Life settlement

[twaddle]

My dad recently sold his business and has a bunch of key man life insurance he no longer needs. He thinks he might be able to extract some value in the form of a life settlement.

He's 69 and in fairly good health, and my impressions wrt life settlements are:

1) You have to be knocking on death's door

2) The life settlement "industry" is full of sharks who will offer pennies on the dollar

Anybody have any experience with life settlements? Any recommendations for non-sharks who can offer him a fair deal or at least an appraisal of his policies?

[haha]

Is this a paid up, whole life policy? Is there any stated endowment value?

One issue is maybe the policy would be valuable to him as an estate planning tool? This is an area where FPs who work with well-to-do clients are often up to speed, as well as good estate planning attorneys. Also, the guy who sold him the policy may have suggestions.

A whole life policy will have a cash value- that is your rock-bottom pay-out for surrendering the policy back to the issuer today. Beyond that, you can value the policy the same way a purchaser might. Get tables showing raw survival for a cohort of men. Like 87544 men alive on their 69th B’day. Then advance year by year, making a fraction of (starters-completers)/starters for each year. Then take these fractions, and multiply each one by the discounted value of the payout for one who dies during that year.

Add all these discounted payouts and that should give a pretty good benchmark for the value of the policy. There are a few things you would be ignoring. You could adjust the figures for half year averages, assuming that half will die in each half of the year. But I think it is a complication that is not necessary.

You may spot some problem with my algorithm. I haven’t done this in a while, and I don’t have a data-set handy to test it. But I think it should be sound. Let me know if you try it and get a weird result.

Ha

[twaddle]

Thanks, Ha. I think my math is buggy.

If I understand your algorithm, you're saying that the present value of a policy would be: SUM over years of (death probability * present value of benefit).

I'm using the following table for death probabilities:

Actuarial Life Table

And I'm using benefit/(1+discount_rate)^years for the present value of the benefit, which I suspect is incorrect.

So, for a discount rate of 5% and a benefit value of $1M, the first term in the sum for a 69 year old is .026454 * $1M = $26,454.

And the second term = 0.028904 * $950,380.95 = $27,527. So, the sum of the terms seems to be getting too large too quickly.

Can anybody find my bug?

[haha]

Off the top of my head, I think using annual death rates introduces a flaw. My mental model is that of a viatical company buying say 100,000 policies from 100,000 69 year old men. Each year they will get some payouts. But since each year the pool will be reduced, the expected payout will be less by that reduction.

For example, which would be worth more? 100,000 policies on 100,000 (70) year old men, or the 97,354 policies that will be left at age 70 from a pool begun at age 69?

So we have to reduce the expectancy at each age to account for the shrinking pool. After all, no more than 100% of these guys can die, right?

Let's see if that fixes it.

Ha

[twaddle]

I think I'll have to research this a bit. I tried multiplying each term by the remaining population fraction (1-death_probability), but it still seems to grow too fast....

[FIRE'd@51]

Ha's explanation seems intuitively correct to me. Once the numbers are in a spread sheet, I suppose a check would be to set the discount rate to zero and see if the present value is $1 million.

[twaddle]

With a discount rate of 0, the value grows to over $1M after only 17 years using:

SUM over years of {death_probability * (1 - death_probability) * pv_benefit}

[haha]

Agree. I reduced each year probability of death by multiplying by(1-death rate of previous year). Then I summed all the undiscounted values until age 119. It comes out to almost $8mm. By my reasoning it should equal only $1,000,000- the maximum that can be collected no matter how long it takes.

So I have a logic flaw. I need to go out in the sunshine for a while- but if you haven't figured it out my evening, I'd enjoy getting back to it. Please post your solution when you do figure it out.

I have a feeling that if we work with the raw number of survivors each year, it will jump out more clearly.

ha

[haha]

OK, couldn't leave. I found the flaw. If you start with raw numbers it is easier to keep things straight. I didn't bother to do the discounts yet, but the flaw was in the number of horses still in the pool each year. I think your discount formula is good. However, I would imagine that viatical firms use 15% at least.

If you aren't satisfied with what you come up with, PM me with your email and I’ll send you my spreadsheet.

Now I really am going out!

[twaddle]

I just got back from a walk myself. I came up with something that looks a little better, but I'll compare to your solution after I get back from some errands.

Basically, I think the original algorithm was close, but each term double counted the previous term values. Now, I get a value of $84K using a 5% discount rate for a $1M policy on a 69 yo male.

I'll try to verify that, and then I need to subtract out premium payments to get the remaining value (if any).

[haha]

Quote:

Originally Posted by twaddle Basically, I think the original algorithm was close, but each term double counted the previous term values. Now, I get a value of $84K using a 5% discount rate for a $1M policy on a 69 yo male.

One of us is far afield. My value is quite a bit higher. Some of the FPs on the board must have access to whole life quotes. A quick check for the maximum value is what an insurance company would charge your Dad for a new single pay policy. You would have to adjust that for payments still due

Ha

[FIRE'd@51]

According to the linked actuarial table, the life-expectancy for a large group of 69 year-olds is about 14 years, so the PV of $1 million at 10% for 14 years is about 263k; at 15% = 141k; at 5% = 505k. If you subtract the PV of the premiums from this amount, I would think it would be pretty close.

I'm not sure what discount rate the buyer would use, although I am sure it is not 5%. Also, the buyer would probably tack on a few extra years on the assumption that those in poor health would not sell the policy.

[samclem]

Isn't there a requirement that an individual get certification of a diagnosis of near-term demise before receiving these payments? The cash value is available at any time, but I thought tapping into the death benefit had some strings attached.
If not, I'd think a lot of folks now feeling the pressure from adjustable-rate mortgages would be using this to get a few hundred extra bucks every month (regardless of the later consequences of not having insurance)

[brewer12345]

Quote:

Originally Posted by samclem Isn't there a requirement that an individual get certification of a diagnosis of near-term demise before receiving these payments? The cash value is available at any time, but I thought tapping into the death benefit had some strings attached. If not, I'd think a lot of folks now feeling the pressure from adjustable-rate mortgages would be using this to get a few hundred extra bucks every month (regardless of the later consequences of not having insurance)

Nope, this is the seedy secondary market for life policies, AKA "stranger-owned life insurance." I wouldn't touch this with a 10 foot stick.

[haha]

Quote:

Originally Posted by FIRE'd@51 According to the linked actuarial table, the life-expectancy for a large group of 69 year-olds is about 14 years, so the PV of $1 million at 10% for 14 years is about 263k; at 15% = 141k; at 5% = 505k. If you subtract the PV of the premiums from this amount, I would think it would be pretty close.

This isn't the way an actuary does it. They take each year separately, and discount a payment at that point appropriately.

Ha

[twaddle]

Quote:

Originally Posted by haha This isn't the way an actuary does it. They take each year separately, and discount a payment at that point appropriately.

Looks like they might use a couple methods:

Life Settlement Valuation, Life Settlement Investors, Viatical Investors

I've seen discount rates range from 12-20% in some discussions on the net.

Of course, the future value of premium payments hugely offsets the present value of the benefits. And, assuming insurance companies are rational about pricing premiums, the premiums should fully offset the present value of benefits unless your health has materially changed during the term of the policy.

So, I consider the calculation interesting but academic. I did learn a few new tricks with excel, though.

I told him to shop his policy around at a few places and report back what he finds....

[Texas Proud]

To me the problem is that the valuation from an insurance company and a 'factoring' company (don't know if it really is a factoring or not, just like that word ) are two very different numbers...

If you sell it to someone, they want to be guaranteed a profit by discounting it SO much they can not lose... so, they would likely assume you to die at 95 or 100 and also discount it a lot.. I would assume that the cash value is the floor, but that you would not get much more than that.

Now, some policies do not have a cash value... my mother has some fully paid whole life that do not have a cash value... my dad sold insurance back in the late 50s, early 60s and paid for them with the commissions or something... so we have not made a payment in over 30 years... but since it is only a $25K policy who cares...

[samclem]

Quote:

Originally Posted by brewer12345 Nope, this is the seedy secondary market for life policies, AKA "stranger-owned life insurance." I wouldn't touch this with a 10 foot stick.

Oh. So, you'd get a nickel on the dollar and whoever gets the policy is money ahead the sooner you croak. Under these circumstances, I'll bet the insured starts getting unsolicited offers for skydiving lessons, free packs of cigarettes in the mail, and exotic "action vacation" offers to Myanmar. "Honey, was that car parked outside the house again today . . . "

Not that I'm paranoid or anything.

[haha]

Quote:

Originally Posted by twaddle Looks like they might use a couple methods: Life Settlement Valuation, Life Settlement Investors, Viatical Investors ..

From your article-

Life Settlement Pricing-Probabilistic Method

The probabilistic method of pricing a life settlement uses the life expectancy figure to determine the mortality factor applicable to the given life. To do this, the LE is applied to a mortality table, and the mortality factor or rating applicable to the given insured is derived from the table itself. The resulting figure, stated as a percentage, represents an indication as to the degree to which the given life can be considered more or less impaired than a “standard” life having similar characteristics (i.e. age, gender, smoker/non-smoker, etc.). For example, a standard insured (the average life for the given motality table) would carry a mortality rating of 100%. A similar but impaired life bearing a mortality rating of 200% would be considered to have twice the chance of dying early than the standard life. Obviously, any insured can expire at any point in time but, in general, an impaired life (one bearing a greater than standard mortality rating) can be expected to expire earlier than the standard life. In the probabilistic pricing approach, the mortality rating is used to create a range of possible outcomes for the given life and assign a probability that each of the possible outcomes might occur. This listing represents a mathematical curve, known as a mortality curve. This curve is then used to generate a series of expected cash flows over the remaining expected lifespan of the insured and the corresponding policy. Then an Internal Rate of Return (IRR) calculation is used to determine the price of the policy.

Of the two approaches, the probabilistic method is more rational because the calculations acknowledge the fact that there are a range of possible outcomes associated with each insured life. In other words, it is possible for the insured to pass away at any point in time and the effect of each possible outcome on the return earned from the purchase of a policy covering the given life will vary. Obviously, if the insured dies earlier than expected, the return will be higher than if the insured dies when expected (at the LE) or later than expected. In addition, the calculation allows for the possibility that if the insured dies earlier than expected the premiums needed to keep the policy in force will not have to be paid. Conversely, the calculation also considers the possibility that if the insured lives longer than expected, more premium payments will be necessary. Again, based on these considerations, each possible outcome is assigned a probability and the range of possible outcomes is then used to create a price for the policy.

Most institutional investors are inclined to purchase a sufficient number of policies covering a sufficient number of lives to benefit from the law of large numbers. Because of this fundamental insurance concept, the probabilistic method of pricing has becoming the preferred method used by sophisticated investors to price life settlements.

I did this in the 80s. Mostly for so-called structured settlements for severely injured winners of large judgments. So it was in effect a slightly medically weighted way of pricing an annuity. Even back then, I saw no one who was pricing them by the less sophisticated method of just discounting back a single assumed or derived deterministic life expectancy. Who would expect for get paid for that? All you would need would be a wild guess and an HP-12C.

This was also the beginning of the viatical market expansion. I felt it was morbid and also likely to blow up in the purchasers faces. Which it did, for many of them at least

Ha

[brewer12345]

Quote:

Originally Posted by samclem Oh. So, you'd get a nickel on the dollar and whoever gets the policy is money ahead the sooner you croak. Under these circumstances, I'll bet the insured starts getting unsolicited offers for skydiving lessons, free packs of cigarettes in the mail, and exotic "action vacation" offers to Myanmar. "Honey, was that car parked outside the house again today . . . " Not that I'm paranoid or anything.

Exactly. There have also been instances of policies being up for sale being circulated to potential buyers with the SSN and other identifying details attached. No thanks.