EXPENSES
“The key point is that ASC§820 requires the estimation of what a third party participant would pay to purchase the life settlement, not what the entity itself would pay.”
Portfolio managers must use a methodology that can establish, at
least annually or quarterly when plausible, a fair value compliant with ASC§820.10. Acceptable statistical methods (such as Bayesian) are valid for compliance with AU§328 (ISA§540) to arrive at a weighted average fair value per policy (and thus the sum will be a fair value of the portfolio). Annually, the difference between the prior period value and the newly established value will be clearly documented, transparent and available to be consistently used year after year in a fair valuation.
Historically, life settlements have been priced using two methods:
the point-to-point method and the actuarial method (sometimes referred to as the probabilistic cash flow method). The point-to-point method assumes that the policy will mature on the valuation date plus the determined life expectancy (LE) of the insured. Premiums are paid until the maturity date and the death benefit is received on the maturity date. This method can significantly underestimate the value of policies which have large premiums after the LE date. The point-to-point method is not appropriate under fair value accounting.
Actuarially sound pricing The actuarial method is currently used by virtually all purchasers of life
settlements. This method assumes that a portion of the death benefit is received and a portion of the premium is paid at each interval in the valuation. The benefit amount received is based on the probability of the insured’s death in the interval, multiplied by the death benefit. The premium is based on the probability of being alive at the beginning of the interval. The net amounts are discounted to arrive at the value.
The actuarial method thus requires four key inputs: the mortality rates, the discount rate, expenses and the life insurance premiums. Any life settlement valuation must deal with following variables, each of which affect the resulting valuation, some more than others.
MORTALITY RATES
• What mortality table serves as the basis in the determination of the mortality multiple?
• How was each of the LE estimates (as provided by different LE underwriters) used in the valuation? Were LE estimates combined, individually projected, etc? How ‘accurate’ are the LEs?
• How does the valuation handle future industry mortality table changes?
DISCOUNT RATE • Does the valuation use a different discount rate for each policy?
• Does the valuation use a single discount rate regardless of length of the LE, or are multiple rates used based on the duration? Is there any reflection of a risk premium over a risk-free rate?
• Does the rate incorporate credit risk (ie, defaults on payment by the insurance carrier)?
• What methodology is used to select the discount rate(s)? 68 CAYMAN FUNDS | 2012
• Does the valuation reflect the cost of ongoing and forecast maintenance expenses (trust, premium payments, collection of death benefits, etc)?
LIFE INSURANCE PREMIUMS
• Has the valuation validated that the policies are currently in force and that the premium schedules provided will keep the policies in force?
• Is the premium assumption (premium amount and mode of payment) consistent with the way in which the policies are currently administered?
Purchase price development
The following steps outline the typical approach used by buyers of portfolios of these types of assets.
1. Each life settlement policy at the point of underwriting will have at least two, and possibly three, commercial LEs—ideally producing a portfolio of policies based on the perspective of the same commercial LE underwriters for the entire portfolio. (Respectable LE underwriters will produce a report containing the underlying survival function for each insured case.)
2. Each policy will be priced independently for each commercial LE using the same probabilistic (ie, actuarial method) pricing model. The starting point is to average the LE underwriters’ prediction. In other cases, the purchaser may require the offer to be priced based upon a specific commercial LE only, no matter how many LEs may have been discarded at the time of pricing. Another example we have seen is to place higher weights on certain LE underwriters versus others (supporting documentation is required to describe the rationale for using uneven weights).
3. The buyer will also take into account any fees paid during the acquisition (such as due diligence or to facilitators), along with the cost of maintaining and servicing such policies.
4. If a buyer and seller come to an agreement, then the buyer will initially lock in the weights used for the LE underwriters that produce the accepted offer. This means the initial pool valuation will in essence reflect the weighted average of the assessments produced by the LE underwriters.
Financial statement estimates
Upon the successful purchase of life settlement policies, the following steps outline a fair value-based estimation process:
1. The pool size dictates if there exists any credibility. There are a number of various perspectives on how big a pool must be to reach “credibility”. Some of the rating agencies state that credibility is reached when a pool exceeds 300 policies, while some views in the academic area see the need for 1000+ policies. Regardless of pool size, a best practice is the continual assessment of the experience as it develops. For life settlements, this is no different. The asset holder must compare “actual to expected” mortality results. Over the long term, this sort of pseudo-mortality study will produce insight to the accuracy of the LE underwriters’ predictions. Common statistical analysis, such as Bayesian, will provide the basis to refine the weighting factors.
2. The other key point is to regularly update the LEs to current valuation date (ideally by having newer LE assessments and by mathematically bringing the LE estimate forward to the valuation date from the date of the LE assessment). Run two sets of portfolio valuations, one based on individual LE underwriters, which will define the bounds of the valuation, and another to represent the best estimate which relies on a management chosen weighted average of the LE providers.
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