LIFE SETTLEMENT

BUSINESS ADVISOR Review

„„ Managing Rate Increases and Unlocking the

Value of Life Insurance Policies

M
BY EDWARD HUI
anaging the risk of Especially in light of these re- carrier’s risk level. Finally, it
a Cost of Insurance cent developments, the author is important to recognize that a
(COI) rate increase believes that life settlement in- rate increase is a tail risk; it is
on in-force policies is an im- vestors should be more focused a reasonably low likelihood but
portant consideration for all on managing the risk of a rate potentially high severity event.
life settlement investors. If a increase. There are at least two
rate increase occurs, the conse- options available: an analysis of
“..a rate increase
quences could be very serious. the carriers themselves and a re- is a tail risk; it is Edward Hui is a specialist in old age
a reasonably low mortality and product development
However, there are multiple view of policy features. As will
and he frequently presents on the
factors to consider, as the risk be discussed below, where the likelihood but topics. He brings 15 years of ex-
and impact levels will vary sig- risk of a COI increase is man- potentially high perience from the insurance indus-
nificantly by carrier and prod- aged through a focus on policy try including pricing, research, and
uct. features, the solution is more
severity event”
valuation expertise. He is a member
The assessment of these items,
While COI rate increases have definite and can also signifi- of the 2008 and 2012 VBT Creation
in addition to the consequenc- Committee and the Individual Life
been very rare in the past, the cantly increase investor returns.
es to the insurance company, Experience Committee that reports
risk in the future is not trivial. Method 1: Rate Increase on mortality experience and trends.
should be made by the investor
In addition to rates being in- Assessment at the Carrier Level In 2008, Mr. Hui was elected to the
for each carrier being reviewed.
creased on new business by The first method to managing Reinsurance Section Council of the
For the insurance company, the
some carriers at the old ages, the risk of a rate increase is to Society of Actuaries where he heads
consequence of a COI increase the research team.
on March 2, 2010, The Phoenix analyze the risk at the carrier
can be catastrophic -a dramatic
Companies noted in their an- level. For each relevant carrier, Mr. Hui is the Chief Underwriting Of-
decrease in new business, and
nual report on Form 10-K that this involves assessing the like- ficer at Caldwell Funding Corpora-
thus the going concern for the
they will be increasing the cost lihood and severity of a rate in- tion, Stamford, Conn., responsible
business. Agents would much for underwriting and pricing meth-
of insurance rates for certain crease based on its key drivers:
rather have the implicit guaran- odologies. Prior to joining Caldwell,
in-force policies. Details con-
tee that rates will not increase
tinue to emerge, but it is clear • Exposure of the carrier to Mr. Hui was a pricing officer with
product under pricing; (by using another carrier), than General Reinsurance responsible for
that Phoenix has implemented
have history repeat itself on setting pricing policy, mortality re-
a rate increase on certain uni- • Contractual requirements and
their clients. search, and the development of life
versal life policies effective on terms that govern rate chang- insurance products used by carriers.
the next policy anniversary date es; In addition, the rate increase it- Mr. Hui is a Fellow of the Society of
following April 1, 2010. What self may not be effective, as it Actuaries, a Member of the American
• The financial strength of the
is currently less clear is the de- is only allowed prospectively, Academy of Actuaries, and holds a
carrier;
gree of the rate increase, wheth- and can be offset by negative Chartered Financial Analyst desig-
er rates will be raised further in • Reputation risk to the carrier selection. In other words, a rate nation. For more information, visit:
the future, whether more poli- and whether the carrier is a increase would induce some www.caldwell-ls.com.
cies will eventually be affected, going concern or in run-off; healthy policyholders to termi-
and whether other carriers will and, nate and find cheaper coverage
follow suit. • Perceptions of efficacy of a elsewhere, thereby leaving the
rate increase. remaining pool with a higher
“While COI rate
concentration of unhealthy
increases have been Afterwards, the investor is then lives. Efficacy becomes an is-
very rare in the past, better positioned to manage the
sue because the remaining pool
the author’s view is risk with either: structured fi- of less healthy lives could still
that the risk in the nance or policy selection where have higher mortality than
future is not trivial” policies are chosen based on a
needed under the rate increase
WWW.LIFESETTLEMENTREVIEW.COM REPRINTED WITH PERMISSION #3011 MAY 2010
 LIFE SETTLEMENT
BUSINESS ADVISOR Review

in the first place.
Method 2: Making Full Use of
Policy Features
The second method to managing the
risk of a rate increase can actually re-
move the risk by concentrating on a
completely different approach to pol-
icy selection. This approach focuses
on features and covenants within cer-
tain policies that will essentially pre-
clude the effects of a rate increase.
The benefit of these secondary guaran-
tee features is reduced risk; irrespec-
tive of whether or not a rate increase
occurs, the policy is guaranteed to re-
main in-force, provided a separate and
predetermined funding or payment re-
quirement is achieved.
In addition to rate increase protection,
for a very select group of policies,
there is even a reduction or delay in
premiums. This equates to a signifi-
cantly higher return for the investor in
comparison to running the premiums
at the industry’s optimized COI rate.
In fact by taking advantage of certain
policies with these features, a very
sophisticated life settlement manager
is able to increase returns by several
hundred basis points compared with
a pricing analysis using ordinary COI
rates. In other words, if the policies
are properly selected, a very sophisti-
cated manager can remove an inves-
“..if the policies are
properly selected, a
very sophisticated
manager can remove
an investor’s exposure
to COI increases
while simultaneously
increasing expected
returns significantly”
The drawback of this strategy is in its
complexity. While the vast majority
of policies have some type of second-
ary guarantee, the life settlement mar-
ket has not really taken advantage of
the strategy because it initially re-
quires intensive modeling well beyond
the standard industry software, as well
as comprehensive product knowledge.
Also, the product features vary wide-
ly by carrier and product type; many
policies have moderate to high costs
and some have multiple options, with
partial and lifetime guarantees, mul-
tiple accounts, and complex formu-
las. Optimizing the premium stream
requires the combinatorial analysis
of these different options, together
with an accurate assessment of the
insured’s expected mortality. Finally
the vast majority of insurers will sim-
ply not provide in-force illustrations
on this minimum guaranteed basis,
sometimes citing the complexities in-
volved. Fortunately however, the end
“The very significant challenges
come from calculating and
validating the optimized
premium stream for the product
feature(s), and in finding
policies within these products
containing moderate to highly
favorable costs.”
Conclusions
The recent change to COI rates brought by Phoenix
highlights the need for life settlement investors to
more carefully consider the potential for COI increas-
es and how to manage this risk. There are at least two
solutions, and both methods noted in this article will
help dramatically reduce exposure to this risk. As-
sessing the likelihood and severity of a rate increase at
the carrier level will help manage the overall risk for
the portfolio. Strategies focusing on specific products
with secondary guarantees will help provide a definite
removal of risk at the product level. In fact a very
select group of these policies will also increase returns
by reducing or delaying the premium carrying costs.
Thus with sophistication and time, some policies with
secondary guarantees will eventually command a
moderate to significantly higher price in the life settle-
ment market.
Accumulated Cashflow
$7,000,000
Pricing with Industry Software
$6,000,000 Pricing with Secondary Guarantee Feature
$5,000,000
$4,000,000
$3,000,000

tor’s exposure to COI increases while result of the strategy is that it is easy $2,000,000
simultaneously increasing returns sig- to use and validate. The very signifi- $1,000,000
nificantly. cant challenges come from calculating
$0
The following is an example of a sec- and validating the optimized premium 1 6 11 16 21
ondary guarantee policy feature and stream for the product feature(s), and $1,000,000

its effect on premiums and returns (see in finding policies within these prod-
charts below): ucts containing moderate to highly fa- Year

vorable costs. Expected Premiums (Accumulated)

Source: Caldwell Funding Corporation

Example: Female Nonsmoker, issue age 78, 10MM face $5,000,000

Pricing with Industry Software
Pricing with Industry Pricing with Secondary Pricing with Secondary Guarantee Feature
Software Guarantee Feature $4,000,000

Expected Premiums over 5 years $1,439,000 $1,342,000 $3,000,000

$2,000,000
Expected Premiums over 10 years $2,710,000 $1,485,000

$1,000,000
Valuation (% of face) 6.3% 11.4%

$0
IRR 15% 21% 1 6 11 16 21

WWW.LIFESETTLEMENTREVIEW.COM REPRINTED WITH PERMISSION #3011 Year MAY 2010