Hedge Funds Turning to Life Settlements for Absolute, Uncorrelated Returns

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1 definitive source of Life Settlements Hedge Funds Turning to Life Settlements for Absolute, Uncorrelated Returns By Jennifer Banzaca Among other lessons, the recent recession taught that the returns on many assets are more correlated than previously assumed. From late 2007 through early 2009, it seemed that everything moved in the same direction: down. Or almost everything. A few asset classes or more appropriately, investment categories remained, during the recession and beyond, resolutely uncorrelated. Litigation funding is one such investment category, as we discussed in a previous issue of Hedge Fund Law Report. See In Turbulent Markets, Hedge Fund Managers Turn to Litigation Funding for Absolute, Uncorrelated Returns, Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009). Another such category is life settlements. In a nutshell, a life settlement is the process by which an investor (often a hedge fund) purchases a life insurance policy from the person who originally purchased the policy the so-called insured. Specifically, the hedge fund or other investor generally pays the insured an amount greater than the cash surrender value of the policy, but less than the death benefit, in exchange for the right to collect the death benefit and the obligation to continue paying premiums for the life of the policy (and the insured). For insureds, especially those that need money today, life settlements represent an opportunity to cash out of a policy for an amount often greater than what an insurance company will pay. For hedge funds, life settlements offer an investment, the returns on which are driven largely by the fund manager s ability to accurately predict the life expectancy of a group of insureds. In other words, the success of a strategy focused on life settlements has less to do with microeconomic variables (such as corporate earnings) or macroeconomic variables (such as interest rates), and more to do with demographics. It s a different ball game, and a different skill set the quintessential uncorrelated investment category. Not surprisingly, hedge funds are becoming increasingly interested in life settlements. Accordingly, this is the first part of a three-part series in which Hedge Fund Law Report will provide a detailed analysis of the key legal and business considerations for hedge funds investing in life settlements. In this part, we discuss: state and federal regulation of life settlements; premium financing; pricing of life settlements; advantages to hedge funds of investing in life settlements (including lack of correlation with other assets); concerns of which hedge funds should be cognizant when investing in life settlements (including illiquidity and longevity risk); structuring of hedge funds to invest in life settlements; cash management and adequate capital considerations; specific recommended items for disclosure in the private placement memorandum of a fund organized to invest in life settlements; due diligence considerations; a brief overview of the relevant tax considerations, including the recommended jurisdictions for organizing life settlement hedge funds; the tertiary market and securitization; and opposition from the insurance industry. Part two in this three-part series will focus in more depth on tax considerations relating to life

2 definitive source of settlement investing, and part three will focus in more depth on securitization of life settlements. State and Federal Regulation of Life Settlements A life settlement is the process by which a hedge fund (or other investor) purchases a life insurance policy (or a group of such policies) from a provider (as defined below) that has purchased such policies directly from insureds. potential upside to the investors consists in the death benefit payable upon the death of the insured, less the value premiums paid during the term of ownership of the investor s ownership of the policy. According to Boris Ziser, a Partner at Stroock & Stroock & Lavan LLP, before the life settlement industry, insureds who wished to cash out had only two options: surrender the policy to the insurance company and collect the cash surrender value, or simply stop paying the premiums and let the policy lapse. In allowing the policy to lapse, Ziser said, the insured recovers none of the value previously paid to the insurance company as premiums. life settlement industry gives a third alternative, Ziser noted. Now, the insured can sell that policy to a third party and receive what is oftentimes a multiple of the cash surrender value. Regulation of life settlements varies in the U.S. from state to state; regulation of a particular life settlement is governed by the state in which the relevant policy is issued. According to Ziser, in states that regulate life settlements, the initial purchase of the policy must be consummated by a licensed life settlement provider. documents pursuant to which that purchase is done are reviewed and approved by the regulators of the relevant state, Ziser said. Depending on the state, you can t do a life settlement for a certain period of time after the policy is initially issued. most common time period is two years, although some states have a longer period. As indicated, hedge funds generally purchase life insurance policies, or pools of such policies, through brokers or providers. Benjamin A. Geber, CEO and Managing Partner of hedge fund Bally Capital Management, LLC, explained: In a transaction, if a hedge fund wants to buy a policy, they don t buy them directly from the insured. y go through a broker or a provider. Providers have to be licensed in any of the regulated states to buy policies out of that state. In unregulated states, the broker could facilitate the transaction and the hedge fund could buy directly through a broker. A provider is a licensed entity established for the purpose of purchasing life insurance policies. Geber said that providers generally have to be licensed by state insurance regulators, but not with the Securities and Exchange Commission (SEC). Brokers generally do not have to be registered with a state insurance regulator or with the SEC. However, sources suggested that the absence of a requirement of SEC registration for either brokers or providers may change. Currently, most life insurance policies even when sold in life settlement transactions are not considered securities for purposes of federal securities regulation. However, the SEC recently stated that variable universal life insurance policies are securities because of the composition of these policies in particular, because the value of such policies fluctuates based on the performance of their subaccounts, which consist primarily of mutual funds. As such, brokers and life settlement providers that buy and sell variable universal life insurance policies must register as broker-dealers with the SEC.

3 definitive source of Premium Financing Another variation on the core idea of third party funding for life insurance is known as premium financing. Generally, in a premium financing arrangement, a high net worth individual will pledge assets, or the life insurance policy itself, to obtain a loan to pay the premiums on a life insurance policy. death benefit and any gains (if the policy is a variable policy that is in part invested in securities) are used to repay the loan plus interest, and the net death benefit is paid to the policyholder s beneficiaries. Premium financing is a way for high net worth individuals, generally over 55 years of age, to purchase life insurance without selling assets. Most premium financing arrangements require at least $2 million in net worth and $100,000 per year in net income. insured generally has the option, after 24 months, to repay the loan and maintain the insurance policy in force. Alternatively, after 24 months, the insured can surrender the policy to the insurance company for its cash value, or sell it in a life settlement. Pricing of Life Settlements According to Ziser, when a hedge fund buys a policy, that investor acquires both the right to the death benefit and the obligation to pay future premiums. What a hedge fund pays for the policy is an amount typically greater than the cash surrender value but less than the death benefit. Ziser noted that the purchase price is a function of a number of factors, including: health of the insured, age of the insured, amount of the annual premiums, credit rating of the insurance company and predicted life expectancy of the insured. All those factors go into a pricing model that the investors have developed, Ziser explained. Based on that data and pricing model, they determine what price they would be prepared to pay for that policy and what rate of return that policy would provide, given various assumptions. When the insured passes away, it s the investor that gets the death benefit under the policy. ir return will be based on the death benefit versus how much they paid, and the premiums they ve paid. Added Marc Rovner, Principal at insurance brokerage firm Rovner & Company, LLC, if you have a group of policies held by people that are 70 years old, based on your actuarial tables, you figure they are going to live another ten years and they each have $1 million life insurance policies. As an example, if the premiums are $30,000 per year per person, over ten years it would cost you roughly $300,000 versus that $1 million death benefit. In that case, you re in the money. Advantages to Hedge Funds of Life Settlement Investing As noted, a primary attraction of life settlements for hedge funds is that they offer uncorrelated returns. However, life settlements offer at least two other benefits. First, life settlements generally offer high quality credit risk, for two reasons. First, they offer the credit of the insurance company, and insurance companies are required by state regulators to maintain capital adequate to pay claims. Second, the insurance industry may have an implicit federal guarantee, as evidenced by the recent bailouts of insurers including AIG, Hartford Financial Services Group Inc., Genworth Financial Inc., Prudential Financial Inc. and MetLife Inc. That is, the federal government is unlikely to let insurers default on life insurance claims. This, said Ziser, is a key benefit for hedge funds active in life settlements.

4 definitive source of (However, the consumer protection arguments that apply to natural person beneficiaries may not apply with equal force to corporate or investor beneficiaries.) Second, the returns offered by life settlements are not just uncorrelated, they are also absolute and potentially high. As Bally s Geber noted, institutions started to realize that in life settlement transactions, the real profit was in the death benefit eventually paying out and that the intrinsic value of the policy could be way more than the insurance company was going to give the insured. Potential Drawbacks While the benefits of life settlement investing can be considerable for appropriately structured hedge funds (more on structuring below), there are at least three concerns of which hedge funds investing in this area should be cognizant. First, and most prominent, is so-called longevity risk the risk that the insured will live significantly longer than expected. If the life expectancy of the insured exceeds the life expectancy predicted by actuarial tables or other sources, the hedge fund can wind up paying more in premiums than modeled. At some point, the premiums paid out will exceed the death benefit, and the investment s negative return will grow (as with a short position on a rising asset). Moreover, based on time value of money considerations, a dollar paid in premiums today is worth more than a dollar of death benefit in the future. This is one reason why the life settlements industry originated in the context of terminally ill insureds, and why even today investors will only enter into life settlement transactions with respect to insureds of advanced age. One of the factors that determines how successful an investment will be is whether the policy matures on the same schedule as the investor predicted when they determined their pricing for the policy, Stroock s Ziser noted. Put simply, if an insured lives longer than anticipated, the return on that investment will decline because you have to continue to pay premiums for that extended period of time. Conversely, if the insured passes away sooner than expected, the return on investment increases because you receive the return on your capital and the full death benefit earlier than expected and you had to pay fewer premiums than anticipated. A second risk though at this point a muted one involves the concept of insurable interest. In brief, at common law, one person could not purchase an insurance policy on the life of another. idea was to avoid perverse incentives. Over time, that doctrine has evolved and expanded so that a party generally can only purchase direct insurance with respect to something in which he or she has an interest. According to Earl Zimmerman, a Partner at law firm Sutherland Asbill & Brennan LLP, you need to be concerned with the issue of insurable interest. If you buy a policy and you don t have an insurable interest in that person s life, what can happen is the life insurance company can rescind the whole policy or the estate of the deceased could file a lawsuit arguing that they deserve the proceeds of the policy. However, most courts that have heard challenges to the validity of life settlements based on claims that the investor did not have an insurable interest have dismissed such arguments. claim is sometimes made, but courts are reluctant to invalidate life settlements based on the argument. As a policy matter, this is in part because the real

5 definitive source of party in interest doctrine evolved to protect insureds, and life settlements do present the same type of threat to insureds as does one party purchasing insurance on the life of another. A third concern for hedge funds involves regulatory risk. Zimmerman noted that relevant laws vary from state to state and are constantly evolving. Most recently, the SEC formed a task force on life settlement securitizations. You need to get a sense of where the law could go because even if it doesn t affect the policies that have already been issued, it could affect your ability to sell the policies later if you want to exit or the policies you can buy in the future. To mitigate the first risk longevity risk funds can diversify their life settlements on a number of margins. Geber recommended that funds have a diversified pool of policies in a life settlement portfolio. Zimmerman agreed and added that funds should make sure they do not have policies only issued by a single insurer. Funds can further diversify their holdings including policies of insureds in a wider age range or with a wider range of medical conditions. Structure of Funds Investing in Life Settlements Life settlements are a long-term investment, generally with a life of seven to ten years. As is the case whenever hedge funds invest in illiquid assets, funds that invest in life settlements should be structured so that the lock up of capital matches the duration of the underlying investments. This may lend itself to private-equity style funds or hybrid funds. On hybrids, see Hedge Fund Managers Turn to Hybrid Fund Structures to Reconcile Fund Liquidity Terms and the Duration of Assets, Hedge Fund Law Report, Vol. 2, No. 5 (Feb. 4, 2009). See also How Can Hedge Fund Managers Prevent or Mitigate Revocations of Redemption Requests?, Hedge Fund Law Report, Vol. 2, No. 21 (May 27, 2009). In my opinion, anything that s heavy to the life settlement side should have longer lockup periods, at least for the term that hedge funds would expect their initial payouts, Geber said. He added that in light of the long required lockup, and the longer time horizon (versus many of the assets in which hedge funds invest) required to realize value, disclosure regarding the term of the investment is particularly important in the life settlement context. Investors need to understand the long-term nature of these types of investments. It really comes down to education and full disclosure. If there s good education and disclosure behind it and the investors know where they re putting their money and the possible results of their investments, then they understand that these are illiquid investments. Adequate Capital As the fund assumes the payment of policy premiums and other ongoing costs, the fund also should have adequate capital reserves or a credible expectation of new and sufficient capital to meet the ongoing financial obligations. Along similar lines, managers are advised to develop a specific valuation policy for life policies, because life settlements are not traded on an established exchange and are not even amenable to the techniques employed to value other illiquid assets. According to Ziser, this is a long-term asset and not necessarily liquid. In addition, it s an investment that requires capital in order to keep it in effect. I think that a fund that invests in life settlements should be able to withstand a long enough duration of investment as well as have sufficient liquidity to be able to continue to pay premiums on the policies.

6 definitive source of Added Rovner: the hedge funds need very strict structural procedures in place to be sure no premium payments are missed. It s a poor investment if you buy a policy and pay significant amounts of money to pay the premiums each month only to let the policy lapse because of a missed payment. Business Plan Various managers that have organized funds to invest in life settlements have included in the private placement memoranda of the relevant funds a business plan for the funds in other words, a thorough description of the mechanics and parameters of the strategy. Such business plans or strategy descriptions typically include descriptions of the following: types of policies in which the fund will invest: whole life, term or variable, or some combination. age range of insureds from which the hedge fund will purchase policies. life expectancy range of insureds (e.g., 10 to 15 years of remaining life expectancy). Cash management policies for the payment of insurance premiums. Whether the fund will actively trade policies in the tertiary market (discussed below), or whether it will hold them to maturity, or some combination. How the fund will mitigate the various risks identified above, including how it will diversify among policy types, carriers and the insureds. Also, the manager of a hedge fund that invests in life settlements should have infrastructure in place (or should retain third party expertise) for keeping track of when the insured dies. Generally, funds can employ tracking agents who will monitor the whereabouts and mortality status of each insured. Due Diligence Life settlements are similar to other investments in that thorough due diligence, especially before but also after investing, is critical to the success of an investment. But the specifics of due diligence in the life settlements area are unique. Rovner suggested that in analyzing policies for possible investment, hedge fund managers should have reputable firms perform multiple life expectancy reports on the insureds. I would advise that the fund managers make sure that the life expectancy reports were done by reputable firms. You should also have multiple reports done and only invest in pools where the average of the three most reputable firms were used. Stroock s Ziser added that before investing in life settlements, fund managers should study the industry and hire knowledgeable advisers, including lawyers and actuaries. way the life settlement industry generally works, particularly in states that regulate life settlements, is that the initial purchase of that policy has to be done by a licensed life settlement provider, Ziser explained. Any hedge fund manager that hires a life settlement provider should obviously do the proper due diligence on that provider, such as investigating its licensing status, business practices and how long it has been in business. It s not entirely dissimilar to the due diligence the manager would do on any business counterparty. manager should also understand the economic principles behind the investments so they are able to analyze any particular policy and develop a pricing model with which they re comfortable.

7 definitive source of Tax Consequences taxation of gains on life settlements is a key concern for many hedge funds. As a general matter, under Revenue Ruling , if a hedge fund holds a life settlement policy to maturity, the gain will likely be ordinary income; if a fund sells a life policy before maturity, the gain would likely be capital gain. Internal Revenue Service has stated that the proceeds of any life insurance policy received by a non-u.s. secondary market purchaser such as a Cayman Islands hedge fund classified as a corporation for U.S. tax purposes, or an offshore fund organized in a jurisdiction that does not have a treaty with the U.S. are subject to a 30 percent U.S. withholding tax. This means that if the hedge fund that owns the policy is organized in a non-treaty jurisdiction and the death benefit is $1 million, the insurer would send $700,000 to the hedge fund and remit $300,000 to the U.S. federal government. For more on tax issues in life settlement investments, see Providing Certainty on Death and Taxes: IRS Issues Initial Guidance for Sellers and Purchasers of Life Insurance Policies, Hedge Fund Law Report, Vol. 2, No. 19 (May 13, 2009). As such, hedge funds that invest in life settlements are more likely to be organized in jurisdictions that do have treaties with the U.S., such as Luxembourg and Ireland, and less likely to be organized in jurisdictions that do not have treaties with the U.S., such as the Cayman Islands. On Luxembourg funds, see Luxembourg Authorities Create Fast-Track Procedure for Approval of Transfers of Illiquid Assets to Hedge Fund Side Pockets, Hedge Fund Law Report, Vol. 2, No. 29 (Jul. 23, 2009). On Cayman Islands funds, see Consistent With International Trends, Cayman Islands Monetary Authority May Require More Transparency from Cayman-Registered Hedge Funds, Hedge Fund Law Report, Vol. 2, No. 26 (Jul. 2, 2009). Sutherland Asbill s Zimmerman explained, with respect to the Cayman Islands: re are a number of life settlement companies set up offshore, and where there is a treaty, the death benefit is not taxed under the treaty. Instead, it s just taxed as income in the jurisdiction you re in. With hedge funds, there are many based offshore in the Cayman Islands, and there is no treaty with the Cayman Islands. So, you would lose the treaty benefits. Tertiary Market and Securitizations While life settlements themselves are deemed a secondary market in life insurance policies, a tertiary market has developed in which buyers of life policies may sell them to third parties. For example, a hedge fund that needs liquidity or that simply has an investment view may wish to sell a policy or group of policies. Historically, the tertiary market has had limited depth. Another advance in the life settlements market is securitization. In a life settlement securitization, a bank buys a pool of life insurance policies and contributes the pool to a trust that issues bonds to investors. bonds represent a claim on the death benefit proceeds of the policies in the trust. Recent press reports indicate that several banks are investigating life settlement securitizations. Credit Suisse reportedly is creating a platform to buy large numbers of life insurance policies, securitize them and offer resulting bonds to investors. It may also be exploring swaps to provide similar economics.

8 definitive source of securitization development has garnered the attention of regulators. House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises recently held a hearing to discuss life settlement securitization arrangements. SEC is also concerned with the securitization of life settlements: it has formed a task force to investigate this latest Wall Street trend. Opposition From the Insurance Industry Ziser explained that there has been opposition from the insurance industry to life settlements. He suggested: I think that you can debate the reasons for that. One of the issues at hand is that a significant portion of the policies generally lapse before an insurance company would ever have to pay a death benefit. That lapse rate is often taken into account when setting premiums. With a life settlement, the policy is not likely to lapse because you have a hedge fund that makes sure the premiums are paid. That obviously has an impact on the lapse assumptions the insurance company may have taken into account. Now insurance companies have come out and said that if the life settlement business continues, they may have to raise their premiums. I think that s debatable because you have to take the size of the life settlement industry into account. It s a very small percentage of the insurance industry, so it s hard to imagine how that small a segment would impact such a large industry on a widespread basis. Added Rovner: the life insurance companies are not happy about hedge funds paying more than the cash settlement value of the policy because then they are still responsible for that death benefit. It throws off their models as well. y price their policies based on the actuarial tables that they ve created as to how many policies are actually going to come to fruition and now you re in a scenario where hedge funds are skewing their tables because they can be sure that hedge funds aren t going to miss premium payments. If they factor this into their models, they may have to charge more for their policies, which could make them uncompetitive. Some insurers have drafted policies that prohibited life settlements, but such restrictive terms are rare because they limit policyholders options (and thus diminish the relative attractiveness of the product in a competitive business). As Rovner noted, the insurance industry could stop these types of settlements, but you don t see that happening often. Right now, it s a lot of talk but not much action. I think they re still trying to figure out how they can deal with this issue without hurting their potential for new policies. If an insured doesn t have this viable option for getting rid of a policy he doesn t need anymore, or can t afford, will the insured take out the policy in the first place? I m not sure it s a valid concern, but the insurance companies don t want to take any action that hurts them financially.