Stephen J. Spagnoli and Benjamin (B.J.) K. McComas
There may be philosophical consensus that a human life is priceless, but investments in life settlements could certainly come with a price tag. Life settlements are third-party investments in life insurance policies. The secondary market for life insurance policies has been fast-emerging in recent decades, and estimates have placed the value of policies eligible for life settlements at around $170 billion.1
Given recent allegations of misconduct in this market, there is also the potential for life settlement investments to make up a new wave of asset class litigation.
Current litigation in this market includes a pending class action lawsuit in which the plaintiff investors are alleging intentional and negligent misconduct by secondary market participants. In the Aviles case, the net losses to the life settlement fund are alleged to be nearly $600 million.2
The plaintiffs have alleged misconduct in the underwriting of the settled life insurance policies in order to stimulate investor interest and competition. With additional allegations ranging from inflation of investment-grade credit ratings to fraudulent conduct by fund managers, the plaintiffs’ allegations bear resemblance to the residential mortgage-backed securities (RMBS) litigation that has been ongoing over the past decade. While comparing life insurance to consumer mortgages is an “apples to oranges” comparison, there are common considerations—and challenges—underpinning these types of litigation.
Life Settlement Basics
Investors are drawn to life settlements due in large part to the opportunity for sizable returns upon the maturity of a policy. In this way, life settlement investors hold a financial stake in the insured’s demise.3 In life settlement transactions, insureds over a certain age who wish to dispose of their life insurance policies sell those policies to third-party investors, who become the beneficiaries on the policies and are responsible for maintaining premium payments. Upon the death of the insured, the investor collects the net death benefits. For both parties, this is potentially attractive: the insured, who no longer wants or can afford their policy, receives a lump-sum payment that exceeds the cash surrender value offered by their insurer, and the investor holds an opportunity to earn significant yields on their investment. That opportunity, however, is directly correlated to the longevity of the insured.
The process of underwriting a life insurance policy in a life settlement transaction is similar to that used to underwrite a mortgage loan. However, instead of evaluating credit risk, a life settlement is underwritten to evaluate the longevity risk of the insured.4 After the underwriter completes the authorized collection of the insured’s medical history, personal attributes, and other risk factors, life tables or other proprietary algorithms are used to estimate the life expectancy of the insured. The life expectancy may also be considered in light of the investor’s purchase criteria. Ultimately, the insured must die on, or before, the date projected at underwriting in order for the expected returns to be realized.
Current Litigation and Considerations
The underwriting practices and life expectancy determinations of life settlement underwriters are key issues in current life settlement investment litigation. Claims of underwriter negligence and fraud are not dissimilar to the allegations made in RMBS cases. Further, and as demonstrated in RMBS litigation, establishing negligent or fraudulent underwriting defects in life settlements cases may be credibly done by evaluating the individual polices that compose the pools, and in light of what was available to the life settlement underwriter.
Forensic underwriting (or simply “re-underwriting”) is, in its own right, a challenging endeavor. First, these re-underwriting efforts often involve large-scale data management, document review, and potentially even expert analysis. Second, underwriting is inherently subjective, which may result in two separate underwriters reaching two different, yet reasonable, life expectancy determinations. Third, data integrity and availability may limit a re-underwriter’s ability to effectively review the policy through the same looking glass as the original underwriter. In the Aviles case, for example, some of the underwriting for the life settlement policies was performed back in the mid-2000s, and therefore files may be incomplete or missing altogether. Finally, establishing what life expectancy tables or mortality databases were used to underwrite the policies is a critical component of the analysis. Some industry insiders have openly opined that life expectancy tables have not been accurate in the past,5
which may skew the longevity estimates against the investors’ interests. Updates or modifications to the tables and databases in the intervening years could also inhibit an effective re-underwriting effort, as it would frustrate a “day one” approach to the re-underwriting. To compound this issue, such tables and data may be proprietary from one underwriter to the next, which means that several different sources could have been used to derive life estimates for one securitization pool.
These considerations presume that the life insurance policy was lawfully originated to begin with. In “Stranger-Originated Life Insurance” (or STOLI) transactions, unscrupulous third parties have induced uninsured elderly or terminally ill individuals to acquire life insurance, with all parties intending to subsequently assign the benefits to an investor. The insurable interest of these third parties may be called into question, and several states have laws that expressly prohibit such transactions. Litigant life settlement investors may cite these state laws, together with corresponding investment agreement provisions, as a basis for challenging the inclusion of a policy in an investment pool.
The Aviles case suggests that underwriting will be a critical issue of consideration by courts hearing life settlement investment-related litigation. With a sound re-underwriting approach, litigants can either raise or rebut defect claims in the policies and provide the court with the supporting data needed to effectively meet the legal standards of proof. Given the potential size of the industry, investments in life settlements may be expected to grow—as may the “longevity” of life settlement-related litigation.
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1 MacDonald, J. (2014, December 5). Retrieved from https://www.bankrate.com/finance/insurance/life-settlement-gets-face-lift.aspx ↩
2 viles et al v. S&P Global, Inc. et al, case number 1:17-cv-02987 (S.D.N.Y).↩
3 Kadlec, D. (2014, November 5). The Creepy Truth About Life Settlements. Retrieved from http://time.com/money/3556983/life-settlements-creepy-truth/↩
4 Maxon, James W. (2008, September 1). Synthetic Structures to Hedge Longevity Risk in Life Settlements. Retrieved from https://www.mmmlaw.com/media/synthetic-structures-to-hedge-longevity-risk-in-life-settlements/ ↩
5 Powell, R. (2010, July 29). Life settlements are DOA as an investment. Retrieved at https://www.marketwatch.com/story/life-settlements-are-doa-as-an-investment-2010-07-29↩
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