Avoiding the arbitrage trap: some life insurance companies are being targeted by investment firms that attempt to create blocks of policies that will be candidates for life settlements a year or two after issue.

Life insurance professionals must constantly remind themselves to focus on sound, fundamental business practices. In the game of football, the most fundamental focus is on blocking and tackling. Similarly, for those running a life insurance company, a primary focus must be on issuing profitable new business.

Executives typically receive periodic reports showing the amount of new business produced compared with a corresponding, preceding period. Likewise, the persistency of new business is a metric used by some to monitor the ultimate profitability of that new business. Certainly, writing new policies that lapse soon after issue typically results in the company losing the initial investment required to produce that business.

The question insurers should ask themselves is, "Can good fundamentals be deceiving?" Specifically, can increased production with better-than-expected persistency, sometimes be bad? Unfortunately, the answer may be "yes." It appears that some life insurance companies are being targeted by investment firms that wish to make money by creating a "mortality arbitrage." Typically, this is accomplished by taking advantage of the targeted company's underwriting procedures, which are constrained by legal and economic forces. This arbitrage most often takes the form of a block of policies that have been included in a life settlement vehicle created by the investment firm.

History of Life Settlements

Life settlements have appeared on the scene over the past 10 to 15 years. They are investment vehicles that package a block of life insurance contracts for sale to an investor group. Historically, the owners of the affected policies have been either very sick individuals (possibly patients diagnosed as terminal) or older individuals who wish to cash out of policies issued many years before, in order to use the available funds for living expenses. This type of life settlement can be positive for both the original owner of the policy, who receives more than his or her cash surrender value by selling the policy, and for the buyers of the policies, who can obtain a double-digit return on their investment.

By the very nature of these policies, they typically generate negative cash flow to the issuing insurance company. Since the persistency of policies included in a life settlement pool typically is 100%, with the investment vehicle paying the premiums required, the issuing insurance company's profitability is likely to be impacted negatively. If the policies are limited to very sick individuals or older policyholders, however, the negative impact on life insurance companies may not be that significant.

The Current Situation

As this potential arbitrage market has grown, there appear to be more entities wishing to create life settlement pools than there are policies available to fill them. Likewise, the difficulty identifying policies that qualify as life settlement candidates has limited the growth of these vehicles. Therefore, it now appears that some investment firms wishing to sell these vehicles are attempting to create blocks of policies that will be candidates for life settlements a year or two after issue. There is even a name for these: "wet ink policies."

In order to make any sense as an investment opportunity, the policies included in a life settlement pool must have projected death claims that exceed projected premiums. This occurs for most level term policies somewhere near the midpoint of the level term period (for example, around the 10th policy year for a 20-year level premium term policy).

Thus, firms are attempting to create a mortality arbitrage wherein life insurance companies will issue policies on a standard basis that the investment firms believe to be substandard from a mortality standpoint. The question is, why would insurance companies do this? The answer is, they would not do so knowingly. However, they may issue policies to individuals who have higher-than-expected rates of mortality because, economically, they cannot afford to spend the amount necessary in the underwriting process to identify such policies. An example of this type of policy involves recently sick individuals who apply for small face amounts of coverage and who are willing to answer application questions incompletely.

Alternatively, companies may be legally constrained in the underwriting process from reflecting higher-than-expected mortality for certain groups. Companies that from time to time conduct an underwriting sale, in which they lower their typical underwriting standards to increase the production of new business, may also become arbitrage targets. The pricing of a product will take a measure of this extra mortality into account through the use of historical mortality for either the company or the industry. However, a company being targeted by firms attempting to create a portfolio of policies with substandard mortality issued on a standard basis may experience substantially higher mortality, and better persistency, on these policies than was assumed during the pricing process.

Even with the expected increase in mortality, these policies may produce a negative return to the investors of the life settlement arbitrage vehicle. This negative return may be due to statistical fluctuations in actual experience due to the relatively small size of these life settlement portfolios. Alternatively, the negative return might be due to the substantial renewal profit margin that is required of these products, due to the insurance company's initial investment in commissions and underwriting. The increase in expected mortality may not sufficiently offset this implicit margin to create a positive return for the investors.

Thus, while the insurance company might lose money on these policies due to the greater-than-expected mortality, better persistency and initial up-front investment in agent commissions and underwriting expense, the life settlement investor may not make as much (or may actually lose money) as was expected when the investment vehicle was created. It is worth noting, however, that the promoters of the investment fund may still profit, because they might receive a placement fee at the time of issue and, in some cases, might participate in the agent commission that was received when the business was originally issued.

Insurable Interest 

The issue of insurable interest certainly begs for examination, either by the insurance company issuing the policy or by the regulators who oversee the insurance industry. Policies issued with the intent to be included in a life settlement investment pool typically lack insurable interest by the eventual owners of the policies at the time of issue.

It is difficult to see how the issuance of policies subject to inclusion in a life settlement pool shortly after issue is in the public's best interest. Allowing this life settlement arbitrage violates the insurable interest foundation upon which the concept of life insurance was created. Likewise, doing so will increase the cost of coverage to those who actually need it. Companies must remain vigilant and monitor increased purchases of term-type coverages that are best suited for this arbitrage due to their relatively low premium outlay. Likewise, insurers could effectively eliminate or minimize this market by identifying those policies that could legitimately be settled for more than their cash surrender value. While this may cost insurers some money in the short run, it could save them substantial sums in the long run, and would greatly enhance the value to the covered owners of the policies they sell.

Key Points

* Insurers might not realize they are issuing policies on a standard basis that the investment firms believe to be substandard from a mortality standpoint.

* Both insurers and investors might lose money on these life settlements.

* Insurers must monitor increased purchases of term-type coverages that are best suited for this arbitrage.

Contributor Bradley M. Smith is a principal in the Dallas office of Milliman Inc.