, securitization experts will keep focusing on the highly
controversial but lucrative asset class. After all, the future of life settlement-backed securities
finally depends on the consensus within the investment community.
Comparison with Mortgage-backed Securities

To further understand the distinct features of LSBS, we find it useful to compare it with MBS.
The majority of mortgage-backed securities are issued by U.S. Government and government-
sponsored enterprises (GSE), including Ginnie Mae, Fannie Mae, and Freddie Mac. The sellers
are major banks that issue mortgages. After September 2008, Fannie Mae and Freddie Mac are
all controlled by the government. Along with Ginnie, the three GSEs and their bonds are now
explicitly guaranteed by the U.S. Government. While there are $14 trillion mortgage debts all
over the country, the size of mortgage-related securities is over $8.9 trillion. These mortgage-
backed securities are collateralized by the mortgages and the borrowers’ monthly payments,
generating monthly interest rate cash flow.
However, as we introduced, most life insurance policies are settled by private entities, so are
the securities backed by the policies. The total value of life insurance policies is similar to that of
mortgage debts, but the size of life settlement-backed securities is only $12 billion. The sellers
are senior individuals who want to sell their policies for cash. These securities are not
guaranteed by U.S. Government, however, collateralized by the insurers’ abilities to pay death
benefits. One significant feature of LSBS is that these securities do not generate periodical
interests, but the bond holder must pay yearly premiums. Security holders, however, can collect
death benefits after the deaths of insured people.
Generally, LSBS is much safer than MBS. But it is so much different from the more popular MBS
so whether it will be accepted by investors or not is still a question.

Valuation of Life Settlement-backed Securities
Although we have not come up with a detailed valuation model for LSBS, we do want to
introduce the idea of the valuation of LSBS.
Suppose a pool of life settlements to be securitized initially has settlers. Equation (1)
describes the settlers left in the pool over time by deducting the sum of deaths over time t.
∑ (1)
As showed in Exhibit 2, the cash flow of the securitization consists of the premiums of all settlers
left in the pool and the one-time benefits of all deaths. We could look into the cash flow from
individual policies. Assume the premium rate is P, and the benefit would be B. And for simplicity
we assume that B and P are equal for each settler over time. Then,
……
(2)
Then the value of the securitization, V, would be the sum of all cash flow generated, discounted
by risk-free rate, . Then, Equation (3) then gives the most basic valuation model for life
settlement-backed securities.
∑ ⁄ (3)

Conclusion: The Future of Life Settlement-backed Securitization
The future of the security is based on the future of life settlement market. With a new wave of
baby boom, life insurance, one of the most fundamental investment tools will definitely see a
huge boom in future not far from us. Meanwhile, the average age of U.S. citizens is becoming
older and older – last generation of baby boom is going into their twilight years. In addition, the
life expectancy of American people is increasing in the same rate with the average rate, beyond
consensus of insurer community, making the premium rates unreasonably high. With all these
factors, life insurance policies can be a burden when people become old. Life settlement, as a
legacy of viatical settlement in 70’s, becomes a considerable option for these elderlies.
While securitization of life settlements has nothing to do with these insured, it is a financing
approach for companies investing in life settlements. Securitized pool of policies gives these
investors opportunities to reallocate the life settlements and the life extension risks behind
them, just like mortgage-backed securities. However, different from MBS, LSBS is backed by the
life insurance market, which is much more stable less influenced than most other markets, for
example, mortgage, which is greatly affected by the situation of economy.
We believe that the biggest challenge for the securitization of life settlements is not life
extension risk. However, this emerging market faces two major problems:
1. The obstinate resistances from insurance giants like MetLife, New York Life, ING, etc.
They claim that life settlement would erode their profitability. In our opinion, life
settlements, if appropriately utilized, can actually benefit major insurers. First, the
amount of surrender value paid to policyholders is almost 5 times that of the benefits
paid to beneficiaries. Life settlements can decrease this expenditure, and investors are
more interested in trading securities than holding it and waiting for the death benefit.
Second, AIG owns a huge amount of life settlements in order to hedge its portfolio of
policies. Life settlement could be beneficial to insurers in some ways;
2. Trading life insurance policies, fundamentally, is betting on early deaths. This does not
sound very tasteful but this is the truth. Whether life settlements and the securitization
will be accepted by most security specialists is questionable. More terribly, if not well-
supervised, unsavory actions like STOLI will happen which is detrimental to the life
settlement market, the investors and the whole financial industry, destroying the
reputation of Wall Street.
But overall, life settlement-backed securitization has a lot to be expected. Today, if only ten
percent of the surrendered policies are instead settled, there would be almost $100 billion flow
into the market of life settlement. We are going to keep track of this upbeat market and conduct
more in-depth research on it.

References
Stone, Charles A., Anne Zissu. “Securitization of Senior Life Settlements: Capturing Value from
Early Death”. The Journal of Derivatives. Vol. 13, No. 3: pp. 66-72. New York: Institutional
Investor Journals. Spring 2006.
DBRS, Inc. “Selected Commentaries: Life Settlement ABS Developments”. New York: DBRS, Inc.
June 2008.
Bhuyan, Vishaal B. Life Markets: Trading Mortality and Longevity Risk with Life Settlements and
Linked Securities. Hoboken: John & Wiley Sons, Inc., 2009.
American Council of Life Insurers (ACLI). Research Report: ACLI Life Insurers Fact Book 2009.
Washington D.C.: American Council of Life Insurers, 2009.
Fasano, Michael. “Securitization of Life Settlement Cash Flows” Washington D.C.: Fasano
Associates. October 31, 2008.
Xu, Jiaquan, Kenneth D. Kochanek, Sherry L. Murphy, Betzaida Tejada-Vera. “Deaths: Final Data
for 2007”. National Vital Statistics Reports. Vol. 58, No. 19. Atlanta: National Center for Health
Statistics. May 20, 2010.
Society of Actuaries (SOA). 2008 Valuation Basic Table. Schaumburg: Society of Actuaries.
Revised, June 16, 2009.
The Securities Industry and Financial Markets Association (SIFMA). “US Bond Market
Outstanding (2010 Q2)” New York: SIFMA. October 15, 2010.
PIMCO. “Bond Basics: Mortgage-Backed Securities” Newport Beach: PIMCO. February 2009.


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fugui Financial

© 2010 by R. Brezeck Wang, fugui Financial Career Workshop.

fugui Financial Career Workshop

fugui Financial Career Workshop (fFCW) is a student-

This is for reference only

Goldman Sachs Group, Inc.

This is for reference only

This is for reference only

History of Life Settlement

How Does It Work

Return = Death Benefit – (Premiums + Purchase Price)

This is for reference only

Current Condition of the Market

This is for reference only

This is for reference only

The Framework of LSBS

This is for reference only

Possibility of Securitization of Life Settlements

This is for reference only

Comparison with Mortgage-backed Securities

This is for reference only

This is for reference only

This is for reference only

This is for reference only

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