Senior life settlement policies (SLS) can be used as collateral to back medium-term notes (MTNs). SLS involve selling an unwanted life insurance policy to a third party for a lump sum, with the third party taking over premium payments. SLS policies can be pooled and used to collateralize MTNs, with the maturity dates of the SLS policies synchronized to the MTN term. The value of the SLS-backed MTN is equal to the value of the pooled SLS policies, which will be redeemed at maturity to pay the face value of the MTN. Calculating the present value of the face value and coupon payments shows the SLS collateral would cover around 80% of the M

1. Author: Partho Chakraborty
SLS Backed MTN
Introduction
Any Financial Instrument draws its intrinsic value through collaterals. Collaterals are
assets provided to secure an obligation. Traditionally, banks might require corporate
borrowers to commit company assets as security for loans. Today, this practice is
called secured lending or asset-based lending. Collateral can take many forms:
property, inventory, equipment, receivables, oil reserves, etc. Collaterals give the
instrument not only their value but also ensure that the financial instrument gets
traded and acts as security whereby a line of credit can be drawn against it.
Collaterals can be of any form as long as it gives a value to the Financial Instrument.
The most favoured collateral is cash and thus any cash backed financial instrument
is most favoured and always in demand. But on the other hand given a choice
nobody wants to block cash given its liquidity. Thus the majority of Financial
Instruments have little or no cash. It will have movable or immovable assets, assets
such as shares, debentures, etc.
SLS
The latest entrant as a collateral is SLS. SLS stands for Senior Life Settlement
Policies. A senior life settlement involves the sale of an unwanted insurance policy
to a third person at a price that is lower than the policy's face value. The original
policy owner gets a lump sum in cash. The third party is then legally responsible for
all further premiums on the policy. This settlement amount, as a rule, exceeds the
policy's cash value accumulated until that date.
Senior citizens often opt for senior life settlements for a variety of reasons. This is
mostly done when the person encounters an emergency or other financial need. The
senior life settlement company buys the policy from him and collects his premiums in
an escrow account. When the policy is bought by a third party, the original holder
can stop paying the premium. Then the new buyer takes over, after paying the cash
for the policy.
Generally, people take several policies in their early life. But, when they enter into
old age, people find that they no longer have to keep many of those policies. Also,
many senior citizens find it difficult to pay insurance premiums. In order to alleviate
the financial strain of paying the premiums, many seniors choose to take a policy
settlement.
There are many settlement brokers who make the entire process of life settlement
policy easier. They first analyze the policies and auction them to various interested
parties. The policies are sold to the person or people who offer the highest bid. The
new holders are then liable for all the premiums on the policy going forward. Senior
life settlement policies can be owned and bought by individuals or companies.
SLS Policies have varying terms and varied redemption amount. These policies must
be synchronised to the MTN’s tenure. For example, if a MTN is for a 10 year period,
the SLS policy must be less than or equal to a 10 year maturity such that it matures
before the MTN’s maturity date.
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2. Author: Partho Chakraborty
For example a MTN for say US$ 100 face value maturing in say September 25,
2011, could have SLS policies for amounts such as US$ 10 maturing in August 21,
2008, US$ 50 maturing in September 25, 2010 and say US$ 40 maturing in
September 01, 2012. The maturity dates of SLS policies could be more or less close
to the maturity date of the MTN but it can never exceed the maturity date of the
MTN.
The SLS Policies once redeemed pays for the MTNs face value. SLS Policies in the
secondary market has seen a huge growth with various reports suggesting that it
could touch US$ 200 Billion in years to come.
MTN
MTNs or Medium-term Notes are corporate debt obligations offered to investors
continually over a period of time by an agent of the issuer. They are offered to the
public under SEC Rule 415 (the self registration rule). This rule allows issuers to
sell securities on a continuous basis so that issuers have the flexibility to issue
securities in favourable market conditions. They are priced at a spread to the
Treasury yield curve at the time of the offering and typically issued at par. The
maturities vary from 9 months to 30 years. Note that the term "medium-term notes" is
not related to the term to maturity of the securities and Borrowers can issue fixed- or
floating-rate MTNs.
A medium term note (MTN) is a debt note that usually matures (is paid back) in 5–
10 years, but the term may be less than one year or as long as 50 years. They can
be issued on a fixed or floating coupon basis. Floating rate medium term notes can
be as simple as paying the holder a coupon linked to Euribor +/- basis points or can
be more complex structured notes linked, for example, to swap rates, treasuries,
indices, etc. When they are issued to investors outside the USA, they are called
"Euro Medium Term Notes". Issuance of MTNs to investors based in the USA
requires a separate US MTN program.
MTNs can be issued with a fixed maturity date (non-callable) or can be issued with
embedded call or put options and triggers where the notes will redeem early based
on certain parameters. MTNs are most commonly issued as senior, unsecured debt
of investment grade credit rated entities which have fixed rates. MTNs offer more
flexibility to the issuer and investor both in terms of structure and documentation.
The Walt Disney Company issued a note with a term of 100 years! So notes is a
misnomer, but it did describe them more accurately when General Motors
Acceptance Corporation (GMAC) first issued them in the 1970's as notes with terms
greater than commercial paper, but less than most bonds, so that GMAC could
match the terms of the notes with its auto loans.
This type of debt program is used by a company so it can have constant cash flows
coming in from its debt issuance; it allows a company to tailor its debt issuance to
meet its financing needs. The main benefit of MTNs over bonds to both issuers and
investors is the flexibility of its structure and documentation. MTNs can match MTN
terms with liabilities of the issuer.
MTNs can have floating or fixed rates; formulas that tie return to equity, commodity,
or currency prices. They can even have calls, puts, other options built into them.
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3. Author: Partho Chakraborty
They can be issued as zero coupons, or have step-up or step-down coupons, or
inverse floating rates; or be denominated in a foreign currency, or pay interest based
on an index. Interest payments can be monthly, quarterly, or semi-annually.
Valuation
As mentioned-above MTNs are merely pieces of paper deriving their underlying
value through cash or assets or SLS. If a MTN is issued by the Government then it is
backed by a Sovereign Security. In theory any corporate can issue a MTN and give
its value through any asset such as SLS. Thus the value of a SLS based MTN is
actually the value of the SLS and the coupon or interest it pays. The SLSs would be
redeemed on maturity giving the face value of the MTN to the holder of the
instrument. It also would have to generate the interest to be paid to the holder on a
per annum basis till maturity
A MTN has a fixed tenor and gives a fixed return. So the SLS must be factored to
give the desired return at the maturity date. As MTNs are generally of high values,
they would require many SLS to give it its value.
A policy is normally valued by first finding out its Paid-up value, then deriving the
Surrender value and finally the Loan value. In these Structured Products the
Surrender Value is typically less than 1% of Face value. So a US$ 5 Million Policy
will have less than US$ 50,000 as Cash Surrender Value (CSV). The reason the
Cash Surrender Value is so low is to discourage encashment of SLS as the
premiums paid is used to service the Coupon and at the same time build up the
reserves to pay the Face Value of MTN on Maturity. Care is also taken to minimise
the premiums to the lowest possible level, which leaves hardly any room for Cash
Surrender Value.
Also the structure is such that the Cash Surrender value is separate from the Net
Present Value (NPV), as the NPV is based upon the rate of return of the policy,
(typically NPV is based on 21.00 % IRR) based on when the policy matures.......that
is the core of SLS business. As mentioned before, by design there will typically be
very little CSV as the investor goal is to limit the premium payment only to "cost of
insurance" ("COI" ...the lowest premium possible and still keep the policy in "good
standing") thus no build up of CSV. The reason for COI premium v/s a higher
premium building CSV is that the investor return on cash invested needs to be in the
15 – 21% IRR range and the insurance carrier is only going to credit 3.5 – 6.5% on
the premium in excess of COI. Accordingly, the MTN would pay only the COI
premium and any CSV will be extremely nominal.
Suppose you are purchasing $550M for the $200M MTN (2.75 to 1), the market cost
of SLS acquisition would be between US$49,500,000 to US$ 60,500,000; the Cash
reserves held within the Trustee would be $90,500,000 to $110,500,000.
This gives US$ 140 Million to US$ 171 Million or 70% to 85.5% of the MTN face
value.
The cash surrender value would be on average 1% per policy, which would be US $
5,500,000
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4. Author: Partho Chakraborty
Let us calculate the valuation for a US$ 200 MTN with a Coupon of 6.5% per annum
for 8 years.
Let us find out the Present Value of the par value or face value. For this we use the
Formula to find the Present Time Value of Money:
Where the values are:
A = US$ 200
r = 6.5%
n = 8 years
P = 120.85
Let us now find out the Present Value of the Coupons. For this we use the formula to
find out the Present Value of Coupon Payments
Where the values are:
c = 6.5
r = 6.5%
n = 8 years
C = 39.58
Adding both the present values we get: US$ 160.43
US$ 160.43 is 80.21% of MTN face value. This is consistent with the value of SLS as
shown above in Page 3.
If we take 80% of 160.43% as computed above, the loan amount for a MTN of US$
200 is US$ 128.34.
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5. Author: Partho Chakraborty
Note: Names are Suggestive and are strictly not to be taken on Face Value. It
is only to give a feel and touch of how transactions can be structured
and names are indicative
This article is meant for education purposes only and it is not be
reproduced for any commercial purpose by print or electronic medium
whatsoever
This article is written by:
Partho H. Chakraborty
A - 305, DSR Spring Beauty Apts., 124/1, ITPL Main Road, Brookefields, Kundalahalli, Bangalore -
560 037, India
Tel: +91 80 420 50293, Cell: +91 99863 22504
email: parthohc@airtelmail.in; parthohc@rediffmail.com
Skype: parthohc01
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