July 7, 2002

James Client, Trustee
Client Family Irrevocable Trust
C/o Acme Supply Company
300 Rainbow Parkway
Anytown, USA 12345

Re: Sale of Aetna Life Insurance Policy No. 12345678

Dear Mr. Client:

Your attorney, John Esquire, asked me to review the possible sale of the trust owned Aetna universal life policy to Coventry First, LLC, a life settlement firm located in Fort Washington, Pennsylvania. The specifics of the Aetna policy are noted in Exhibit 1.

The sale of life insurance policies on the so-called secondary market to life settlement firms is a new business and there has been little critical analysis of this business as yet. I have recently studied life settlements and written a column about them. The source of information for my May 2002 AAII Journal column came from Coventry First, the firm that has made the best purchase offer for your Aetna policy. It appears that the offer being made for the purchase of your policy is substantially better than the three purchases Coventry First provided me information about for my column. This apparent difference may be just the nature of the life settlement business or your situation may be benefiting from competitive bids from several life settlement firms. Mr. Insurance Agent's letter dated June 24, 2002 notes that "By 'working' the market, I have been able to improve the offer from $1,400,000 to $1,700,000…" This appears to be a legitimate claim. Indeed, it appears that the yield Coventry First is trying to earn on the transaction with you will be in the 12% to 13% range. The yield of the three redacted Coventry First cases I reviewed appeared to be 17% to 18%, which is about what I was told is their target investment return.

Conclusion

Before I get into the details I want to give you my conclusions. My analysis suggests that selling or keeping the policy produces no clear winner and loser. Depending on how the trust may wish to restructure the policy, selling it has advantages during certain periods of time and disadvantages during other periods. Like a telescope with radically different results depending on which end you look through, how the policy is restructured will dictate the periods of time when advantages and disadvantages occur. That is, keeping the policy and restructuring it based on the policy design identified as alternative #1 produces a projected advantage until Mrs. Insured is 92, then it is a disadvantage. Restructuring the policy using the policy design identified as alternative #2 has an initial disadvantage, but produces better projected result beginning at age 91.

Mr. Insurance Agent's Analysis

Mr. Insurance Agent used a flawed analysis to conclude that it is clearly in the trust's interest to sell the policy. He misrepresents what he refers to as my formula. I won't bore you with my complaint about how he is misusing it, but will point out that his major analytical error is in suggesting the only choice is between selling the policy or keeping the policy as it is presently structured. The policy currently has an Option 2 death benefit structure. Option 2 means that the death benefit will equal $2,500,000 plus the cash value. Consequently, the mortality costs for this policy will always be based on the full $2,500,000. Given Mrs. Insured's age, and a sub-standard rating, it is unrealistic to expect to pay these kinds of mortality costs if Mrs. Insured lives well into her 90s. But as we will see there are policy design alternatives that remove this Option 2 problem, making Mr. Insurance Agent's only choice a false one.

Coventry First's Policy Structure

Based on my understanding of Coventry First's methods of restructuring universal policies, if they purchase this policy, they are likely to change its death benefit structure from Option 2 to Option 1. Option 1 is a level death benefit design that would probably be set at around $3,700,000. It is also likely that Coventry First will substantially underfund this policy by paying little or no premiums. Under current pricing I estimate that this policy will continue at a level death benefit of $3,700,000, without any premiums, for about six years until Mrs. Insured is 91. I also calculate that six years is about the life expectancy assigned to this case by Coventry First. Based on their purchase price of $1,700,000 and the probable commission paid to Mr. Insurance Agent of $100,000 I calculate that the pre-tax investment yield in six years with a death benefit of $3,700,000 is 12.76%. If Mrs. Insured lives beyond six years, and there is a 50% chance she will, Coventry First will have to essentially pay term insurance costs on $3,700,000 for a 91-year-old. These costs would be extraordinarily high. For example, estimated mortality costs for $3,700,000 at 91 are $418,000, $747,400 at age 95 and $923,150 at age 98. This is a risk no individual would take. But to the extent Coventry First has purchased enough policies, have properly underwritten them and haven't paid to much to buy them, mortality probabilities will work in their favor so that the half of insureds who pass away before life expectancy will provide the funding for the half that don't. Because of these probabilities Coventry First can take on this kind of funding risk. I point this out to explain why you cannot use the same kind of policy structure as Coventry First, or the false choice Mr. Insurance Agent has presented.

Alternative Policy Restructures

After considerable analysis I conclude that there are two possible restructured policy designs to consider if you choose to retain this policy. These restructured policy designs are as different as looking through both ends of a telescope. Compared with selling this policy for $1,700,000, the first alternative produces better value in the short- and medium-term and the other alternative produces better value in the medium- and long-term:

1. Reduce the death benefits to $2,163,000 Option 1 (level death benefits) with no further premiums. This $2,163,000 amount is what the sales proceeds of $1,700,000 would earn at the after-tax rate of 3.5% in seven years, one year after the life expectancy assigned Mrs. Insured by Coventry First. This is the amount of level death benefit that is projected to be supportable with the policy's current cash value based on current pricing conditions. Table 1 shows the value of selling the policy for $1,700,000 with these proceeds invested at an after-tax rate of 3.5% vs. maintaining a level death benefit of $2,163,000. Depending on Mrs. Insured's health and future Aetna interest crediting, it is possible additional premiums would be necessary if the policy is retained.

Table 1 - Sell Policy vs. Keep Alternative #1

(1) Sale proceeds are invested in bonds with an assumed after-tax yield of 3.5%.
(2) Based on our simulation of the Aetna policy (Exhibit 2) w/ projected cash values of $607,274 at 100. Depending on Mrs. Insured's health and Aetna interest crediting it may be necessary to pay additional premiums, which may make keeping the policy a lesser value. But the relative difference would depend on how yields of the sale proceeds hold up.

2. Reduce death benefits to $1,400,000 Option 1 (level death benefits) with annual premiums of $60,000. This alternative is compared in Table 2 with selling the policy for $1,700,000 plus investing the $60,000 premium if retained, earning an after-tax yield of 3.5%. It is possible that Aetna's interest crediting could be lower than can be earned outside the policy making keeping the policy a lesser value. The opposite could also occur.

Table 2 - Sell Policy vs. Keep Alternative #2

(1) Sale proceeds are invested in bonds with an assumed after-tax yield of 3.5%.
(2) Based on our simulation of the Aetna policy (Exhibit 3) w/ $1,400,000 initial death benefit and $60,000 premiums every year. Both selling and keeping the policy will be affected by changing fixed-income yields.

The projected advantage in keeping the policy under alternative 2 beginning at age 91 is because we have reduced the death benefits to their minimum amount so we have eliminated most of the death benefit cost, the inside cash value build-up is tax-deferred, and the death benefits are tax-free. The $60,000 added to the $1,700,000 sales proceeds are not protected from taxation and the after-tax investment return should be about 60% of the growth within the policy.

If you tentatively decide on keeping the policy, using either alternative, I will need to get a confirming illustration from Aetna. It is possible that my simulations are inaccurate enough to cause you to rethink this tentative decision. I didn't get additional Aetna illustrations beforehand because I used a myriad of trial-and-error simulations that would have been too time consuming and inefficient to obtain from Aetna.

After you have had a chance to study this report please contact me to arrange for a conference call to discuss it. I am also available to discuss this in a conference call with you, your attorney, and Mr. Insurance Agent if you think this would help you make a decision.

Very truly yours,

Peter Katt, CFP, LIC

Cc: John Esquire, Esq.

Enclosures