The History of the Life Insurance Industry Provides Good Reasons for Investor Confidence in the Secondary MarketLike the life insurance industry itself, the secondary market for life insurance is a riskmanagement industry, not a risk avoidance industry. While Life Settlement Investors take andmust either mitigate or become comfortable with mortality risk, headline risk, calculation risk andviator fraud risk, there is one risk that a Life Settlement Investor must never take, and that is therisk of not receiving the death benefit of an owned policy. A competent Life Settlement Providerwill assure that the policy is in good standing at the time of purchase by the investor and willutilize the best tools available for projecting the cost of policy maintenance until maturity by deathof the insured. A competent Life Settlement Asset Manager will pay premiums in an amountadequate to maintain the policy and will provide annual reviews to assure that policy funding ismaintained appropriately. But what about the one circumstance that is out of the control of theInvestor, the Provider, and the Asset Manager: insurance company insolvency?Life insurance initially is purchased to mitigate the risk of potential financial loss at the time ofdeath. The two more common reasons life insurance is purchased are to replace income lostwhen the earner dies and to assure that the insured‟s estate passes to beneficiaries undiluted. Ifa life insurance company issued only one such policy, the risk would be that the insured woulddie before the company had the opportunity to collect enough premium money and investmentincome to pay the death claim. Insurance companies mitigate this risk by assessing the medicalcondition of the each applicant before entering contracts and by issuing hundreds or thousands ofpolicies to spread that risk. Additionally, they share the risk of policies with large face amounts(the initial death benefit displayed on the Face Page of the life insurance contract) with othercarriers. Premium income fuels the insurance company, but it is the investment income thatprovides the reserves, surplus, and profit. Life company investments, like those of other financialinstitutions, have suffered from the collapse of the mortgage market and the subsequenteconomic downturn. As a consequence, it is important to ask, how safe is investing in thesecondary market for life insurance?This paper will provide an assessment of the level of risk to the Life Settlement Investor ofinsurance company insolvency.The Level of RiskThere is no available record that documents that any life insurance company licensed todo business in any of the fifty states has ever failed to pay a death claim in accordancewith the terms of a life insurance contract.In my judgment, only the collapse of the life insurance industry would result in the failure to paythe full death benefit of a policy upon the death of the insured while the policy is in force. Theviability of the industry is dependent upon payment of death claims, and life insurancecompanies, trade organizations, and state regulators are positioned to assure payment of deathbenefits.In some cases, requests for policy loans (except automatic premium payment loans), payment ofcash or surrender values, policy surrenders, fund transfers, cash outs, and similar payments andcertain policy changes and conversions have been delayed, occasionally for several years, and,in a few cases, settlements with policy owners requesting surrender of their policies have beendeeply discounted. This is of no concern to Life Settlement Investors who maintain cashsurrender values at the lowest possible level and who never anticipate borrowing policy values forother than premium payments on „whole life‟ policies and never would surrender any form ofpolicy to an insurance company.
When life insurance companies are in declining financial condition or have been placed inreceivership or liquidation, the policies frequently are assumed by other carriers within a relativelyshort period of time. The industry has a strong record of protecting all policy owners throughassumption of liability, merger, and acquisition. (Case studies are provided in the Appendix).Regulation of the Life Insurance IndustryInsurance is monitored and regulated by state insurance departments, and one of their primaryobjectives is protecting policyholders from the risk of a company in financial distress. When acompany enters a period of financial difficulty and is unable to meet its obligations, the insurancecommissioner in the company‟s home state initiates a process - dictated by the laws of the state -whereby every attempt is first made to help the company regain its financial footing. This period isknown as rehabilitation.If it is determined that the company cannot be rehabilitated, the company is declared insolvent,and the laws of the state require the commissioner to ask the state court to order the liquidationof the company. The insurance commissioner, either appointed by the governor or elected,heads the state insurance department and monitors and regulates insurance activity within thestate. The commissioner also has the responsibility to determine when an insurance companydomiciled in the state should be declared insolvent and to seek authority from the state court toseize its assets and operate the company pending rehabilitation or liquidation.Life Insurance Company Rehabilitation or LiquidationWith only a few known exceptions, life insurance companies that have become insolvent over thepast thirty years have been financially marginal, low rated, stock insurance companies operatingon a regional basis. These companies typically have held A. M. Best ratings of C, C-, or D (Weakto Poor) or have been non-rated, usually a sign of financial weakness, and have been no differentin financial make-up from financially weak companies in the industrial sector. Yet, death claimsmade against insolvent carriers in all cases have been paid in full.There are only two highly rated carriers licensed in all 50 states that have experienced severefinancial difficulty, Executive Life Insurance Company (ELIC) and Mutual Benefit Life InsuranceCompany (unrelated to Mutual Benefits Corporation, a failed life settlement provider). See theAppendix for Case Studies of the causes and consequences of financial difficulty in these twocompanies and three others.Reinsurance and State Guarantee FundsThe secondary market typically focuses on policies with large face amounts. It is not uncommonfor policies to have face amounts of $5 million, $10 million, or even $20 million dollars. Noinsurance company can afford to take the risk of an early death claim in these amounts. Insurersenter into reinsurance treaties with other insurers and spread the risk with a sharing of thepremium dollars. Thus, a company issuing a $10 million dollar policy may only have a $1 or $2million dollar risk while as many as a dozen other insurers share the remaining $8 to $9 milliondollars of risk. These reinsurers must agree to the decisions to offer insurance, therebyimproving the underwriting process, and eliminating the risk of a single catastrophic loss to theprimary insurer.Most states have guaranty funds, financed by the life and health insurance companies licensed inthe state, to help pay the claims of financially impaired insurance companies. State laws specifythe lines of insurance covered by these state guaranty insurance funds and the dollar limitspayable. The coverage of these guaranty funds is usually for individual policyholders and theirbeneficiaries and not for values held in unallocated group contracts. Reliance on the availabilityof these funds to cover claims against a failed insurance company is not advised; however it is -2-
unlikely that, short of collapse, the life insurance industry would allow a situation to develop inwhich claims against the funds for payment of death benefits would ever occur.There is no available record showing that a state guaranty fund ever has been utilized to recoverdeath benefits. In some cases, funds have been used to recover cash surrender values. Thegreatest utilization of state guaranty funds has been in the area of recovery from health insurancecompany failure. However, in the unlikely event of funds ever being required for the recovery ofdeath benefits, there are significant limits on the maximum death benefits covered by theguaranty funds, some of which have increased in the last few years. For example, Connecticut,Minnesota, New Jersey, New York, Utah, and Washington limit payment to $500,000, and theother 44 states, the District of Columbia, and Puerto Rico limit payment to $300,000 (New Mexicoallows the Superintendent of Insurance to set higher amounts by regulation). Cash valuerecovery, the more common use of guarantee funds, typically is limited to $100,000.According to the National Organization of Life and Health Guaranty Associations (NOLHGA),“State life and health insurance guaranty associations provide a safety net for their state‟spolicyholders, ensuring that they continue to receive coverage even if their insurer is declaredinsolvent. Working together through NOLHGA, the guaranty associations form a national safetynet, protecting insurance consumers all across America in their time of need.” Fortunately, it is asafety net that is unlikely ever to be needed.Primary Carriers in the Secondary MarketThere are five primary life insurance companies that issue policies that are purchased in thesecondary market. These five are among the strongest insurance companies in the world, and, infact, some are owned by parent organizations outside the United States. Statutorily, theinvestments of the United States subsidiaries of these companies, like subsidiaries of domesticparents, are separate and protected from use by parent companies. The portfolios of these fivecarriers are sound and are representative of the life insurance industry as a whole. Thesecompanies are: Transamerica Life Insurance Company (owned by AEGON) American General Life Insurance Company (owned by AIG) John Hancock Life Insurance Company (owned by ManuLife) Lincoln National Life Insurance Company (owned by Lincoln National Financial) Pacific Life Insurance CompanyThe strength of these primary players, the fact that no death claim on an inforce policy has everbeen denied or delayed longer than the terms of the contract provides, and the commitment ofthe industry to protect its viability by timely payment of death benefits and absorption of policiesissued by financially troubled companies by assumption of liability, merger, and acquisition, giveinvestors good reason to be confident in the safety of their investment.Case Study AppendixExecutive Life Insurance Company – Case StudyELIC, a California based company operating in 49 states, and its sister company, First ExecutiveLife of New York, were subsidiaries of First Executive Corporation. At the time of liquidation,ELIC enjoyed an A+ rating from A. M. Best. ELIC was a large issuer of life insurance, structuredsettlement annuities, group annuities, and guaranteed investment contracts (GICs) issued topension plans and municipalities. A conservation order was issued for ELIC on April 11, 1991, -3-
and a liquidation order was entered on December 6, 1991. Most of the companys policies wereassumed by Aurora National Life Insurance Company in 1993.Along with First Capital Life and Fidelity Bankers Life, failed subsidiaries of First Capital Holdings,and a number of smaller carriers, ELIC and First Executive Life of New York were activelyinvolved in the trading of “junk” bonds and were working closely with Drexel, Burnham andLambert, the investment banking firm driven into bankruptcy by its illegal activities in the junkbond market under the direction of its employee, Michael Milken, who was indicted on 98 chargesof racketeering and securities fraud.The policies of First Capital Life were assumed by Pacific Corinthian Life, a subsidiary of PacificMutual Life Insurance Company. The policies of Fidelity Bankers were assumed by Hartford lifeInsurance Company.Mutual Benefit Life Insurance Company – Case StudyThe other notable exception to the profile of a failing company is Mutual Benefit Life InsuranceCompany, a large mutual company (owned by its policy owners) operating in all states. Holdingan A. M. Best rating of A+ until shortly before its failure, Mutual Benefit was placed inrehabilitation under the supervision of the New Jersey Department of Banking and Insurance onJuly 16, 1991. Policies ultimately were assumed by Anchor National Life, a company that I earlierhad served as Chief Marketing Officer. At the time of assumption, Anchor had become a whollyowned subsidiary of SunAmerica Group, which subsequently was acquired by AIG. The policiesare now maintained by AIG SunAmerica Life Insurance Company.Like other smaller carriers such as Monarch Life, announcement of the failure of significantinvestments in commercial real estate held by Mutual Benefit led to a run on cash surrendervalues by policyholders driving the company into bankruptcy. The policies of Monarch Life wereassumed by Merrill Lynch Life, which subsequently was acquired by AEGON.New England Mutual Life Insurance Company – Case StudySince the early 1990‟s, merger and acquisition activity in the insurance industry has beenvigorous, and it is sometimes difficult to trace the responsibility for maintaining the policies ofcompanies no longer in business whether because of regulatory intervention or because ofoutside acquisition. An example of the latter would be New England Mutual Life InsuranceCompany, an old line mutual company that had been in business for over 150 years when it wasacquired by Metropolitan Life Insurance Company (MetLife). Having been an officer of thatcompany in the late 1970‟s, I believe that the attempt to expand distribution beyond the GeneralAgency system to financial planners, stock brokers, CPA‟s, and estate planning attorneysdepleted a significant portion of the company‟s surplus, the assets above the required reserves tomeet future liabilities. While not subject to regulatory intervention, this made the companyattractive for takeover.Kentucky Central Life Insurance Company – Case StudyA more complicated example of regulatory intervention would be Kentucky Central Life, aLexington, Kentucky based company that migrated from receivership to liquidation. TheKentucky Department of Insurance took control of Kentucky Central in February 1993. Thecompany was declared insolvent, due in large part to bad real estate loans and consistentlyquestionable investment decisions. Jefferson-Pilot Life Insurance Company, the mergercompany of Thomas Jefferson Life and Pilot Life, before its merger with Lincoln National Life,assumed the policies in May of 1995 and provided $250MM of support. Additional support forother than death claims came from the State Guaranty Funds. The balance of Kentucky Central‟sreal estate assets were liquidated under guidance and direction by the state insurancecommissioner and the courts. -4-
Shenandoah Life Insurance Company – Case StudyA Virginia domiciled mutual life and health insurance company that issued life insurance policies,annuities, and dental insurance in 31 states and the District of Columbia, Shenandoah Life wasplaced in receivership in February 2009 in the wake of losses in Freddie Mac and Fannie Maestock and a failed merger with Indiana based American United Mutual. A judge placed thecompany in receivership and appointed the State Corporation Commission as receiver, beginninga review designed to determine whether Shenandoah Life should be rehabilitated or liquidated.At the time of the receivership order, Shenandoah Life enjoyed a B++ rating from A. M. Best. Thereceiver began negotiating a sale of the company to Assurant, Inc. and its affiliate, Union SecurityInsurance Company in 2009 and has been negotiating with Prosperity Life Insurance Group ofAustin, Texas since mid-2010. During the receivership, all death claims on inforce policies havebeen paid as have health claims and continuing annuity payments. All other transactions, suchas policy loans or surrenders, have been suspended. Jerry D. Cherrington Senior Insurance Advisor The Peninsula Group, LLC March 8, 2011 -5-