A TIA white paper¹ examining the economics of Stranger-Originated Life Insurance (STOLI) transactions foretold more than two years ago that life expectancy calculations were untenable and would change on one or both sides of the STOLI transaction. STOLI (also known as Investor Originated Life Insurance or IOLI) transactions, unlike stand-alone life settlements, generally involve the issuance and settlement of a policy initiated by an investor who lacks an insurable interest in the insured. A STOLI transaction typically involves a life insurance company, a life settlement provider, and a special-purpose lender providing premium financing.

STOLI is fundamentally a "mortality futures" transaction in which the different parties involved in the transaction have different expectations about the future value of the article of trade in the futures contract. This article of trade in STOLI is the life expectancy of the insured. This life expectancy or “LE” is calculated one way by the life insurance companies on issuance of a life insurance policy and then calculated differently for the life settlement market-maker and premium-financing lender for settlement purposes. The longer the LE calculation by the life insurer, the lower and more attractive the premium. The shorter the LE calculation for the life-settlement market maker, the more they can offer to purchase a policy. Of course, only one of these LE calculations can be correct.

While certain life insurers appear to have modestly changed their LE calculations over the past few years (i.e., premiums for certain products have increased over the past few years), 21st Services, a major independent provider of LE evaluations in the secondary insurance market, recently dropped a "bombshell" by announcing the substantial lengthening of its LE determinations by up to 35%, which adversely impacts many life settlement offers by even more than 35% and renders many other policies un-sellable at all for reasons discussed below. This announcement has affected both STOLI and life settlement and premium financing transactions as market participants scramble to adjust to the change.

Importance of LEs. The life settlement and premium finance markets rely extensively on LE evaluations of insureds in order to value life insurance policies. Investors use these LE reports to price policies for acquisition and to project the expected investment returns. Lenders depend on LE reports to assess the value of policies provided as collateral for premium finance loans. Depending on the financing program, the policy may be the primary or only source of security in the event of the borrower’s default. Thus, as noted in a March 2008 study conducted by Milliman USA and Phoenix Life Solutions, LE estimates “may be the single most important factor in calculating the value of a life settlement policy or investment portfolio of settlement contracts.”²

LEs & Valuation. Generally, a shorter LE report results in a higher policy valuation, since an investor expects to pay fewer premiums on the policy, while receiving a quicker payout of the death benefit. If, however, the insured’s actual LE exceeds the report, the investor will have underestimated both the costs to maintain the policy and the timing of the payout. The result is a decline in the investor’s rate of return. Thus, an across the board lengthening of LE evaluations by a major provider like 21^st Services effectively lowers the value of the policies that relied on the prior, shorter estimates.

Impact. This correction by 21^st Services has affected every facet of the secondary insurance and premium finance industries and temporarily locked up these markets. From the investment perspective, investors are experiencing a significant decline in the value of their policy portfolios, with some reports suggesting a 7% to 10% drop in projected internal rates of return.³ Further, investors are withdrawing funds pegged for life settlement investments until the market adjusts. As a result, many pending life settlements have fallen through, since life settlement providers no longer have the financing to support prior offers. Other pending settlements are on hold as providers demand updated LE reports or seek to renegotiate their offer prices, making brokers work overtime to save deals.

The premium finance market has not been left unscathed by the correction, as lenders suddenly find that the value of their collateral (e.g., the policies) may be impaired. Policies financed using the shorter 21^st Services LE reports (or some blended approach) now may have insufficient value to cover the repayment of a loan when it comes due, meaning a loss for the lenders.

Finally, the LE adjustment adversely affects policy owners, who could be left with policies that they are unable to sell or must sell at a much lower price. In addition, depending on the financing program, owners with financed policies may be required to provide additional security to make up for the collateral shortfall caused by the policy’s devaluation. Policy owners that have premium finance loans coming due in the near future may face even more difficulties. The nationwide credit crisis leaves little to no opportunity to refinance these loans, and, as noted, a sale of the policy on the secondary market will likely draw less than previously expected, leaving owners without adequate proceeds to repay the loans. Depending on the financing program, owners may now have unanticipated personal liability or tax exposure from the discharge of their debt. Thus, consumers who thought they were entering into low or no cost transactions may now find that is not the case.

Other LE Providers. It remains to be seen how other major LE providers, such as ISC Services, EMSI, Fasano Associates or AVS, respond to 21^st Services’ announcement. Fasano Associates, which claims a 96% accuracy ratio for its LE estimates, made adjustments to its 65 and over mortality tables earlier this year.⁴ In addition, the market share and relatively short LE estimates of 21^st Services as compared to other LE providers⁵ made its adjustment quite substantial. Adjustments by other LE providers may not have such a significant impact.

What the Future Holds. While the current outlook is dicey, many in the settlement industry believe the correction is critical to the long-term growth of the secondary insurance market and ultimately will bring more investors and cash to the table. Both investors and lenders will adjust their pricing and valuation models to reflect the longer LEs, which will provide greater assurance in the accuracy of policy valuations. Increased investor confidence and accurate valuations are crucial to the development of settled policies as a securitized asset class. Of course, longer LE reports will generally result in lower prices for policies, which may not be as beneficial for consumers or settlement brokers, who typically receive compensation based on a percentage of the offer price. Thus, although the market will likely move forward, significant changes in investment returns profitability may be experienced by all parties.

By: Jonathan M. Forster, Shareholder and National Chair of Wealth Management and Co-Chair of Life Insurance Groups, Greenberg Traurig, LLP; Jennifer M. Smith, Associate, Greenberg Traurig, LLP

1. "Stranger-Originated Life Insurance, Free Insurance? Found Money? A Good Investment? A Scam? What is it Anyway?," (http://www.theinsuranceadvisor.com/?id=312&openwindow=http://www.theinsuranceadvisor.com/documents/STOLIWhitePaper-Final.pdf)
2. Ed Mohoric and Robert O. Kinney, “Life Settlement Mortality Considerations and Their Effect on Portfolio Valuation,” Milliman USA and Phoenix Life Solutions, March 1, 2008 (https:// www.phoenixwm.phl.com).
3. See Donna Horowitz, “Market Rocked as 21^st Services Changes Mortality Tables,” The Life Settlements Report, Vol. II, No. 16 (Sept. 18, 2008)
4. “Fasano Announces New Mortality Tables for Over-65 Market,” Business Wire, February. 26, 2008
   (http:// www.businesswire.com).
5. See e.g., Valerie Coffey, “2007 Preliminary U.S. Life Settlement Market Analysis,” Life Policy Dynamics, Presentation, Sept. 17, 2008.