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Managing Rate Increases and Unlocking the Value of Life Insurance Policies
carrier’s risk level. Finally, it is important to recognize that a rate increase is a tail risk; it is a reasonably low likelihood but potentially high severity event.
BY EDWARD HUI
anaging the risk of a Cost of Insurance (COI) rate increase on in-force policies is an important consideration for all life settlement investors. If a rate increase occurs, the consequences could be very serious. However, there are multiple factors to consider, as the risk and impact levels will vary significantly by carrier and product.
Especially in light of these recent developments, the author believes that life settlement investors should be more focused on managing the risk of a rate increase. There are at least two options available: an analysis of the carriers themselves and a review of policy features. As will be discussed below, where the risk of a COI increase is managed through a focus on policy features, the solution is more While COI rate increases have definite and can also signifibeen very rare in the past, the cantly increase investor returns. risk in the future is not trivial. Method 1: Rate Increase In addition to rates being in- Assessment at the Carrier Level creased on new business by The first method to managing some carriers at the old ages, the risk of a rate increase is to on March 2, 2010, The Phoenix analyze the risk at the carrier Companies noted in their an- level. For each relevant carrier, nual report on Form 10-K that this involves assessing the likethey will be increasing the cost lihood and severity of a rate inof insurance rates for certain crease based on its key drivers: in-force policies. Details continue to emerge, but it is clear • Exposure of the carrier to product under pricing; that Phoenix has implemented a rate increase on certain uni- • Contractual requirements and versal life policies effective on terms that govern rate changthe next policy anniversary date es; following April 1, 2010. What • The financial strength of the is currently less clear is the decarrier; gree of the rate increase, whether rates will be raised further in • Reputation risk to the carrier and whether the carrier is a the future, whether more poligoing concern or in run-off; cies will eventually be affected, and, and whether other carriers will follow suit. • Perceptions of efficacy of a rate increase. “While COI rate increases have been Afterwards, the investor is then very rare in the past, better positioned to manage the the author’s view is risk with either: structured fithat the risk in the nance or policy selection where future is not trivial” policies are chosen based on a
“..a rate increase is a tail risk; it is a reasonably low likelihood but potentially high severity event”
The assessment of these items, in addition to the consequences to the insurance company, should be made by the investor for each carrier being reviewed. For the insurance company, the consequence of a COI increase can be catastrophic -a dramatic decrease in new business, and thus the going concern for the business. Agents would much rather have the implicit guarantee that rates will not increase (by using another carrier), than have history repeat itself on their clients. In addition, the rate increase itself may not be effective, as it is only allowed prospectively, and can be offset by negative selection. In other words, a rate increase would induce some healthy policyholders to terminate and find cheaper coverage elsewhere, thereby leaving the remaining pool with a higher concentration of unhealthy lives. Efficacy becomes an issue because the remaining pool of less healthy lives could still have higher mortality than needed under the rate increase
Edward Hui is a specialist in old age mortality and product development and he frequently presents on the topics. He brings 15 years of experience from the insurance industry including pricing, research, and valuation expertise. He is a member of the 2008 and 2012 VBT Creation Committee and the Individual Life Experience Committee that reports on mortality experience and trends. In 2008, Mr. Hui was elected to the Reinsurance Section Council of the Society of Actuaries where he heads the research team. Mr. Hui is the Chief Underwriting Officer at Caldwell Funding Corporation, Stamford, Conn., responsible for underwriting and pricing methodologies. Prior to joining Caldwell, Mr. Hui was a pricing officer with General Reinsurance responsible for setting pricing policy, mortality research, and the development of life insurance products used by carriers. Mr. Hui is a Fellow of the Society of Actuaries, a Member of the American Academy of Actuaries, and holds a Chartered Financial Analyst designation. For more information, visit: www.caldwell-ls.com.
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LIFE SETTLEMENT BUSINESS ADVISOR
in the first place. Method 2: Making Full Use of
The second method to managing the risk of a rate increase can actually remove the risk by concentrating on a completely different approach to policy selection. This approach focuses on features and covenants within certain policies that will essentially preclude the effects of a rate increase. The benefit of these secondary guarantee features is reduced risk; irrespective of whether or not a rate increase occurs, the policy is guaranteed to remain in-force, provided a separate and predetermined funding or payment requirement 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 significantly 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 sophisticated manager can remove an investor’s exposure to COI increases while simultaneously increasing returns significantly. The following is an example of a secondary guarantee policy feature and its effect on premiums and returns (see charts below):
Source: Caldwell Funding Corporation
“..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 secondary guarantee, the life settlement market has not really taken advantage of the strategy because it initially requires intensive modeling well beyond the standard industry software, as well as comprehensive product knowledge. Also, the product features vary widely by carrier and product type; many policies have moderate to high costs and some have multiple options, with partial and lifetime guarantees, multiple accounts, and complex formulas. 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 simply not provide in-force illustrations on this minimum guaranteed basis, sometimes citing the complexities involved. Fortunately however, the end result of the strategy is that it is easy to use and validate. 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.
“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 increases 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. Assessing 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 settlement market.
$7,000,000 $6,000,000 $5,000,000 $4,000,000 $3,000,000 $2,000,000 $1,000,000 $0 $1,000,000 1 6 11 16 21 Pricing with Industry Software Pricing with Secondary Guarantee Feature
Expected Premiums (Accumulated)
$5,000,000 Pricing with Industry Software Pricing with Secondary Guarantee Feature $4,000,000
Example: Female Nonsmoker, issue age 78, 10MM face Pricing with Industry Pricing with Secondary Software Guarantee Feature Expected Premiums over 5 years Expected Premiums over 10 years Valuation (% of face) IRR WWW.LIFESETTLEMENTREVIEW.COM $1,439,000 $2,710,000 6.3% 15% $1,342,000 $1,485,000 11.4% 21% REPRINTED WITH PERMISSION #3011
$0 1 6 11 Year 16 21
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