3. Reverse Equity Transactions

A reverse equity transaction is a financial product that allows an individual—in this case, a senior citizen—to extract equity from an asset without the use of credit but rather life expectancy. For the sake of this discussion, reverse equity transactions may be defined as senior life settlements and reverse mortgages. These transactions have become increasingly popular with investors in recent years because they offer returns in the low to mid-teens that are largely uncorrelated to equities, fixed income, credit, real estate, and commodities. On the consumer side, these transactions can provide for health care and retirement costs in a person’s golden years.

Many institutional investors (especially hedge funds and private equity funds with expertise in credit) conceptualize life settlements and reverse mortgages as structured financial products. They securitize or bundle the underlying cash flows and repackage hundreds of life insurance policies or reverse mortgage loans en masse. With the securitization market close to nonexistent, this is a tall order. From the standpoint of global-macro play, these transactions can be better described as a countercyclical value investment that for the purposes of this book hinges on uncertainty in the U.S. social security system. Simply put, as seniors (and baby boomers) approach retirement and find that their retirement funds have been wiped out due to the credit crisis, and social security is unable to honor their obligations, the value of the reverse equity asset class should become apparent.

Life Settlements

A life settlement (see Figure 3.1) is the sale of a life insurance policy from a policyholder to an investor (in most cases, a qualified institutional buyer¹) through a state-regulated originator (provider) for an upfront cash payment. The investor in the policy makes all the subsequent premium payments to the insurance carrier and collects the death benefit upon the senior’s death. For example, a 70-year-old man who has a $100,000 life insurance policy would sell his policy to an investor for $25,000 up front. The investor would become the policy’s owner and would pay $3,500 per year in premiums to the insurance carrier until the senior’s death. At that point, the investor would collect $100,000. Prior to purchasing the policy, the investor would obtain a life expectancy report. It would enable him to model the expected mortality of the insured and calculate how much he is willing to pay for the insurance contract. The transaction process and valuation are discussed later in this chapter. Figure 3.2 shows the cash flows associated with a life settlement from an investor’s perspective.

Figure 3.1. Basic life settlement

Figure 3.2. Life settlement cash flows

The life settlement market has grown rapidly over the past few decades, growing from $50 million in 1990 to between $14 and $16 billion today (see Figure 3.3). According to Conning Research, in 2008 roughly $16 billion of policies were settled. Future market projections have been set at more than $160 billion over the next 10 to 15 years based on the size of the baby boomer population.

Figure 3.3. Life settlement market size (estimated)

The mainstream media views a life settlement as a macabre investment product. However, the actual mechanics of the transaction are no different from an annuity or pension plan that also has an economic interest in someone’s death. The focus should be on seniors’ ability to obtain market value for an asset they were not even aware they possessed. Moreover, the life settlement market consistently provides billions of dollars to seniors in exchange for a policy that otherwise would have lapsed. According to the Life Insurance Settlement Association (LISA), life settlements provide seniors with roughly $7 million per day in cash. On average, life settlements provide three to four times more money to senior policyholders than the cash surrender value provided by the insurance company. Life insurance companies in the U.S. enjoy very high lapse ratios; specifically, it is believed that almost 90% of life insurance lapses without paying a single death benefit claim. (Note that for policies purchased by individuals who are older than 65, the lapse ratios are much lower.)

Historical Context

The secondary market for life insurance in the U.S. was created in 1911, when a Supreme Court judge ruled that a life insurance policy should be treated like any other asset, similar to property, gold, silver, and so on. Therefore, a life insurance policy, like property, could be sold and transferred to a third party with no insurable interest² in the policy or stake in the well-being of the policy owner. The policyholder could name whomever he wanted as the beneficiary. Moreover, this legislation also allowed an individual to borrow against his life insurance policy. The following is an excerpt from the historic case that provided the foundation of the now multibillion-dollar life settlement market:

The rule of public policy that forbids the taking out of insurance by one on the life of another in which he has no insurable interest does not apply to the assignment by the insured of a perfectly valid policy to one not having an insurable interest. In this case, held that the assignment by the insured of a perfectly valid policy to one not having any insurable interest but who paid a consideration therefore and afterwards paid the premiums thereon was valid, and the assignee was entitled to the proceeds from the insurance company as against the heirs of the deceased.³

Throughout the 1980s, life settlements were known as viatical settlements (see Figure 3.4). This term is used for life settlements in which the policy owner has a life expectancy of less than two years. The viatical market, which is what cast the entire market in a negative light, was created by seedy investors purchasing the policies of those diagnosed with HIV or AIDS, which at the time were not understood the way they are today. People diagnosed with the virus sold their life insurance policies to pay for the high costs associated with treating their illness. When it turned out that people could live with HIV/AIDS for several years, many investors lost money. These viatical settlements turned the institutional investment community off the life insurance market for roughly the next 15 years. The mid-1990s saw a rebirth of the market when European investors, especially from Germany, began to invest in traditional life settlements due to favorable tax treatment of death benefits in Europe. Soon other institutions followed, and the market began its journey to becoming an accepted and understood part of the financial sector.

Figure 3.4. Life settlement market time line

Source: LISA

Market Participants

A life settlement transaction has several parts, making it complex for investors with no previous experience with structured finance. However, the trend is toward efficiency. To break down a life settlement transaction, first we need to understand who is involved at the single policy level. Every life settlement transaction has seven main players:

• The policyholder, also known as the viator, seeks to sell his or her policy.

• The financial planner, CPA, attorney, estate planner, life insurance broker, or life settlement broker may or may not be registered with the state.

• The provider or originator acts as a buy-side broker and needs to be licensed in every state in which it purchases policies.

• Life expectancy (LE) underwriter.

• Securities intermediary, escrow agent, or verification agent.

• Investors are most often qualified institutional buyers with at least $100 of assets under management (pension funds, insurance companies, hedge funds, private equity funds, family offices).

• The policy servicer makes all premium payments on behalf of the investor for the duration of the policy, collects the death benefit, obtains and stores all medical and policy records, and sweeps the social security database to track for policy maturities.

Figure 3.5 shows how the various service providers operate in concert.

Figure 3.5. A detailed view of the life settlement process

Underwriting

In a life settlement transaction, investors typically obtain life expectancy certificates from independent medical underwriters, which are used to determine a policy’s price. In short form, these LEs provide a median life expectancy for an individual, which takes into account a mortality multiplier, or essentially the excess mortality probability of an individual relative to a group of contemporaries. One method used to determine this mortality multiplier is the modified debit methodology. Hypothetically, given that a baseline mortality probability in a single year of the life of a 75-year-old is 200 deaths per 1,000 people, a certain illness could result in 100 additional debits. This translates into this individual’s having a mortality probability that is 300% of the baseline. The median life expectancy is then the point at which roughly a 50% mortality probability exists. Interestingly, life insurance and life settlements use a very different set of assumptions to price the very same product (see Figure 3.6). Life insurance carriers assume much longer life expectancies, whereas an owner of a portfolio of life settlements assumes much shorter life expectancies. This is simply due to differences in business models. For a life insurance carrier to project strong future earnings, it is in the carrier’s best interest to model an ideal scenario in which its customers purchase policies in their mid-30s, and 90% of them lapse in their 80s. This would allow the carrier to reinvest premiums for 50 years! A life settlement fund also wants to project strong future returns, so it models to its investors purchasing policies of 75-year-olds who pass away at 80. Actual mortality probably leans more toward the carrier’s models.

Figure 3.6. Life expectancy perspectives

From the life settlement perspective (as well as reverse mortgages), underwriting is done by analyzing life expectancy data on older policyholders, who often have some degree of illness or impairment. Data on this group of policyholders is thin because only recently has anyone seen value in tracking insurance data for individuals older than 70. Life expectancy data for life insurance carriers is much more robust than data for a life settlement investor. Carriers have over a hundred years of data on tens of thousands of policies to pull from, although this data mostly tracks younger individuals. Figure 3.7 shows the mortality curve generated on a group of 300 individuals.

Figure 3.7. Cumulative maturities for a life settlement fund (300 policies)

Pricing

Investors can employ one of three methodologies when valuing a life settlement asset: deterministic, probabilistic, or stochastic. In a deterministic approach, a finite LE is simply entered into a discounted cash flow model, as shown in Figure 3.8. A probabilistic methodology determines the expected discounted value of a premium payment and death benefit in a given year. A stochastic approach, or Monte Carlo simulation, is most commonly used to generate the expected return on a pool of life settlements.

Figure 3.8. Deterministic calculator

In addition to life expectancy assumptions, an investor must have the following pieces of information to value a life settlement:

• Policy type. Whole life,⁴ universal,⁵ convertible term,⁶ regular term,⁷ and variable policies⁸ are rarely purchased in the secondary market. Term policies have very short durations, and variable life policies are treated as securities by the U.S. Securities and Exchange Commission (SEC).

• Premium mode. Fixed or floating.

• Death benefit or coverage amount of the life insurance policy. Some policies offer a guaranteed death benefit rider, which protects the total coverage amount of the contract.

• The age, sex, and smoking status of the insured.

• Life expectancy estimate.

• Cash surrender value. The cash value a policy can build up over the life of the policy. Although it is simply added to the purchase price of a life settlement, the cash value (if sufficient) can be applied to premium obligations, making the policy self-sustaining.

• Outstanding loans against the policy. Any loans taken out against the policy may affect the total available cash in the policy, as well as the policy’s death benefit.

• Premium illustrations to age 100. A premium illustration is simply a schedule provided by the insurance carrier of all future obligations the policy owner must make to keep the policy active. The premium and cost of insurance (COI) can rise over the duration of a contract, so investors must consider a rise in COI when modeling a policy’s value.

The deterministic approach is used to price a single life settlement policy, but it can be grossly inaccurate. Rarely can a single person’s life expectancy be predicted.

Figure 3.9 shows the expected mortality distribution of 10 different pools of life settlements. Predicting the probability of mortality for any one individual is extremely difficult. But through the law of large numbers, constructing models and portfolios using a larger number of lives (more than 300) produces more accurate modeling and return assumptions, as shown in Figure 3.10.

Figure 3.9. Monte Carlo simulation of 10 different pools of lives

Figure 3.10. Stochastic simulation of returns

Generating life expectancies, which in turn affects pricing, also relies heavily on which mortality table is used. Among the tables are several classes from which to choose. Figure 3.11 shows how the mortality curve of a 76-year-old female nonsmoker differs by class in the context of the 2008 Value Basic Table,⁹ which is the most notable mortality table produced by the Society of Actuaries (SOA).¹⁰ The various classes (left) range from 70 to 160 and in this case move from conservative to more liberal.

Figure 3.11. 2008 VBT class comparisons

Source: Society of Actuaries

Figure 3.12 illustrates the disparity between male and female life expectancy. Delving into the mathematics and details of actuarial science and pricing methodologies for life-linked assets such as life settlements or reverse mortgages is outside of the scope of this book. Two books that discuss more of the quantitative elements of life settlement pricing in great detail are Life Settlements and Longevity Structures: Pricing and Risk Management by Jim Aspinwall, Geoff Chaplin, and Mark Venn (John Wiley & Sons, Inc., 2009) and Life Markets: Trading Mortality and Longevity Risk with Life Settlements and Linked Securities by Vishaal Bhuyan (John Wiley & Sons, Inc., 2009).

Figure 3.12. Male/female class comparison

Source: Society of Actuaries

Risks

Investors in life settlements are exposed to set of unique risks:

• Origination and insurable interest risk: The first two years of a life insurance policy are known as the contestability period, in which an insurance carrier reserves the right to cancel a policy and rescind a claim due to fraud and misrepresentation. Although it is rare, contestability risk can have a negative impact on an investor. It is also important to note that contestability period in many states is being increased from two to five years. One reason for doing this is to prevent the practice of stranger-originated life insurance (STOLI). In a STOLI transaction, someone purchases a life insurance policy on a senior, without having any insurable interest, with the intent to sell that policy on the open market. In many cases, investors keep the policy for the duration of the contestability period.¹¹ STOLI is also called “wet paper.” Inversely, policies that have passed the contestability period are known as “dry” or “seasoned” paper. Although regulation of STOLI varies at the state level, most institutional investors shy away from these deals due to the insurable interest risk. An insurance carrier can cancel a policy and return the premium on any policy if it believes the original policy purchaser did not have insurable interest at origination. In a traditional life settlement, because the original policyholder had insurable interest at the time of purchase, she may assign the policy to whomever she wants.

• Purchase price risk: Miscalculating the life expectancy of an insured can result in overpaying for a policy. Given that an investor has negative carry in a life settlement for several years, a miscalculation of the upfront cost can mean less margin for error.

• Cost of insurance/premium risk: The true “cost” of a life settlement policy is making premium obligations for almost a decade to collect the death benefit. If an investor does not fully understand how to plan for rising premium costs, the total return on the investment can be hurt substantially, especially coupled with any longevity risk or incorrect purchase price.

• Longevity risk: Longevity risk ties together premium and purchase price risk, because it is the risk that the insured surpasses modeled expectations. Using conservative mortality estimations and tables is one way an investor can mitigate this risk. Moreover, by building a large-enough portfolio of life settlements, investors can be more prepared for how their portfolios will behave over a 10- to 15-year time frame. Some investors rely heavily on purchasing policies of those who are impaired. This can be a riskier endeavor. Such policies would cost much more to acquire due to shortened life expectancies and are in direct opposition to modern medicine. This is a side I would not want to take.

• Ramp-up risk: Building a portfolio of 300 policies or so takes time and may not be possible due to capital or market restraints. Holding a portfolio of a small number of policies over a long period of time may create tremendous volatility in investors’ returns.

• Carrier default risk: Prior to the credit crisis of 2008, this risk seemed far-fetched. However, a carrier risks defaulting on a policy if a systemic financial meltdown occurs, as we have seen in recent years. That being said, no policy in U.S. history has ever gone unpaid. In most cases, a failing carrier’s book of policies is sold to another carrier. Moreover, death benefits of $500,000 and cash values of $250,000 are insured by state insurance funds,¹² although in some states if a policy is transferred from one owner to another, this guarantee becomes void. Typical life settlement investors purchase only policies issued by at least BB-rated carriers (rated by A.M. Best Company). Diversifying across carriers is another way to hedge this risk, as well as by purchasing credit protection on a basket of insurance carriers through CDS.

Figure 3.13 illustrates how a portfolio with a larger number of policies can mitigate skewness¹³ and kurtosis risk¹⁴ and create more predictable returns.

Figure 3.13. Diversification

Regulation

Currently the SEC doesn’t treat life settlements as securities. However, in coming years this might be a strong possibility, because post-financial collapse special life settlement task forces have been created. In 2010, the U.S. Government Accountability Office released a special report pushing for more standardized regulation of life settlements (http://www.lifemarketsassociation.org/documents/GAO_10_775.pdf). Currently life settlements and life insurance on the whole are regulated at the state level by the National Association of Insurance Commissioners (NAIC).¹⁵ Regulation is exactly what the life settlements market needs to attract more institutional capital and consumer protection. Figure 3.14 shows how many states have adopted some life settlement regulation since 1992. Any potential investor in the life settlements market should seek expert legal counsel to fully understand the regulatory environment of the marketplace.

Figure 3.14. Life settlement regulation time line

Taxation

Taxation on life settlements is a complex but important subject that is outside the scope of this book. The LISA website best describes the topic:

With new clarification from the IRS, some of the proceeds of a life settlement are almost certainly taxable. After a hearing held by the Senate Select Committee on Aging, in 2009, the IRS released Revenue Ruling 2009-13 to “clarify” the issue. Though this ruling is very complex and confusing, and LISA has sought to have it clarified, that information is not yet available, and some issues are sure to be negotiated. The general treatment requires determinations of cost of insurance which are not readily available to consumers. LISA welcomes feedback on this from affected consumers or their representatives. Historically, the amount recouped up to the cumulative premiums paid is tax-free, but the IRS has determined that the “cost of insurance” must be addressed as an issue. Additional money up to the cash surrender value option is to be seemingly treated as ordinary income. Any excess cash above the cash surrender value is apparently to be considered capital gains. The assistance of a professional tax advisor should always be sought. The proceeds of a life settlement could also be subject to the claims of creditors. If the seller is within two years of death, other laws making the proceeds tax-free may apply.

Figure 3.15 shows a life settlement regulation map.

Figure 3.15. Life settlement regulation map

Source: LISA

Reverse Mortgages

In addition to life settlements, reverse mortgages will play an ever-growing role in U.S. financial products. Also called “loans of last resort,” reverse mortgages are a way for seniors age 65 and older to access the equity in their homes without turning to traditional credit markets. Despite their “loan” characteristics, reverse mortgages are contingent more on life expectancy than credit.

History of Reverse Mortgages

Reverse mortgages, which are gaining more attention now than ever before, have been around for more than 50 years. The first reverse mortgage was granted in 1961 by Deering Savings & Loan of Maine. In 1988, the Federal Housing Authority Insurance Program was created, making possible the first federally insured reverse mortgage in 1998, which was distributed by fewer than 50 lenders across the nation. Due to the product’s success, the home equity conversion mortgage (HECM) loan program expanded to all lenders in the country. Over the past 20 years, more than 500,000 reverse mortgages have been written by more than 1,000 lenders.¹⁶

The most common type of reverse mortgage is the HECM,¹⁷ which currently makes up roughly 90% of all outstanding reverse mortgages in the U.S. HECM is a reverse or reverse annuity mortgage in which the U.S. Department of Housing and Urban Development (HUD),¹⁸ through the Federal Housing Authority (FHA),¹⁹ guarantees that the borrower will receive monthly payments from the insurer (FHA) if the lender is unable to make payments to the borrower.²⁰ HECM reverse mortgages differ from nonconforming reverse mortgages in that the loans are insured and meet certain criteria set by the FHA. The requirements for nonconforming and conforming reverse mortgages differ slightly. Nonconforming mortgages are more flexible by definition.

The requirements for a nonconforming reverse mortgage borrower (as opposed to a HECM loan) are as follows:

• The lender sets the minimum age.

• The borrower must own the property in full or have the proceeds of the reverse mortgage pay off the existing mortgage balance.

• The home must be the borrower’s primary residence.

All the basic information on the HECM reverse mortgage program can be found on the FHA HUD website at http://www.hud.gov/offices/hsg/sfh/hecm/hecmabou.cfm.

The FHA HECM borrower requirements are as follows:

• Be 62 years of age or older

• Own the property outright or have a small mortgage balance

• Occupy the property as your principal residence

• Not be delinquent on any federal debt

• Participate in a consumer information session given by an approved HECM counselor

The mortgage is based on the following:

• Age of the youngest borrower.

• The borrower’s life expectancy underwriting. In a nonconforming mortgage, more emphasis and better underwriting methodologies may be used.

• Current interest rate.

• Lesser of appraised value or the HECM FHA mortgage limit or the sales price initial mortgage insurance premium (MIP). Your choices are the 2% HECM Standard option or the .01% HECM Saver option.

Here are the financial requirements:

• No income or employment qualifications are required of the borrower.

• No repayment is necessary as long as the property is your principal residence and the obligations of the mortgage are met.

• Closing costs may be financed in the mortgage.

The following eligible property types must meet all FHA property standards and flood requirements:

• Single-family home or one-to-four-unit home with one unit occupied by the borrower

• HUD-approved condominium

• Manufactured home that meets FHA requirements

The FHA HECM Reverse Mortgage Program has five payment options, which can also be applied to nonconforming loans:

• Tenure: Equal monthly payments as long as at least one borrower lives and continues to occupy the property as a principal residence.

• Term: Equal monthly payments for a fixed period of months selected.

• Line of credit: Unscheduled payments or in installments, at times and in an amount of your choosing until the line of credit is exhausted.

• Modified tenure: A combination of line of credit plus scheduled monthly payments for as long as you remain in the home.

• Modified term: A combination of line of credit plus monthly payments for a fixed period of months selected by the borrower.

Although there are no limits in terms of house value for a HECM reverse mortgage, as determined by an appraisal or recent sale, the maximum loan limit is $625,500. Nonconforming mortgages carry no such limit. In addition, borrowers are charged an upfront insurance premium of 2% of the maximum claim amount for HECM the Standard option and .01% for the HECM Saver option. In addition, there is an annual mortgage insurance premium of 1.25%. Other HECM costs may be added to the total loan and deducted from the mortgage proceeds.

Reverse mortgage fees can be costly for borrowers. HECM lenders typically charge an origination fee of up to $2,500 if the home is valued at less than $125,000. Otherwise, the fee is 2% on the first $200,000 of home value and 1% thereafter. HECM origination fees, however, have a limit of $6,000.

Closing costs for a HECM loan, or nonconforming loan, include the home’s appraisal, title search, and insurance, as well as surveys, inspections, recording fees, mortgage taxes, credit checks, and other fees.

HECM borrowers must also pay a MIP as part of the loan. The MIP is charged upfront and is 2% in the HECM Standard option and .01% in the HECM Save option of the lesser of the home’s appraised value, the FHA HECM mortgage limit for the area, or the sale price. The MIP is charged annually for the duration of the loan at 1.25% of the balance. This insurance guarantees payments to the borrower and insurances that the total debt on the house can never exceed the home’s value.

Servicing includes sending you account statements, disbursing loan proceeds, and making certain that you keep up with loan requirements such as paying taxes and insurance. HECM lenders charge a monthly servicing fee of no more than $30 if the loan has an annually adjusting interest rate and $35 if the interest rate adjusts monthly. At loan origination, HECM lenders set aside the servicing fee and deduct the fee from your available funds. Each month, the monthly servicing fee is added to the loan balance.

HECM and nonconforming borrowers can choose an adjustable interest rate or a fixed rate. Similar to a traditional mortgage, interest rates may adjust monthly or annually. HECM loans that adjust annually cannot adjust more than 2 percentage points per year and not by more than 5 total percentage points over the life of the loan. FHA does not require interest rate caps on monthly adjusted HECMs.

A HECM reverse mortgage must be repaid in full when the borrower dies or sells the home. The loan also becomes due and payable if the borrower does the following:

• Fails to pay property taxes or hazard insurance or violates other obligations.

• Permanently moves to a new principal residence.

• Fails to live in the home for 12 months in a row. An example of this situation would be if you (or the last borrower) were to have a 12-month or longer stay in a nursing home.

• Allows the property to deteriorate and does not make necessary repairs.

Reverse mortgages are attractive from an investment perspective simply because they possess characteristics similar to other credit-linked structures but are not actually linked to credit. FICO scores are factored into the calculations of a reverse mortgage as much as life expectancy is. Unlike life settlements, however, reverse mortgages are not as “uncorrelated” to traditional asset classes, because future home prices play a significant role in the valuation of a reverse mortgage.

From an economic point of view, reverse mortgage backed securities offer a tremendous amount of opportunity as the securitization market seeks new assets from which to generate yield. Assets such as reverse mortgages, which can thrive during poor credit environments, seem ideal for the “new normal.” Ginnie Mae has already established a Home Equity Conversion Mortgage Backed Security (HMBS) program by bundling several individual HECM loans.

Figures 3.16 and 3.17 show the total HECM loan issuance from 2000 to 2008 and the volume of the HMBS market.

Figure 3.16. HECM loan issuance

Source: MortgageDaily.com

Figure 3.17. HMBS volume

Source: GNMA HMBS

Reverse mortgages have an added layer of complexity over a life settlement due to their reliance on housing prices relative to life expectancy, or if the house’s value is less than the loan. Although in an FHA, HECM reverse mortgage insurance protection hedges against this risk, also known as crossover risk, in a nonconforming mortgage this risk is among the largest in reverse mortgage investing. Here are some other risks:

• Home price risk: If property values depreciate significantly, the crossover point is reached sooner. Geographic concentration can also magnify this risk, as will loan seasoning, because the increase in the loan balance generally outpaces historic home price appreciation.

• Interest rate risk: An increase in interest rates increases the cost of funding in a securitization structure with floating-rate bonds, whereas the increase in the interest rate for the collateral is effectively capped by the property value.

• Actuarial risk: Cash account loans have no stated maturity or term. Therefore, borrowers who remain in their homes for an extended period can cause crossover loss as the loan balance compounds every year going forward.²¹

One other major risk with reverse mortgages at the lender level is default risk. For example, if a 75-year-old woman stops paying her property taxes and maintaining her home, a reverse mortgage lender would need to repossess her home because technically she is breaching her contract with the bank. However, this poses an enormous risk for a lender. Nobody wants to be forced to evict an elderly person from her home, and the reputational and image risk in doing this could be irreversible. Finding an incentive for a borrower to maintain her home after she has handed over the keys to someone else is a difficult administrative problem facing any reverse mortgage lender. Moreover, managing a portfolio of homes across the country (on a single-loan basis) could be a nightmare. For all these reasons, structured products linked to reverse mortgages are a cleaner, more liquid method of accessing the benefits of the asset class. Although such products as the GNMA HMBS have a number of drawbacks, such as the life expectancy assumptions made to underwrite the notes, these products will be refined as demand for noncredit-linked yield increases and demographic fundamentals take over.

Conclusion

Given the uncertainty in public and private retirement systems, reverse equity transactions will play a significant role moving forward. Investors looking for a unique way to prepare for a downturn in the U.S. economic system as a result of underfunded pension programs, massive amounts of government debt, and the rapidly growing number of retirees (baby boomer population) should take a deeper look at such products as life settlements and reverse mortgages. The major barrier for entry into the market is expertise and bite size. The important disclaimer when discussing both the life settlements market as well as the reverse mortgage market is that these are negative cash flow assets. Therefore, investors must be prepared or hold some level of cash on hand to make premium payments (in the case of a life settlement) or annuity payments (in the case of a reverse mortgage). By bundling either one of these assets in a securitized pool, investors might be able to circumvent the negative carrying costs. Furthermore, because these assets have variable durations, meaning that the event could happen in two years but also could happen in 20 years, being prepared to maintain an asset longer than expected is of the utmost importance. For many hedge fund investors, this may seem like a terrible use of cash; however, keep in mind that the investment itself is broken down over multiple years. For example, a $30 million commitment to the asset class may mean using $15 million to purchase policies and reserving $15 million for premium payments for four or five years. Premium schedules are maintained to clearly outline future obligations.

For many investors, tying up a substantial amount of capital into life settlements may be difficult, unless a dedicated fund is structured to do so. Regardless, this strategy is more one of risk aversion than generating home-run returns. The demographic and economic fundamentals are certainly apparent, but investors must have long-term investment horizons and be unaffected by severe illiquidity. Life settlements, although there are secondary and tertiary markets, are still difficult to move. That being said, provided that capital reserves are sufficient, a liquidity event need not occur to generate the windfall.

Endnotes

¹ Primarily referring to institutions that manage at least $100 million in securities, including banks, savings and loans institutions, insurance companies, investment companies, employee benefit plans, or an entity owned entirely by qualified investors. Also included are registered broker-dealers owning and investing, on a discretionary basis, $10 million in securities of nonaffiliates. Qualified institutional buyer (QIB) is defined in the U.S. Securities Act of 1933.

² An interest in a person or thing that will support the issuance of an insurance policy; an interest in the survival of the insured or in the preservation of the thing that is insured. http://www.thefreedictionary.com/insurable+interest.

³ U.S. Supreme Court, Grigsby v. Russell, 222 U.S. 149 (1911), Grigsby v. Russell, No. 53, Argued November 10, 13, 1911, Decided December 4, 1911, 222 U.S. 149, CERTIORARI TO THE CIRCUIT COURT OF APPEALS, FOR THE SIXTH CIRCUIT.

⁴ A form of life insurance that applies part of the premium payments to build an investment or savings value for the policy owner. The investment or savings value is called the policy’s cash surrender value. http://www.americanbanker.com/glossary/w.html.

⁵ A form of life insurance that combines term insurance protection with a savings feature. The portion of the funds allocated to the savings feature is invested in a tax-deferred account that typically earns interest at rates comparable to prevailing money market interest rates. http://www.americanbanker.com/glossary/u.html.

⁶ Convertible term insurance allows the policyholder to change the face value of the term policy in force into a permanent form of life insurance, such as whole life, universal life, or variable life, without any penalties or evidence of insurability. http://www.allinsuranceinfo.org.

⁷ A life insurance policy purchased for a term of years. If the person dies during this term, the beneficiary receives the face amount of the policy. The policy expires at the end of the stated number of years. http://www.pcafoundation.com/main/glossary.htm.

⁸ A form of life insurance very similar to whole life insurance. In a variable life insurance policy, the cash value is invested in equity or debt securities. Policyholders can select and switch investment instruments. http://www.americanbanker.com/glossary/v.html.

⁹ http://www.soa.org/files/pdf/research-2008-vbt-report.pdf.

¹⁰ SOA is the largest professional organization, dedicated to serving 21,000 actuarial members and the public in the U.S., Canada, and worldwide. SOA’s vision is for actuaries to be the leading professionals in the measurement and management of risk. http://www.soa.org/Home.aspx.

¹¹ The time period during which the insurer is not obligated to pay a claim (usually two years) because of material misrepresentations found in the application. A policy becomes incontestable when the contestability period is over. http://www.smartmoney.com/personal-finance/insurance/life-insurance-glossary-8009/.

¹² http://www.annuityadvantage.com/stateguarantee.htm.

¹³ Skewness is a parameter that describes asymmetry in a random variable’s probability distribution. http://www.riskglossary.com.

¹⁴ Kurtosis is a parameter that describes the shape of a random variable’s probability density function (PDF). http://www.riskglossary.com.

¹⁵ NAIC members are the elected or appointed state government officials who, along with their departments and staff, regulate the conduct of insurance companies and agents in their respective state or territory. http://www.naic.org.

¹⁶ Senior Equity Financial, Inc. http://www.seniorequityfinancial.com/history_of_reverse_mortgages.php.

¹⁷ http://www.hud.gov/offices/hsg/sfh/hecm/hecm—df.cfm.

¹⁸ http://www.hud.gov/offices/hsg/sfh/hecm/hecm—df.cfm.

¹⁹ http://portal.hud.gov/portal/page/portal/HUD.

²⁰ http://guarantytitlepalatka.com/realestateterms1.html.

²¹ For details on reverse mortgage risk mitigation, see Nemo Pererra, Chapter 7 of Risk Mitigation in Reverse Mortgages and Linked Securities: A Guide to Risk, Pricing, and Regulation, 68-74 (Vishaal Bhuyan, ed., 2010), available at http://search.barnesandnoble.com/books/product.aspx?r=1&isbn=9780470921517&cm_mmc=Google%20Product%20Search-_-Q000000630-_-Reverse%20Mortgages%20and%20Linked%20Securities-_-9780470921517.