1. Description of Life Markets
The title suggests that this book treats two developments in trading life contingent securities, life settlements market and the longevity securities market. In fact, the book provides complete coverage of life settlements, but very little on managing longevity risk of pension plans and annuities. Despite the book's title, it is almost entirely about life settlements. The book's 19 chapters (244 pages) cover life settlements very well, including the basics of life insurance, motives for a policyholder to sell her/his policy, underwriting policies for sale in the secondary market, securitization of portfolios of policies, ethics of settlements, valuation of life settlement securities and more. The 10-page epilogue provides an overview of synthetic longevity-based securities. These ideas can be applied to pension and annuity longevity risk management, but there are better resources available for this (I give some later).
While Bhuyan is shown as author on the cover, his online vita cites him as editor. Editor is a more appropriate description of his role because the book has 17 other contributors, many of them well-known experts, listed under 14 of the book's 19 chapter titles. The chapters vary in their length and technical level. For example, Chapter 9, ‘Life Settlement Securitization’ by Emmanuel Modu, covers A. M. Best Company's approach to the life settlement business in 43 pages, some of it very technical. (By the way, this chapter is essentially the same as Modu's paper with the same title on the A. M. Best web site.) On the other hand, Chapter 5, ‘Underwriting’ is a brief, non-technical, two-page discussion of asset servicers and life settlement exchanges.
2. About the author
Bhuyan graduated from The University of Pennsylvania in 2005 with a degree in history and sociology. He is the managing director of his own financial advisory firm. He recently published another text on reverse mortgages and has a forthcoming text on esoteric investments.
3. Appraisal
The book explains very well the basics of life settlements and related securities. It may be very helpful to investors who are considering buying life settlement securities. However, substantial parts of the book are available free online or at a university library.
Here is a brief description of the life settlement business. When a policyholder no longer needs life insurance, she/he can surrender the policy to the life insurance company for the cash value (usually much less than the death benefit) and stop paying premiums. In the US (where this business started), there is an alternative to surrendering a policy. The policyholder can legally transfer ownership to a third party, who can change the beneficiary. The buyer may pay a lot more than the cash value, especially if the person insured has a current life expectancy that is less than anticipated when the policy was issued. This life settlement market has advanced to the point that there are brokers, underwriters, actuaries, and lawyers who specialize in these transfers. Portfolios of the transferred policies are bundled into securities with each policy naming the underlying fund as beneficiary. The fund pays premiums required to keep the policies enforced until the death benefit is paid. The shareholders get the death benefits that are paid to the fund as the insured lives die. The shareholders take the risk that the price paid for the policy does not accurately reflect the remaining life expectancy. The longer the insured survives, the less profitable it is for the shareholders. This is longevity risk based on the specific group of lives in the portfolio.
Pensions and annuities also have longevity risk; it is a plan liability. After collecting the contributions or premiums the plan is liable for payments as long as the underlying lives survive. Buying a life settlement security for a pension plan fund would put longevity risk on the asset side as well. It is worth noting that while life settlement securities shareholders and pension plans both have longevity risk, the underlying mortality is very different. Pension plans pay benefits to workers as they retire at age 65 or even younger. The life settlement securities are typically based on much older lives. Often, the people selling their polices have some medical condition indicating that they have relatively short life expectancy; this motivates the buyer to pay more for the policy than the owner can get by surrendering the policy to the insurer. The characteristics of the two examples of longevity risk are very different in my opinion.
Chapter 10, ‘Life Settlement Pricing’ by I. James Cavoli, describes three life settlement pricing models, the deterministic, probabilistic, and stochastic pricing models. The deterministic model assumes a fixed or deterministic, remaining lifetime for the person insured. Given the death benefit, the annual premium required to keep the policy in force, and an annual discount rate, the net present value to the owner is the present value of the death benefit minus the present value of the premiums. Ignoring expenses (which can be considerable), the buyer would be willing to pay as much as the net present value. The probabilistic method replaces the fixed remaining life expectancy with a probability distribution for the remaining lifetime. The stochastic model allows for more randomness. For example, the stochastic model might allow for random interests for discounting future cash flows or for random variation in the mortality model (to reflect uncertainty in the impact of future longevity, for example).
Unfortunately, there are errors in Exhibit 10.2 (a portion is reproduced below). The text explains the calculation of the first item in the Premiums (Expected Value) column correctly, but does not explain the values for second and subsequent years and they are incorrect.
The author explains the Death Benefit column as the Face amount multiplied by the Mortality Rate Estimate. (Evidently, the Mortality Rate Estimate column has been rounded off to one decimal place.) It follows that the Mortality Rate Estimate for year 2 is the probability that the life insured survives 1 year and then dies before the end of the second year. That is the only way the death benefit can be paid at the end of year 2. For year 3, the Mortality Rate Estimate is the probability that the life insured survives 2 years and then dies before the end of the third year and so on. The author describes the Premiums (Expected Value) column as the annual premium multiplied by 1 minus the Mortality Rate Estimate. This is correct only in year 1. If the life insured survives year 1, a premium is paid at the beginning of year 2. The correct probability is of the premium payment 1−0.05=0.95. However, for the next year the premium is paid if the life insured survives year 1 and year 2, which happens with probability (0.95)(1−0.0525/0.95)=0.8975. The expected premium for year 2 is, therefore, (0.8975)(30.000)=26,925. The year 2 value in the Premiums column 28,925 is incorrect. In the same way, the entire Premiums column is incorrect, except for the first row. I also note that the Mortality Rate Estimates increase with each year. This is not typical for mortality at adult ages. I think the author intends for these to be the unconditional annual mortality rates, which do typically increase with age, but if that is the case, then the Death Benefit column is wrong.
Nemo Perera discusses the longevity risk of life settlement securities in Chapter 13, ‘Risk Mitigation for Life Settlements’. As he explains, it is very difficult to mitigate this risk. An extreme example of longevity risk was the failure of a life settlement security when effective treatment of HIV/AIDS was developed. The life expectations of the underlying lives, all HIV/AIDS victims, suddenly increased. The fund had to continue paying premiums longer than estimated at the time the shares were sold and eventually it went broke.
In Chapter 15, ‘Synthetics’ Antony Mott proposes longevity swap agreements that would allow life settlement security shareholders to transfer catastrophic (for the shareholders) longevity risk to other investors in return for reduced payments from the fund. I do not think these swaps are available now to life settlement funds; this is a proposal. (The chapter is a reprint of an article from The Journal of Structured Finance, Summer 2007.)
As the book explains, life settlement securities have risks common to many investments and some that are not (such as longevity risk). In addition, it describes the complex nature of the transaction involving the usual players in any security issue (lawyers, brokers, for example) and some that are not. These include, for example, tracking agents who periodically check on the insured lives to see if they are still alive (in which case the fund must pay a premium to the insurance company to keep the policy in force) or dead (in which case the fund must notify the insurer to claim the death benefit).
Despite the complexity and exotic nature of the risks involved, the life settlement securities market has developed rapidly. In 2010, the US Government Accountability Office reported to the US Senate that the market ‘grew rapidly from its inception in 1998 until the recent financial crisis. Estimates of the total face value of policies settled in 2008 ranged from around $9 billion to $12 billion.’ The potential is much larger. According to the American Council of Life Insurers Fact Book 2010, US individual life insurance enforce was about 10,324,455 million dollars in face amount in 2009 and about 1.6% of the face amount was surrendered voluntarily; that is about 164,800 million dollars of face amount was surrendered. Not all of that amount would be appropriate for settlements, but one has to think there is still a lot of room to grow.
In summary, this book is a useful introduction to life settlement securities. If you are considering investing in life settlement securities, this would be a good place to start learning about them. On the other hand, if you are looking for information on hedging longevity risk in public or private pension plans, there is not much here for you. You would do better by looking at the web sites of some of the leading researchers in this kind of longevity risk such as Michael Sherris at the University of New South Wales, David Blake (also a contributor to this book) of City University London, or Andrew Cairns of Heriot-Watt University.
