Purchasing power: life-settlement providers must overcome problems in underwriting, financing, marketing and perseverance to tap into a potentially huge market. (Life Settlements).

The benefits of life settlements to consumers and the opportunities they provide producers have been well documented for years. Even conservative estimates of market potential should invite robust competition. Testimonials of satisfied clients and rewarded producers abound. With these kinds of market fundamentals, life-settlement sales should be rising faster than 1990s technology stocks, but they are not.

Instead, they have fallen prey to problems similar to those that initially plagued the long-term-care insurance industry. By recognizing and mastering key disciplines, however, life-settlement providers can break open the stagnant market and start sales on an upward path.

In late 1997, Viaticus Inc., a CNA subsidiary, launched a life-settlement product. Life settlements are similar to viatical settlements in that a third party purchases a life insurance policy from the policyowner at a discount and holds it to maturity. However, the target market, distribution channel and motivation to sell the policy are completely different. (See "Life Settlements vs. Viaticals," on page 108.) Thus, a new industry was born. Over the next two years, other viatical settlement companies introduced their own life-settlement products as the product got traction through advertising, promotion and word of mouth. By December 1999, Conning, an insurance research firm, published a strategic study sizing the life-settlement market at an astonishing $108 billion--more than four times the size of its viatical-settlement market projections. The report also identified some leading life-settlement companies, all of which would disappear from the market within a matter of years.

As these companies were exiting the business, however, others were entering. Importantly, these new entrants were either backed by or had connections to deep-pocketed financial institutions. By late 2001, it appeared that a nucleus of committed, credible suppliers had formed to deliver on the projections of the Conning report. But by early 2003, another round of ungraceful market exits had occurred, leaving the putative industry in a continued state of instability and producers with lingering skepticism.

Given the attractive market fundamentals and the fact that billions of dollars of individual life insurance is surrendered or lapsed each year, why is it that after more than five years of exposure there are still only a handful of life-settlement companies, and why do their names keep changing?

All organizations entering an industry, particularly an industry as unsettled as life-settlement, need to possess the proper head (intellectual capital), heart (marketing commitment) and stomach (perseverance) for it. Although many organizations have looked into the life-settlement business, most quickly determined they did not possess one or more of these disciplines. And, those that entered and then exited the business discovered that they either lost or never had all the required disciplines to sustain their appetite for the business. An analysis of the challenges surrounding each discipline reveals why so few organizations enter the business and why some exit so quickly.

Mastering the Challenges

The two intellectual capital challenges are determining underwriting policy and securing financing. The underpinnings of underwriting policy are establishing mortality multiples for discrete and multiple health conditions and then interpolating that judgment into a life expectancy. Actuaries and underwriters in the life insurance business can draw from a plethora of industry and proprietary seasoned databases to make such decisions. The life-settlement business has neither a centralized underwriting data source nor a critical mass of proprietary experience from which to draw, and drawing inferences or correlations from life insurance data is highly subjective for the following reasons. First, life insurers have proprietary data to refine current Society of Actuaries mortality tables, a resource life-settlement providers do not have. Importantly, life insurers have vast in-force portfolios to mitigate risk and volatility in contrast to life-settlement providers who have statistically insignificant and immature portfolios by comparison.

Second, life insurers further mitigate risk through diversification by issuing a spectrum of policy types and face amounts to all ages and classes of applicants as opposed to life-settlement providers who typically assemble more homogeneous portfolios by purchasing flexible-premium policies in excess of $1 million dollars from males who are over 65 years old and in declining health. Third, the trend in the life insurance industry is to create multiple classes, within both smoker and nonsmoker cells, creating in some cases up to eight to 10 underwriting classes. To what extent is this approach relevant to life-settlement underwriting, and if so, how should it be incorporated into the underwriting process? Another trend among life insurers is to assume aggressive, medical technology and health-care improvements, which translate into longer life expectancies. These projections have yet to be proven over time. Further complicating the impact of medical advances is the issue of whether affluent and high-net-worth insureds, which are the target market for most life settlements, will benefit disproportionately from these advances because of their financial resources or life style.

Consequently, actuaries and underwriters who are used to analyzing the number of outcomes per 100,000 events are not confident when working with single-, double- or triple-digit data points. To compensate for this uncertainty, conservatism and over-engineered pricing formulas are built into life-settlement underwriting policies, thus suppressing robust portfolio growth, which creates a new problem--concentration issues within a limited portfolio. All underwriting and pricing protocols have an inherent propensity to prefer policies with certain profiles considered to be favorable to the provider, which impedes the acquisition of a diverse portfolio. Without the comfort of the law of large numbers, diversification hedges and the uncertain impact of health-care improvements, it could be argued that current life-settlement underwriting is more art than science.

No organization has unlimited capital; subsequently organizations deploy various debt and off-balance-sheet instruments for liquidity and growth. The life-settlement business is a capital-intensive one, given the policy-acquisition and maintenance costs and the fact that an ongoing and growing business is inherently cash flow negative. Unlike established industries, however, the life-settlement business does not have easy access to ready capital due to the aforementioned underwriting issues and the lack of debt/credit ratings. Consequently, financing is thin, inconsistent and complex. Furthermore, if an organization is successful, hundreds of millions of dollars could have been committed with negligible returns, potentially leaving the organization in need of additional capital. Conversely, if policy acquisitions do not meet projections, capital commitments may be withdrawn because the returns that attracted the investor will not materialize and the investor will deploy it elsewhere.

An additional challenge to industry financing is a recent change in accounting protocols, which further taxes a highly cash-flow-sensitive business. Although there are strategies to neutralize the impact of this development, it is one additional hurdle that organizations must commit to solving to enter and remain in the life-settlement business.

Marketing Mistakes

Historically, marketing commitments have been as spotty as financing for three reasons. First, after securing scarce operating and portfolio capital, there may be limited dollars available for consistent and robust marketing initiatives. Second, many organizations lack the necessary patience to let marketing programs take root, making missteps like prematurely starting programs they are not ready to service, stopping programs they cannot precisely quantify or frequently changing messages, audiences and platforms. Third, like many life insurance companies, many life-settlement companies have a belief that once you create the product, the marketing is done. Consequently they take the path of least resistance and rely on existing distributors, who represent a tiny fraction of potential financial-services professionals who could engage in the business. Without appropriate producer recruiting and marketing initiatives, supply overwhelms demand, complicating the issues described above.

Additionally, it is not uncommon for certain capital sources to demand that their relationship with the marketing organization remain proprietary. In absence of transparent financing, many potential producers question the credibility of the business. Furthermore, industry growth is suppressed by the continued abuses and scandals in the viatical-settlement business that have caused many broker/dealers and life insurance companies to discourage or forbid their producers from engaging in the life-settlement business.

Staying in the Business

It is the lack of perseverance, however, that troubles the life-settlement industry the most. When new entrants are minimal or when new entrants enter the market in a tepid manner or when institutional backers quickly abandon commitments, and when no buyers appear when life-settlement companies are put up for sale, credibility evaporates and the market stagnates. Perseverance appears unattainable, since the underwriting, financing and marketing issues cannot be resolved without growth and growth cannot occur before these same issues are resolved.

Solving the Problems

A compelling argument can be made that the product cycle of life settlements will be similar to that of long-term-care insurance. Despite the irrefutable demographics of an aging population curve, longer life expectancies due to medical advancements, fragmented nuclear families and an obvious need for coverage since Medicare paid less than 2% of all long-term-care costs, long-term-care sales were small. Similarly, despite the surrender or lapse of billions of dollars of individual life insurance each year, life-settlement sales are negligible. As life settlements emerged from viatical settlements, long-term-care policies progressed from convalescence and nursing-home policy forms. These policies were issued by a limited number of small companies, whose financial strength, if rated, was in the vulnerable B and C range, similar to nearly all viatical-settlement companies, and like early viaticals, the pricing and benefits were not particularly attractive and distributors were not mainstream insurance and financial services professionals.

Finally, like viaticals, long-term-care scandals and consumer abuses were regularly reported in the media with subsequent warnings to consumers to be wary of the product and of those representing it. The explanation for the undeveloped long-term-care market was strikingly similar to the dynamics surrounding the life-settlement market--insignificant underwriting data, uncertain and long-term financial exposure and negative publicity that poisoned both consumer and industry interest.

Fortunately for consumers, within a few years many prominent companies began to distribute quality long-term-care products through professional intermediaries who advise the age 65+ target market of their planning options. This outcome reflected an unwavering and focused commitment to an emerging market with solid fundamentals by first one, then eventually a few, then ultimately more than 125 companies. This act of perseverance required a stomach to take on the ambiguity, uncertainty and risk of the challenges facing the industry.

Just as someone underwrote the first block of life, auto and maritime policies without a single data point, long-term-care carriers made assumptions and projections and assumed calculated underwriting and financial risk. Long-term-care underwriting is even more complicated than life-settlement underwriting. Although like life settlements, mortality, life expectancy and health-care improvements are relevant, unlike life settlements, additional variables need to be taken into account--morbidity, expanding alternative forms of care, life style, family support and the mental and emotional health of the applicant. Long-term-care pricing, benefits and application requirements ebbed and flowed as the underwriting knowledge base grew. The life-settlement industry can evolve in the same way.

With a long claims tail and heavy reserve requirements, long-term-care portfolios require consistent deep-pocket financing. In exchange for making this financial commitment, the carrier participates in a real growth vs. zero sum market and in a reward commensurate with the risk. Although life-settlement providers enter the market for the same reasons, they end up squandering their initial investment with premature exits. The business will always be a negative net present value one if the investor cannot even make a commitment to seeing it through to its projected positive cash flow point. Depending on the business model and portfolio growth, this point could be as early as the third to fourth year or as late as the seventh to eighth year.

Committed long-term-care carriers also deployed consistent and aggressive educational and promotional initiatives to meet the marketing challenges head on, turning negative perceptions and resistance into product endorsements and market success. This success was achieved by a transparent commitment to the product, distribution channel and consumer. The marketing budget may have paid for the advertisements, lead-generation programs, conventions and seminars, but those were just the media to communicate the core message--long-term care is a good business that we want to build over time. Importantly, committed long-term-care carriers understood new distribution channels must be built. Just like the former network of nursing-home policy agents was supplanted by a new network of long-term-care agents that delivered the long-term-care product effectively and with scale, the previously existing viatical broker network has largely been replaced by mainstream financial services professionals who will enable the life-settlement business to evolve in a similar fashion.

Most life-settlement companies understand the best channel for the product is the proficient and seasoned life insurance or financial-services producer, but many do not know how to leverage those producers, or if they do, there is no chance to prove it because their doors close before they can. There are isolated instances historically and currently that suggest when focused and meaningful marketing commitments are made, results follow. Some day tenacity will bear this out.

The capital markets are creative and opportunistic. Insurance companies are risk takers with patient capital. One day, long-term financing and liquidity will come to the life-settlement marketplace from one or both of these sources--provided some organization has the stomach to assume the underwriting, pricing, accounting and marketing challenges. This will signal others to do the same and deliver the critical mass of product to warrant their long-term investment.

RELATED ARTICLE: Life settlements vs. viaticals.

By definition and under current National Association of Insurance Commissioners Model Law, viatical and life-settlement transactions are one and the same. Both represent the sale of a life insurance policy by the policyowner to a third party. Using a proprietary formula, the third party or provider discounts the death benefit and makes a cash offer to the policyowner or settler. Once the offer is accepted, the provider becomes the policyowner, beneficiary and premium payer and receives the entire death benefit upon maturity. The settler has immediate and unrestricted use of the sale proceeds and the right to rescind the sale within a specified period of time.

Although viatical and life settlements are similar in structure, they differ vastly in target markets, distribution channels, motivation to sell and taxation of proceeds.

                Viaticals                 Life Settlements

Target Market   Terminally ill            Individuals who are not
                individuals, all ages;    terminally ill but
                low-to-moderate face      have experienced
                amounts, typically        a decline in health
                $25,000 to $250,000       since the policy was
                                          originally issued,
                                          age 65+; large-to-
                                          jumbo face amounts,
                                          typically $250,000
                                          to $20 million+

Distribution    Viatical settlement       Insurance, investment
Channel         brokers                   and financial planning
                                          professionals

Motivation      Immediate cash needs,     Change in insurance needs
to Sell         enhanced life style       triggered by evolving busi-
                                          ness, estate or personal
                                          financial-planning needs and
                                          goals

Taxation        Income tax free           Not defined by current
                                          tax code but by expert
                                          opinion believed
                                          to be tax free
                                          up to policy basis,
                                          ordinary income
                                          tax for amounts above
                                          basis up to policy's
                                          cash surrender
                                          value and capital gain
                                          tax for amounts above the
                                          first two calculations

Steven Arenson is principal, Arenson Consulting Inc. He has served as vice president of sales and marketing for CNA-owned Viaticus Inc. and GenRe-funded Living Benefits Financial Services Inc.

Bob Miller has more than 20 years of experience building brand, distribution channels and sales in the insurance and life-settlement industries. Most recently he was chief marketing officer for Centre Life Finance.