February 21, 2005 Edition   |    Back to Table of Contents   |   View Previous Issues

Securitization Of Life Settlements: A Pivotal Phase In The Product Life Cycle

By Boris Ziser and Craig Seitel

Few of us would have predicted several years ago that the increased interest from both foreign and domestic institutional funders in the life settlement marketplace would help to redefine the industry and bolster its credibility within the financial services arena.

Although life settlements evolved from the viatical settlement market in the 1980s, which was dominated by individual investors who purchased policies from terminally ill AIDS patients, the industry has undergone a metamorphosis resulting in a shift in the product’s demographic focus.

With this shift in focus from terminally ill insureds to high-net-worth seniors generally over age 70 seeking an exit strategy from unwanted policies, the industry entered a new era of sophistication and a new stage of the product life cycle that brought greater credibility and a clearly defined value proposition for all players in the life settlement supply chain.

In spite of the structural complexities in securitizing life settlements, it is a growing asset class that has captured the interest of investors from around the world
particularly in the last two years, investors from Germany. Clearly, we are seeing an increasing number of parties interested in entering the industry, whether as originators, brokers or funders.

According to the Viatical & Life Settlement Association of America, the number of industry players has doubled over the past five years
a good sign for this asset class that will help the segment grow.

Although money managers consider a portfolio of life settlements a great asset class because it diversifies investment, the classification of life settlement transactions has been difficult, as they contain elements of a loan, a sale, an equity investment and securitization. Life settlement transactions do not fall into any single category, as various structures are available for these deals.

One of the interesting but also most challenging aspects of life settlement transactions is that they require intensive structuring, particularly with respect to tax considerations. While favorable yields attract investors to participate in life settlement transactions, tax considerations drive the structures. In fact, special tax advantages afforded to German investment funds under the U.S.-German Taxation Treaty have helped drive the influx of significant amounts of German capital into the marketplace.

Similar to other types of corporate deals, a tax-efficient structure is a central goal. Any inefficiency in the tax aspects of the transactions has a rippling effect on the entire outcome, as the tax liabilities reduce the yield, often forcing the investor to underbid for policies (risking losing such policies), in an effort to maintain certain levels of return on investment.

Many of the transactions completed to date have involved investment funds located outside of the United States. Since the life settlements and the payments they produce originate in the U.S., a tax-efficient structure will permit such payments to reach the fund, and ultimately the investors in the fund, in a tax-efficient manner. The extent to which tax consequences can be minimized will, in most cases, depend on whether a tax treaty is in effect between the U.S. and the country of which the investors in the fund are tax residents, and the specific provisions of the tax treaty.

Under the tax laws of the U.S., absent a tax treaty and a proper tax structure, withholding tax will be applied to life settlement payouts leaving the U.S., thereby reducing the yield on the investment and creating a less favorable outcome. If the tax laws of the offshore jurisdiction are not favorable or the tax treaty is not favorable, it may be more tax efficient to structure a transaction in which some level of taxation will be applied in the U.S. The transactions that fall into that category are usually the most difficult from a tax perspective and require significantly more tax analysis and guidance.

In addition to tax laws, U.S. securities laws apply to life settlement transactions as well. Regardless of whether life settlements are determined to be "securities" for purposes of the Securities Act of 1933, the structure itself may involve the issuance of securities, such as trust certificates. Transactions can be structured as private placements, thereby avoiding the registration requirements under the Securities Act that would otherwise be triggered.

Additionally, when offshore funds are involved, Regulation S can offer an exemption from registration under the Securities Act as well. Life settlement transactions must also be structured to avoid triggering compliance requirements under the Investment Company Act of 1940. Depending on the nature of the fund and its ownership structure, other statutes may apply.

When structuring a transaction, in addition to legal considerations, practical considerations and client objectives must also be taken into account. Various structures are available for life settlement transactions, such as trust arrangements, custodial arrangements and Delaware Statutory Trusts or other similar arrangements. Generally, each structure has certain benefits and limitations. Depending on the flexibility and ownership status required by the fund, one or more structures may be available. Various forms of entity are available for life settlement transactions, such as a corporation, limited liability company or a partnership. Given the available alternatives, it is likely that many requirements and preferences of a fund can be addressed.

A while back, the Wall Street Journal reported on a major milestone in the industry with a bond sale involving a large domestic investment banking institution that handled the private placement for $70 million in bonds backed by life insurance policies rated by Moody’s Investors Services. Additionally, A.M. Best assigned a debt rating to one securities transaction where asset-backed bonds were collateralized with $195 million in face value of life policies purchased from people with life expectancies from 48 to 84 months.

Traditional investment grade securitizations are popular investments for pension funds and insurance companies. However, there are more "non-traditional" structured products that are engineered to meet specific investment objectives. The capital sources for these investments are coming from several sources, including various European funds and domestic hedge funds.

Hedge funds are effective sources of capital because, unlike pension funds and the insurance industry, hedge funds are not subject to the numerous regulations that apply to these sectors. As a result, the hedge fund community has much more flexibility with the type and structure of investments it pursues. Because structured products can facilitate the liquidity of investment portfolios with greater efficiency than unstructured whole assets, such as individual life settlements, we predict the investments in life settlements will be concentrated more in non-traditional securities.

Although interest from European investors (particularly those in Germany, Austria and the U.K.) has been strong until now, we are keeping a close eye on the impact a weak dollar might have on prospective foreign investments in the life settlement marketplace. Hedging against a weak dollar will add another element to the structural complexity of life settlement securitization.

Boris Ziser is a securitization expert and partner in the international law firm of Brown Rudnick Berlack Israels LLP located in New York City. Craig Seitel is an investment banker and CEO of Abacus Settlements, LLC, a life settlement provider located in New York City.