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Retaining or Selling Life Insurance:
A Proper Analysis
"The task is to help your client decide
whether to retain this policy or sell in the life settlement market. If
it is retained a premium strategy needs to be selected. there is no 'bright
light' right or wrong decision."
To: Acme Advisors
From: Peter Katt
Re: ABC Life Policy No. 123456789 / Insured Charles
Doe
You retained me to analyze the referenced policy.
I have reviewed various illustrations and a life settlement offer from
Coventry First. My comments follow:
This is an $800,000 specified amount plus the
cash value UL policy. It was issued in March 1984 when Mr. Doe was 60.
He is now 86. I understand Mr. Doe's health is quite good considering
his age, although underwriting for a replacement policy resulted in
an uninsurable result. This is a common circumstance for males of this
age.
The task is to help your client decide whether
to retain this policy or sell it in the life settlement market. If it
is retained a premium strategy needs to be selected. There is no "bright
light" right or wrong decision.
Life insurance is a complex financial asset
because embedded pricing is difficult to interpret and we don't know
when insureds will die. The best we can do is to calculate various IRRs
(cash value and premiums to death benefits over time) to different end
points and use mortality probabilities.
Based on Coventry's offer of $280,000 cash or
a guaranteed $400,000 death benefit to age 95, I calculate that Coventry
has set a life expectancy for Mr. Doe of four to five years. This is
the mortality perspective I am using.
Based on the current annual target premiums of
$49,952 the policy is illustrated to continue until sometime during
the 31st policy year, when Mr. Doe is 90/91, then terminate. There is
a 38% probability Mr. Doe will survive to 91. That is, there is a 38%
probability the policy will terminate without value based on this target
premium.
Based on a higher annual target premium of $81,785
the policy continues to age 95 (8% probability of making it to 95) after
which it terminates with no value. The IRR turns negative at age 94.
The IRR at 90 is 12%; 7.0% at 91; 3.3% at 92; and 0.4% at 93.
Coventry's offer of $280,000 is $39,000 more
than the cash value. Coventry also offered to purchase the policy leaving
a $400,000 guaranteed death benefit for Doe Company to age 95. The cash
offer is best if Mr. Doe lives beyond 92. The guaranteed death benefit
is the best Coventry option to age 92. The IRR is found by taking the
$280,000 as the present value and $400,000 as the future value. For
the $400,000 option the IRR at 7.4% at 90; 6.1% at 91; 5.2% at 92; 4.6%
at 93; 4.0% at 94; and 3.6% at 95 after which the policy terminates.
The difference in IRR at age 90 between target
premiums of $49,952 and $81,785 is 14% compared to 12%, but the $49,952
option terminates at 90/91 while $81,785 is illustrated to continue
to 95. I believe the aggressive option is to pay the target premium
of $81,785. It has a high IRR at age 90 (about 62% chance of occurring).
The $280,000 cash Coventry option is most conservative
because it won't terminate and would continue to grow at the fixed income
rate (but taxable).
I believe a higher cash offer could be obtained
if you take this to several settlement brokers. I wouldn't be surprised
if a cash offer of some $400,000 is made. The problem is that no matter
what the parties to the transaction tell you about privacy (investor
knowing who Mr. Doe is) there is no assurance individual or small hedge
fund investors won't have full information about this policy, including
the insured. I have had this experience in my practice about five times.
Large institutional investors, like I believe Coventry is, don't share
such information with shareholders.
In summary, the most aggressive decision is
to retain the policy and pay the $81,785 premium. This is the best option
if Mr. Doe dies before age 92, but goes negative at age 94 and has no
value after 95. The most conservative option is to take the $280,000
cash because it won't terminate after 95 and would keep growing (if
invested in safe fixed income instruments). Another conservative option
is to take the $400,000 guaranteed death benefit. It has the best late
term return, but terminates after 95. And, if there is no concern about
an individual investor or small hedge fund knowing who Mr. Doe is, the
policy can be offered to multiple settlement brokers.
