Methodology Rating U.S. Life Settlement Securitizations february 2008
CONTACT INFORMATION Claire J. Mezzanotte Managing Director U.S. Structured Finance Tel. +1 212 806 3272 cmezzanotte@dbrs.com Jan Buckler, Ph.D. Senior Vice President U.S. Structured Finance Tel. +1 212 806 3925 jbuckler@dbrs.com Kathleen Tillwitz Senior Vice President Operational Risk Tel. +1 212 806 3265 ktillwitz@dbrs.com Related Research: Legal Criteria for U.S. Structured Finance Transactions dated September 2009 DBRS is a full-service credit rating agency established in 1976. Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute information. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace. This methodology replaces and supersedes all related prior methodologies. This methodology may be replaced or amended from time to time and, therefore, DBRS recommends that readers consult www.dbrs.com for the latest version of its methodologies.
Rating U.S. Life Settlement Securitizations TABLE OF CONTENTS Introduction 4 Methodology 4 (1) Operational Risk Analysis 4 (a) Origination 4 (b) Medical Underwriting 4 (c) Internal Controls 5 (d) Technology 5 (e) Tracking 5 (2) Representations and Warranties 5 (3) Selection of Life Insurance Policies as Collateral 6 (4) Insurance Company Financial Strength 7 (5) Liquidity Providers 7 (6) DBRS Proprietary Evaluation Model to Determine Credit Enhancement 7 Model Overview 9 (a) Mortality Determination 9 (b) Mortality Tables 9 (c) Mortality Stresses 9 (d) Simulation Stresses 9 Conclusion 10 Appendix A: Sample Life Settlement Securitization Flow Chart 11 Appendix B: Operational Risk Summary 12 Origination 12 Risks 12 Mitigants 12 Medical Underwriting 12 Risks 12 Mitigants 12 Tracking Agents 13 Risks 13 Mitigants 13 3
Introduction A life settlement is the sale of a life insurance policy to a third party in which the policy owner receives cash for the sale and the purchaser often securitizes its interest into a life settlement (LS) securitization. The collateral backing an LS securitization is a collection of insurance policies purchased by a transaction issuer. An issuer pools policies and securitizes the resulting cash flows stemming from the ultimate death benefits paid upon the deaths of the original policyholders. In order to receive the death benefits payable by an insurance company, the issuer must pay the associated policy premiums until the death of the insured. Historically, LS securitization transactions have been funded in the private placement market. Methodology DBRS applies both a qualitative and quantitative approach to reviewing an LS securitization transaction. Qualitatively, the ratings process focuses on the operational risk associated with the sourcing, origination and underwriting of the life insurance policies serving as collateral for the rated debt. Additionally, the rating process includes an assessment of the financial strength of the insurers, a review of the representations and warranties made in the transaction and a review of the legal structure and opinions. Quantitatively, DBRS has developed a proprietary model to evaluate each major dimension of the life insurance policy assets, as well as reviewing stresses of a transaction s priority of payments, based on a set of cash flow assumptions as described within this report. The cash flow stresses address the ability of an issuer to meet its obligations. (1) OPERATIONAL RISK ANALYSIS (a) Origination Insurance policies for life settlement transactions are obtained through brokers and insurance agents specializing in the life settlement product type. Insurance agents typically work through a brokerage/broker that has an association with a provider (purchaser of the policies). Brokers may or may not be licensed and the providers are generally responsible for monitoring broker/agent performance. The agent/broker supplies the insured with all the necessary background information regarding the sale of the policy (including any future tax or estate consequences that may result), in addition to obtaining the necessary signed legal documentation and medical records, which are sent to the provider for validation and pricing. Providers are licensed entities that purchase insurance policies directly from sellers. They are responsible for making sure that all sale- or transfer-related documentation complies with applicable state and federal statutes and regulations relating to insurance and life settlement practices and procedures. Providers present policies to the issuer in accordance with an origination agreement that details issuer requirements, pricing and contract terms. It should be noted that the law requires that the owner of a life insurance policy (now the issuer) have an insurable interest in the life of the person named as the insured in the policy (typically a relative or business associate). If a policy is determined not to have a valid insurable interest, the life insurance carrier may contest the claim, consider the policy unenforceable and deny the payment of any death benefits. 4 (b) Medical Underwriting Medical underwriters provide comprehensive reviews of medical records and develop mortality profiles on people who want to sell their life insurance policies. A mortality profile, provided by medical underwriters, includes a summary of pertinent medical conditions as well as a determination of life expectancy.
Issuers typically request that a provider engage the services of at least two independent medical underwriters to evaluate the life expectancies of an insured. Medical files contain a medical history of the insured, often spanning a number of years. Underwriters review each file and, utilizing a debit/credit system, establish a life expectancy calculation based on the medical impairments noted in an insured s medical history. The impact of the impairments on life expectancy calculations is identified in underwriting manuals developed by the life insurance industry. Underwriters typically use judgment in evaluating treatments and longevity of illnesses when interpreting medical risk factors. Life expectancy calculations are developed from the insured s medical files, which are submitted to the provider by the broker or agent and then forwarded to the medical underwriter. While there is no requirement that the files contain medical information covering a certain length of time, life expectancy calculations from multiple and independent medical underwriters are necessary to abate the risk of an incorrect life expectancy calculation and should generally be no more than 12 months old. (c) Internal Controls Internal assessments and quality control reviews performed by medical underwriting management are critical in recognizing procedural errors that may not be easily detectable. In addition, a monitoring process should be in place to ensure that all insurance companies that have issued LS securitization policies are stable and have the financial resources to pay the death benefits. DBRS believes that all participants in the life settlement process should have substantive internal controls in place to identify, monitor and resolve operational issues. (d) Technology Most medical underwriting companies make extensive use of technology to house data, track files and maintain underwriting manuals and models. While DBRS does not subscribe to specific systems architecture, adequate systems controls, consumer privacy protection and backup procedures including disaster recovery and business continuity plans are considered critical processes and should be in place. Further, issuers must ensure that an insured s documentation is in compliance with Health Insurance Portability and Accountability Act (HIPAA) privacy requirements to allow transfer of the insured s medical history. (e) Tracking The tracking agents are licensed settlement providers responsible for contacting, typically on a quarterly basis, the insureds (or their representatives) to verify the current life/death status. Tracking functions are critical to the life settlement process and must be performed in a timely manner in order to facilitate prompt claim filing. In some cases, since the death certificate is necessary to make a claim, the tracking agent is also responsible for obtaining copies of death certificates and filing the documentation necessary to facilitate the collection of death benefits. (2) REPRESENTATIONS AND WARRANTIES When rating an LS securitization, DBRS considers the completeness and effectiveness of standard securitization warranties and covenants for the proposed transaction, as well as those specifically tailored for LS securitizations. These include representations that address the following matters: The information provided in the schedule of policy collateral exhibit to the Pooling and Servicing Agreement is correct in all material respects. All procedures and documentation for the proper sale of the policy to the issuer has been duly completed in accordance with applicable state and federal law. As of the respective sale date, the insurance policies are free and clear of all filed security interests, liens, charges and encumbrances and no offsets, defenses or counterclaims have been asserted or threatened. As of the respective sale date, each insurance policy is or will be secured by a first perfected security interest in favor of the issuer. Each insurance policy, at the time it was originated, complied (and as of the respective sale date complies) in all material respects with applicable federal and state laws, including, without limitation, consumer credit, truth-in-lending, equal credit opportunity and disclosure laws. 5
Additionally, DBRS considers the adequacy of the following: Representations and warranties of the originator covering, among other things: The life settlement provider is properly licensed to act in the capacity of a life settlements provider in all jurisdictions requiring such a license. The origination of the life settlement policies has been effected in compliance with all federal, state and local laws, rules, and regulations. The life settlement policies comply with the eligibility criteria established for the transaction. The life settlement was completed in accordance with the agreed sale documentation and related conditions. Errors and omissions insurance coverage is maintained at a satisfactory level. Adequate indemnities and/or repurchase obligations in connection with its obligations under the origination agreement by the provider exist and that any caps or exceptions to the indemnity and/or repurchase obligations are not unduly exculpatory to the provider. The origination agreement and the origination procedures provide for the role of an independent verification agent and/or a satisfactory level of compliance with the stated origination procedures can otherwise be demonstrated. Additional criteria of an LS securitization include the following: The purchase of each policy is a valid and legal sale according to applicable state, local and federal law and regulations. The seller of each policy fully understood the nature and financial implications of the transaction and was in full possession of his or her faculties at the time of the sale. All other interested parties to the policy (spouse, any other relative or original beneficiaries, etc.) recognize the nature of the sale contract and forfeit any future claim to the policy s death benefit, thereby minimizing the risk of future contestability by any survivors. There is complete transparency with respect to the economic interests of the transaction s intermediaries and counterparties. (3) SELECTION OF LIFE INSURANCE POLICIES AS COLLATERAL The U.S. insurance industry offers a variety of life insurance products. While most of these products have potential as viable collateral for life insurance settlement securitizations, some are better suited than others. Basic qualifications for life insurance policies eligible for DBRS-rated transactions are summarized below. In addition, DBRS prefers limits on disease concentrations to prevent cure risk. A legally enforceable insurable interest must exist. Policies cannot be cancelled by the carrier, except for non-payment of premium. Policies must be in force. Policies cannot expire or terminate prior to the insured s death event. The insured must be a U.S. resident. Policies cannot be decreasing (common in businesses where policies death benefits decrease until they get to $10,000). There must be no restrictions on the payment or no restriction in the policies that prevents payment of a death benefit in one lump sum. Policies cannot be encumbered by a third party. Policies should have two independent life expectancy calculations. Term policies may be included only if they have already been converted, in addition to whole and universal life policies. Providers must be licensed in all states where the policies are purchased. 6
(4) INSURANCE COMPANY FINANCIAL STRENGTH The repayment of the rated debt is dependent on the financial strength or ability of the insurance company to pay the issuer, via the tracking agent, upon the insured s death. For investment-grade rated debt, the minimum criterion for an insurer s financial strength shall be a minimum of R-1 (middle) or A. To mitigate insurer financial strength concentration risk, DBRS prefers that the face amount of the death benefit for a single insurance company does not exceed 20% of the total face amount of the pool. (5) LIQUIDITY PROVIDERS In order to ensure that there are sufficient funds to pay the premiums on the life insurance policies, a liquidity provider may be included in the transaction. For investment-grade rated debt, the DBRS criterion for a liquidity provider is R-1 (middle) or A. DBRS reviews each liquidity agreement. (6) DBRS PROPRIETARY EVALUATION MODEL TO DETERMINE CREDIT ENHANCEMENT Assessing the impact of the various risk factors in a securitization of life settlement assets requires an overall framework within which to analyze each component of the transaction. DBRS has chosen a modular approach whereby dimensions of risk are stressed in accordance with a rating target. The next section discusses the individual functional modules and operation of the overall model. The following diagram describes the overall process used by DBRS to analyze a life settlement transaction. (1) DBRS conducts loan-level and portfolio-level analysis using the model. The resulting output of the model is the expected gross credit loss. (2) DBRS performs a cash flow analysis based on the output from the model by incorporating assumptions regarding prepayment, timing of loss and interest rates in order to estimate the excess spread available over the life of the transaction and the required credit support for each rating level. (3) The legal and operational aspects of the transaction are also reviewed with the understanding that the credit enhancement is subject to adjustment if necessary. 7
DBRS Life Settlements Rating Process Schematic Quantitative Assessment Qualitative Assessment Proprietary Mortality Evaluation Model Rule-based, formulaic extension of mortalities Mortality Table Based on Valuation Basic Table 2008 Operational Risk Review Origination: Focus on marketing; underwriting; processing; use and quality of technology Servicing and Collections: Focus on resource allocation, use and quality of technology, strategy and historical performance Compliance: Focus on use and quality of internal compliance procedures; depth and results of audits Determine Stresses Apply mortality stresses Determine the schedule of premiums based on a lag in payment of the death benefit and the rating of the insurance company Structural and Legal Analysis Trust Structure: Focus on bankruptcy remoteness, non-consolidation and true sale issues Cash Flow Allocation: Focus on appropriateness of flow of funds and how credit enhancement is affected by cash flow structure; when fees are paid Financial Structure: Focus on appropriateness and effectiveness of triggers and hedging instruments Cash Flow Analysis Apply quantitative inputs to cash flow modeling of proper transaction structure to assess attachment points for credit enhancement levels and ratings thresholds Final Credit Enhancement Output and Ratings Assignment Surveillance At regular intervals, assess ratings stability based on observed trends in transaction performance measured against rating inputs and methodology applied at time of initial rating Take appropriate and timely rating action if necessary Assess observable trends in asset class performance against existing ratings methodology to ensure ongoing rating criteria is current and relevant 8
Model Overview To evaluate the collateral which is, of course, an amalgam of insurance policies on the lives of the insureds many steps are involved, including the procedures outlined previously concerning the assessment of operational risk factors. From a quantitative perspective, DBRS stresses mortalities, understands the structure of the premiums necessary to keep the insurance in force, reflects each insurer s financial strength. (a) Mortality Determination It is industry practice to use Life Expectancy (LE) provider estimates to determine insureds specific life expectancies. However, the LE providers do not actually supply an expected date of death for a particular insured. They assume that there are 1,000 individuals with exactly the same age, gender and impairments as the actual insured and they predict the number of months until 500 of the original 1,000 will have suffered mortality. Thus, the providers are returning the mean of a mortality distribution. The LS securitization industry compares life expectancies provided by multiple LE providers as assumptions for its policy pricing models. DBRS recognizes the merits of this approach and gives credit to the incorporation of life expectancy calculations generated by recognized LE providers. Nevertheless, DBRS does not rely exclusively on LE provider-generated life expectancy calculations in its cash flow assumptions without adding significant stresses to safeguard investors. In the interest of enhancing both its analytical objectivity and independence, DBRS has developed its own proprietary mortality evaluation model. While based upon the work of the LE providers, the DBRS model is a rule-based, formulaic extension of mortalities designed to gauge investor yield response. The following sections provide an overview of this quantitative methodology. (b) Mortality Tables Central to the DBRS approach is the use of a mortality table reflective of the rates of mortality experienced in individuals likely to be evaluated and tracked for life settlement securitizations. While the generally accepted reference source for basic life expectancy data is the U.S. Society of Actuaries (SOA), its statistical resources have not been specifically tailored to the analysis of the target population for LS securitizations. As of the date of this report, the most commonly used data source, the SOA s Valuation Basic Table 2001 (VBT2001), may be out of date and not reflective of the (longer) current life expectancies. A new VBT, currently referred to as VBT2008, is expected to be released within the year. It has been established that mortality rates, in the recent past, have been running at approximately 70% of the VBT2001 experience and approximately 53% of the SOA 75-80 year-old experience. In order to incorporate realistic collateral pool assumptions in its analysis of proposed structured life settlement transactions, DBRS has applied ratios, obtained from the SOA web site, which adjust the VBT2001 to be more reflective of the soon-to-be-released VBT2008. DBRS then graded to ultimate and performed appropriate smoothing for male non-smoker and female non-smoker versions of the table. DBRS refers to the resulting tables as the DBRS 2008 Mortality Tables (see the tables below). (c) Mortality Stresses In order to probe the robustness of the proposed securitization, DBRS first stresses parameters which are determinants of life expectancy. The first determinant is the DBRS 2008 Mortality Table itself. Accounting for increasing overall longevity, cumulative improvement factors are applied. Using the DBRS adjusted tables, a minimum mortality ratio is computed and split into a) basic debits (100 debits = standard mortality), and b) excess debits. A portion of the excess debits are rejected and the age of the insured, as well, is reduced. Thus, depending on the transaction rating, an improved mortality table, a stressed mortality ratio and a stressed age will facilitate the determination of life expectancy in the Monte Carlo simulation. (d) Simulation Stresses Beginning with the first insured, variates are drawn until mortality is determined. In order to normalize its ratings response, DBRS adds a number of months (a post-mortality shift) to the mortality date. DBRS then determines the cash flows associated with this insured, namely (a) the schedule of premiums until the shifted mortality date, (b) a lag in payment of the death benefit, and (c) a stress based on the rating of the 9
insurance provider to reflect some probability that the provider will not be solvent at the time the death benefit is to be paid. All insureds are evaluated and the cash flows are then aggregated. Combining these cash flows with the issuer s securitization model allows DBRS to highlight possibilities that the structure will not allow for full payment to the investors. After an appropriate number of simulations, DBRS analyzes any simulated investor loss experiences for each rating category Mortality Comparison for 75-Year-Old Male Non-Smoker 350 Mortality per 1000 300 250 200 150 100 50 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 Duration VBT 2001 DBRS 2008 Mortality Comparison of 75-Year-Old Female Non-Smoker 300 Mortality per 1000 250 200 150 100 50 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 Duration VBT 2001 DBRS 2008 Conclusion 10 DBRS expects the LS securitization market to mature over time. Even so, life expectancy calculations and mortality rates remain risks in the life settlement process. As a result, DBRS uses its proprietary evaluation model to analyze this extension risk. However, advances in medicine, such as a cure for cancer or other debilitating diseases, could critically impact mortality rates and therefore repayment rates to investors. Therefore, DBRS continues to monitor the industry for progress with regard to its life expectancy calculations and their impact on deal performance, if any.
Appendix A: Sample Life Settlement Securitization Flow Chart X Insurance Company Obligors Insurance Company Insurance Company Collateral Evaluators Original Beneficiaries Beneficiary Insurance Policy Collateral Insurance Policy Insurance Policy Life Expectancy Providers/ Medical Examiners Beneficiary Collateral Administrators Policyholder Sellers Policyholder Policyholder Actuaries Data Aggregators/ Processors Tracking Agent Policy Custodian $ $ Originators Producers Brokers Medical Records Verification Agent Collateral Counsel Premium & Claims Admin. Offer Providers Bids Collateral Manager Premium Payments Claim Payments Funder (Beneficiary) Special Purpose Entity (Issuer) Structuring Agent Investment Bank Risk Mitigators Liquidity Provider Trustee Commercial Bank Transaction Evaluators Counsel Mortality Hedger Maturity Guarantor Investors Senior Investor(s) Subordinated Investor(s ) Equity Investor(s) Accountants Rating Agency 11
Appendix B: Operational Risk Summary ORIGINATION Risks The insured/seller of the life policy or the insured s heirs may not understand the implications of the transaction. Typical broker risk. There is little supervision over the agent/broker. Agents may or may not be licensed. Agents may shop the policy for the best price. Providers may not have adequate controls in place to monitor broker/agent activity. Fraud. Medical files could be altered to obtain a shorter life expectancy calculation. Incorrect transfer of the policy to the new owner (provider/collateral manager). Documents may not comply with state laws and regulations or consumer protection requirements. Mitigants Brokers/agents are responsible for obtaining the necessary signatures of the policyholder to legally transfer the policy to the new owner. Providers typically have operations staff that accounts for all the required documentation and verifies that all necessary signatures have been obtained. However, current documents are not standard, but with the evolution of the product type, DBRS believes standardization will occur over time. The issuer/provider typically has processes and controls in place to monitor broker/agent activity and performance. Processes are generally reviewed through DBRS operational reviews. Representations and warranties provide some protection against fraud by the broker/agent as to the accuracy of legal documents and medical files. Sale occurs after rescission period. The issuer/provider gives representations and warranties that all insurance policies meet issuer eligibility requirements and comply with legal statutes, state laws and regulations, and consumer protection requirements. MEDICAL UNDERWRITING Risks Medical underwriter or life expectancy provider may not be independent. Provider/collateral manager may dictate life expectancy. Underwriting manuals or systems may not reflect the most current medical advances or health and lifestyle changes. Medical files may be incomplete or dated. Documentation may be missing, there may be purported fraud or there may not be enough medical history provided to develop an accurate life expectancy calculation. Inexperienced underwriting staff without access to physicians (due to cost). Mitigants Typically, medical underwriting firms have quality control functions or procedures in place to ensure that staffing, the application of debits/credits and reviews by qualified physicians are sufficient to provide some but not all assurances that the impairments noted in medical files have been accurately assessed and that life expectancy calculations are accurate. Reviews by qualified physicians help ensure that health and lifestyle changes are considered in the underwriting process. 12
TRACKING AGENTS Risks Inability, due to either inadequate staff or lack of technology, to contact the insured to establish status. Inability to obtain death certificate, affecting payment of claim. Inability to provide adequate reporting. Mitigants Tracking agents are typically licensed brokers skilled in finding and contacting people. Tracking agents have access to a variety of databases, including U.S. Social Security, which assist in determining the status of the insured. A frequent determination of the insured s status is necessary in order to make a claim in the event of the insured s death. Tracking agents also assist with obtaining the death certificate and/or submitting the information necessary to make a claim. 13
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