A.M. Best late last month issued a revised rating methodology to be used in the securitization of a life settlement portfolio, placing more of an emphasis on what the agency sees as the increasingly critical issue of life expectancy estimates and medical underwriting.
The newly revised methodology, according to Emmanuel Modu, managing director and global head of structured finance, places the emphasis on what Best sees as the largest potential trouble spot for life settlement portfolios: the life expectancy estimates on which buyers decide to price their offers.
The concern, he said, is that there is still a significant variance between the estimates provided by different medical evaluation firms and that those differences could lead to “examiner shopping” among firms looking to enhance their portfolio.
The potential for expectancy shopping could be an “Achilles heel” for the life settlements market, Modu said, adding that the new methodology “limits the kind of gaming that goes on in the industry.”
Effectively, he said, Best’s new methodology puts a “floor” to life expectancy. On average, he said, a pool of 100 lives would have a life expectancy of about 10 years. “I don’t think you could find enough impaired people to reduce that number below 8,” he said.
In the methodology itself, Best explains why it would be difficult to find enough policies to create a lower life expectancy.
The agency had a research showing that in a “typical distribution” of life expectancies for individuals 65 years of age or older, less than 20% will have a life expectancy of 8 years or less.
The research, Best noted, “is important because it shows that the highly coveted low life expectancies sought by some investors in life settlements just are not plentiful.”
To further illustrate the point, Best also looked at the issue on an individual level. A 75-year-old nonsmoking male, the agency said, would typically have a life expectancy of 14 years based on a 100% mortality rating.
“The mortality ratings generally issued by medical examiners for the impaired lives of this age, sex and smoking status normally would range from 300% down to 150%, which translates to life expectancies between approximately 8.7 years and 11.8 years,” Best noted. “To achieve a life expectancy of about 7 years or less for this type of individual, the mortality rating would need to be about 460% or more–rare mortality ratings for individuals with the profile under consideration.”
Modu said that medical examiners have made some progress in recent years in reducing the differential between estimates, but that significant differences remain.
Best noted in the new methodology that it examined how broad the difference in life expectancy estimates can be, checking the underwriting of 909 lives by 3 major medical examiners for individuals between 75 and 79 at a split of 66% male to 34% female. The difference in life expectancies reported by the 3 firms, Best said, ranged from 8 months to as many as 24.
The impact of a life expectancy can be significant, even if the numbers appear relatively small, Modu said. As an example, Best showed how the internal rate of return for an actual portfolio of about 150 lives is affected based on changes to a life expectancy with a starting rate of 12.4%. If two years, or 24 months, are added to the life expectancy, that rate drops by nearly half to 6.5%.
The secondary market, Modu said, appears to have made progress on regulatory issues such as insurable interest and fee or commission transparency. “People are a lot more careful these days,” he said, noting that the increasing attention to stranger-originated life insurance, or STOLI, has made ensuring that insurable interest was present on the initial purchase of a policy a part of transaction. “I couldn’t make that statement 5 years ago.”
Modu said Best is working on preliminary assessments of life settlement portfolios, which is the first step towards obtaining a rating, but would not reveal the companies involved or even how many the agency was evaluating.
Doug Head, executive director of the Life Insurance Settlement Association, said that “a lot of people are working on” getting portfolios ready for securitization, but that he was not aware of any that were being assigned a rating at this time.
Best had pulled its prior methodology, he observed, because the agency “felt it did not understand” the various risk factors that go into a life settlements portfolio investment.
A revised methodology, he said, is “evidence” that life settlements have made progress towards the mainstream as an asset class, in that a rating agency sees its validity as an investment.
“If they had not seen the validity of the asset class,” he said, “they wouldn’t have bothered.”