Package Deal.

The life-sentiments business is maturing as securitization and valuation models emerge.

In the few years life settlements have existed as a line of business, growth has been sporadic, with a wide range of quality among companies and almost nonexistent regulation. But the industry segment may mature as it moves toward securitization of investors' money into bonds and as regulators try to catch up.

In a life settlement, the owner of a life insurance policy sells it to a buyer at a negotiated percentage of the face amount. The parties engage in such a contract when the owner/insured no longer needs the insurance and because the purchase price exceeds the policy's cash value. The buyer, who works through an intermediary, or originator, profits when the death benefit exceeds the amount invested.

Life Partners is close to arranging securitized bond issues that would be sold at the institutional level, said Brian Pardo, president and chief executive officer of the Waco, Texas-based settlements firm. The reinsured bonds would guarantee a competitive investment return and the potential for greater gains. The news comes from a company, however, that announced a reported $20 billion deal in May 2000, only to see it fall apart.

Meanwhile, the segment as a whole continues to operate largely outside the oversight of insurance regulators, leaving investors and sellers to protect themselves from the risks of fraud or incompetence.

Life-settlement originators argue, however, that the vast majority of business--even before securitized bonds--is and will continue to be between sophisticated buyers and sellers, parties that are exempt from many kinds of regulation.

Regulators are moving to put rules in place. The National Association of Insurance Commissioners has adopted a model law on viatical transactions that also covers life settlements. Eight states have passed laws, but only four states have regulations, said Alan Buerger, CEO and co-founder of Coventry Financial, a life insurance valuation and settlement firm based in Fort Washington, Pa. "So there are 46 states with no regulation," Buerger said. "That's why we support the NAIC model bill."

Bond Securitization

Life Partners is pursuing the bond-securitization strategy it believes will dominate the industry after failing in its original strategy. In May 2000, Life Partners said it had entered an agreement with a large foreign financial institution with net capital of more than $500 billion. This party, which Pardo declined to identify, was to provide Life Partners with capital of $1 billion each quarter for five years--a total of $20 billion--to buy qualifying life policies. The money was to have been securitized and sold to the capital markets as bonds. But the agreement unexpectedly fell apart when the foreign bank's choice of reinsurer, also based in Europe, was not acceptable to the capital markets.

"We had lined up about $800 million worth of policies that fit the buying criteria before we discovered the reinsurer was not acceptable," Pardo said. "However, we have found very significant interest among the big bond players on Wall Street for life settlements as an emerging class." He also has found a U.S.-based reinsurer that meets the capital market's criteria, and he said Life Partners is finalizing details with a couple of bond underwriters. "We no longer see a reason to go through a bank as a provider," Pardo said. "That would just be adding a layer of expenses."

Pension funds have a "voracious appetite" for bonds to match maturities against their future cash obligations to retirees, Pardo added. Each bond tranche would be worth about $500 million in face amounts and have a 10-year actuarial life expectancy. The securitized bonds of the future could guarantee a competitive return of perhaps 6% and provide the possibility of a higher return. "That's attractive to a pension-fund manager," Pardo said.

Setting a Price

A life insurance agent for 30 years, Buerger sensed opportunity in the fledgling life-settlement business. So he agreed to co-found Coventry in late 1998. In the past year, Coventry has created more than $100 million in excess of cash-surrender value for insureds selling their policies. Advancing age, a change in insurability from the time of policy purchase and the premium structure all contribute to how much a buyer is willing to pay. In a recent case, for example, Buerger received a $110,000 offer from what he calls a "provider"--the party that provides capital for purchases-for a $900,000 term life insurance policy on a 72-year-old man. In another case, a divorced woman had $3 million of term coverage on which her former husband agreed to pay premiums for several years after the divorce. She did not want to continue paying those premiums, and Buerger was able to find a buyer to pay her $400,000. She used the money to buy a permanent policy, and the agent earned a new commission, Buerger said.

Buerger suggested that determining the fair-market value of life policies ought to become part of the financial-planning process. People no longer want to own life policies for many common reasons, including the sale of a business, divorce, bankruptcy, retirement, a defective life insurance trust, family issues or estate-tax reform. Any person over 65 with deteriorated health is also a candidate, he added. In a recent interactive virtual seminar, 88% of participating agents said they knew of at least one client who could benefit.

In addition to acting as the originator, Coventry has developed a valuation process using proprietary software. The company's financial analysts need the insured's most recent five years of medical records and an in-force policy illustration to age 90 or 95. "Then our medical director and his staff underwrite the prospect," Buerger said.

Prospects for life settlements look bright, according to a 1999 report by Conning & Co., a broker-dealer that also researches and reports on the insurance industry. Hartford, Conn.-based Conning estimated life-settlement purchases that year to be about $1 billion in face amount, and it conservatively estimated the market potential at about $100 billion.

Privacy Concerns

An outspoken critic of life settlements, Joseph Belth, said the new industry segment is beset by many troubling issues. Chief among them are the risks faced by insureds when their policies are no longer owned by parties with an insurance interest. "Their medical records are open and available for the rest of their lives," said Belth, professor emeritus of insurance in the Kelley School of Business at Indiana University in Bloomington, Ind. "They're completely open forever, and [the insureds] are told they'll be tracked for the rest of their lives. There's a price to pay for that."

Belth also said there is no evidence that the buyers of life settlements have made any money, that the originating companies work in secrecy and "operate by the seat of their pants" and that the state of regulation is "what it was for the insurance industry in the 19th century."

"A person who sells a policy has a right to know who gets the money from his early death," Belth said. "If some reputable company buys the policy, he still loses control. That company could transfer the policy to another party, and it could be resold numerous times. Once you sell the policy, you lose control. The NAIC model law doesn't get into these things."

There is even a question about whether states have the authority to regulate the industry segment. Courts have ruled that a viatical transaction does not constitute the business of insurance and investing in viaticals does not equate to buying a security as defined by securities laws. A viatical differs from a life settlement in that the seller is deemed to be terminally ill and likely to die within two years, but the legal concepts are similar. Also, policy face amounts for viaticals average about $100,000 as compared with $1 million for life settlements, Buerger said.

Both Buerger and Pardo agreed with Belth's contention that investors have not made any money. "The life-settlement business is no more than 3 years old," said Buerger, noting that very few insureds have died. "You need to have a mature block of business. We've created an elaborate simulation program with pools of policies showing it to be a profitable business, but nobody has experienced it."

Pardo said he's not aware of any business being done, except by firms on a small scale. "There are no bond underwritings to date, and that's the form the business will take," he said.

Chicago-based CNA, which uses a buy-and-hold strategy through its subsidiary, Viatricus, claims that it is making money, Pardo said. "Its business is turning over, and they claim they're making a better-than-market return," he said. "I'm familiar with their underwriting guidelines, and we estimate it to be about 14%."

The CNA director of media relations, Katrina Parker, was unable to arrange an interview with someone at the company who could speak about the business. Parker said CNA is not trying to sell Viaticus and that it would not respond to rumors about selling. Lou Nathan has replaced Gary Chodes as president of Viaticus.

Valuation Process

Coventry uses a more involved model than CNA's, but less complicated than that of Life Partners. It works with Dresdner Bank, based in Germany, DG Bank (with offices in New York) and Abbey National, a large bank in the United Kingdom. "We strictly broker," Buerger said. "We get a policy, value it, send it to the providers and pick the highest offer. We have that company buying it, and then it goes into a pool of policies that is the collateral." Coventry earns a fee for being the broker.

Buerger is sensitive to issues raised by Belth. He agrees that individual buyers should not have a place in the life-settlement market, which is why he uses only institutional providers. "Then you have the same kind of relationship as an insurer has with the owner of a life-only payout annuity," he said. "There may be 50 companies that broker policies, but only five use institutional investors."

Tracking Insureds

Sellers using Coventry know who the buyers are. As part of a contract, the insured gives tracking rights through two or three nominees, usually professionals such as attorneys, who will periodically touch base with the insured and file reports with the institution. The "real backstops" for buyers are government databases, including Social Security. "We submit every month to these," Buerger said. "It picks up deaths in six to eight weeks."

Also by contract, the institution agrees to never resell a policy to another party. Some state laws also prohibit that kind of sale, and to monitor potential resales, states perform annual on-site audits, Buerger said. "This is becoming an increasingly heavily regulated area."

As far as selling or disseminating the insured's underwriting information, law prohibits institutions from the practice because it is confidential information, Buerger said. "That's one of my problems with an individual investor," he added.

Among the merits of the NAIC model law is that it is strong in its antifraud provisions, Buerger said. "Ironically, it protects individual investors," he said. The model law limits language that brokers may use in advertisements to lure investors, for example. It also protects insurers from the practice of "cleansheeting," in which applicants inaccurately portray their health conditions and then immediately sell their new policies for cash. The model law also sets forth licensing requirements for those who would be in the business. A controversial part of the model act is a provision that would require funding companies to submit medical information they have to the carriers. That requirement contradicts the incontestable provisions of life policies, Buerger said.

Pardo said Texas recently passed a law requiring that companies be licensed for the life-settlement business. He expects California and New York to follow suit. But he does not expect many states to adopt the NAIC model act. "They've been working on it for 10 years," he said of the act, which mainly addresses viaticals. "The NAIC is out of touch with reality in a lot of things they propose, and in those cases, the states ignore those sections of the laws it is trying to have adopted."