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Everyone Wins: The Story of a Special Life Settlement Transaction

The Initial Purchase

In 1994, a wealthy business owner concluded the purchase of life insurance protection to assure that the taxes on his estate would be paid from the cash proceeds of the policies, that the business could be passed on to his heirs without encumbrance, and that his family members would benefit from the remaining proceeds of the policies.

He and his wife purchased five life insurance policies from four different insurers with an aggregate face amount of $36,000,000. Each of the policies represented the most complex policy form issued by the carriers, Second-to-Die (Survivorship) Modified Whole Life Insurance. A relatively new product at the time, this policy form had a base amount of traditional whole life insurance and an additional amount of insurance that consisted of a combination of decreasing term insurance and paid-up additional insurance.^[1] Several policies had an initial face amount (the death benefit printed on the face page of the insurance policy) of $4,000,000. The traditional whole life portion was $1,000,000, and each policy had an initial combination of $3,000,000 of decreasing term and paid-up additional insurance.

As Second-to-Die policies, both the business owner and his wife were evaluated by company underwriters. The 63 year old business owner was rated "Standard Class" on the policies, which, at the time, was used to classify an unimpaired former smoker. His 55 year old wife received a "Preferred" rating. Her youth and good health resulted in a relatively inexpensive premium structure.

The policies were applied for and owned by the business, which entered into what was then a popular "Split Dollar Purchase" arrangement benefitting the owner who was treated as an employee of the company under the terms of the agreement. Under this arrangement, the company paid premiums and took non-interest bearing collateral assignments on the policies for repayment of the premiums at the second death or from policy values should the policies have been surrendered to the insurers for their cash surrender values prior to death.

^[1] Decreasing Term Insurance, as the name implies, is a staged reduction in the amount of death benefit payable. Paid-up Additional Insurance essentially is a set of single premium death benefit units, each of which requires no additional premium payment. The units may be purchased in cash and by application of yearly policy dividends.

The Transition

In 1996, conditions affecting the business owner's industry began to affect the business adversely. During the business turmoil, his wife died unexpectedly in 1997. The loss staggered the owner, and the business continued to deteriorate until 2002 when the owner announced a cessation of production. The company was sold in October 2003 and was restructured. Ownership of the policies and the accompanying liens changed hands at least twice with the children of the surviving insured becoming joint owners of the policies and the successor company becoming owner of the liens. During this period, the insured was diagnosed with throat cancer.

With the failing of the business, in late 2003, the adult children of the insured found their personal fortunes greatly diminished and sought relief through the sale of the life insurance policies in the secondary market, which had been growing steadily since the beginning of the decade.

Secondary Life Capital to the Rescue

Secondary Life Capital, LLC (SLC) was formed as a secondary market provider firm under the umbrella of The Peninsula Group, LLC in 2003. At an informal dinner during a 2004 industry meeting in Philadelphia, President and Chief Executive Officer, J. Mark Goode, and his senior staff members were introduced to a life insurance professional who described his frustration at trying to place a particular package of substantial life policies because of the complexity of the policies and the obstacles to sale. The difficulties of the transaction were seen as an opportunity to demonstrate the ability of SLC to perform for investors when other provider firms could not.

With the signing of appropriate non-disclosure documents, the identity of the surviving insured and the obstacles to sale and purchase were disclosed to SLC. The following issues made this a more complicated case than what, even in 2004, was an ordinary life settlement:

Only the death benefit of the whole life insurance base policy, representing 25% of the face amount, was guaranteed. The balance was contingent upon circumstances, not all of which would be under the control of the secondary market owners. This presented a risk which SLC, unlike other providers, believed that they could manage.
The identity of the owners of the existing outside liens was, at the time, unknown, even to the insurers.
Whether the liens were interest bearing or non-interest bearing was not known (and the fact that they are non-interest bearing was not discovered until well after the identity of the lien owners was discovered).
Premiums subsequent to those paid under the terms of the split dollar agreement had been paid by extensive premium loans against the cash surrender values of the policies which had reduced the net death benefit and produced significant annual loan interest obligations.
All but one of the children had become estranged from the insured and the one who was not estranged was reluctant to speak with the insured about the life settlement transaction.
The insured, because of the estrangement from the children, was unwilling to cooperate in any way with the sale of the policies in the secondary market Specifically, this meant the following:
- The insured would refuse to sign a release of his medical records rendering it impossible to obtain a current life expectancy projection from a third party life settlement underwriter.
- Although the insured was a public figure whose death undoubtedly would be a matter of public information, tracking his condition, or even his whereabouts, would be more complex.
Dividends,^[2] which were to pay the premiums on the decreasing term insurance and purchase paid-up insurance units equal to the decrease in the term insurance, were being used to pay premiums and the annual interest on the premium loans. This created the potential that the non-guaranteed portion of the death benefit might not be fully available at death.
The children were not in agreement that the policies should be offered in the secondary market.^[3]
No software was available to calculate the present value of future expenses and future benefits to obtain a market value of the policies.
It was difficult to imagine an investor group willing to purchase these policies given these circumstances.

Many other life settlement provider firms simply were unwilling to attempt a potential life settlement of these policies. However, SLC was confident that its investment experience, insurance product knowledge, and legal expertise would be adequate to value the policies and negotiate a purchase and sale.

^[2]Dividends payable under the terms of a whole life insurance policy essentially are a refund of excess premium paid. Because a whole life policy guarantees the face amount, the level premium to be paid until maturity of the policy, and the endowment of the policy at maturity (the cash surrender value will equal the death benefit at maturity), companies intentionally charge more than is needed to cover mortality expense, administrative expense, and investment risk, returning the excess by declaration of a yearly dividend based on actual financial experience.

^[3] During the negotiation process with the children, the insured was confined briefly to a hospital. The children temporarily withdrew their participation in the negotiations, sensing that the insured might be moribund.

For a period of eleven months, from April 2004 to the closing of the sale in March 2005, the SLC management team valued the portfolio, negotiated with the sellers through a team of financial professionals representing the seller's interests, and sought buyers for the portfolio:

Illustrations of projected values based on the existing loans and assumed future dividends were obtained from the insurance companies.
Copies of the policies were examined and their provisions analyzed.
A several years old life expectancy projection was obtained and used as the basis for determining current life expectancy.
A process for evaluating the policies was created and employed to produce the market value of the policies.
Compensation levels were established.
Legal issues regarding the chain of ownership, both of the policies and the liens, were resolved.
Potential buyers were identified.

The Life Settlement Process and Secondary Life Three, LLC

A domestic investment fund expressed interest in the portfolio and employed an outside actuarial consultant to review the value projections made by SLC. The actuary sustained the valuation and each policy was valued and bid on an individual basis.

Tentative offers were made to the owners of the policies initiating the negotiation process. After considerable negotiation, a fund bearing in part the name of Secondary Life Capital was formed for the purchase of the five policies.

As the negotiations proceeded (see below for financial details) and the transaction was approaching its completion, the domestic investment fund manager announced that it would be able to purchase only two policies, one with a face amount of $18,000,000 and the other with a face amount of $6,000,000.^[4] That left three policies, each with a face amount of $4,000,000 and no buyer.

Almost at the last minute and in order to rescue the transaction, Secondary Life Three, LLC (SL3) was formed with local accredited investors to purchase the remaining three policies.

In March 2005, the purchase of the five policies with a combined face amount of $36,000,000 was concluded with a gross purchase price of $9,000,000.

^[4]Following the purchase of these two policies, the hedge fund changed its name and SLC had little personal interaction with the fund.

The Financial Transaction

At the time of purchase in March 2005, the $36,000,000 in face amount had a net death benefit of $31,577,704 after taking into consideration the repayment of the outstanding loans and liens as well as payment of accrued loan interest.

The total gross purchase price was $9,000,000, $8,250,000 of which was paid to the owners of the policies, giving each of them immediate financial security.

SL3 paid a total of $3,320,840 for three policies having a face amount of $12,000,000 and a net death benefit of $9,977,639.

To reduce the cost basis in the account, in June 2005, one policy was sold for $1,154,645 and in July 2005, a policy loan of $1,300,000 was taken in cash against a second policy, leaving SL3 a net cost basis of $866,195 and a remaining net death benefit of $5,413,471.

Since their acquisition and in accordance with accounting principles, these policies have been treated as capital assets, much like capital equipment with the exceptions that there is no depreciation allowance and no ongoing maintenance expense (premium payment).

Premiums on the two policies have been paid by policy loans and no additional premium expense has been incurred by SL3. Interest on the substantial policy loans, which, with the exception of the $1,300,000 cash loan taken by SL3, have been used to pay premiums on these modified whole life policies, has been capitalized annually. This has increased the policy debt and reduced the net death benefit. To mitigate the reduction in net death benefit, policy dividends, as declared by the insurance companies, have been used to purchase paid-up additional insurance.

Prior to purchase, SLC had determined that the surviving insured did not have a terminal condition. With no new medical records available, it was necessary to estimate the life expectancy and, unlike standard life settlements, use a range of life expectancies in valuing the policies.

In a mid-2004 investment presentation, SLC estimated the life expectancy of the surviving insured at between four and six years, which would have resulted in policy maturities between somewhere between mid-2008 and mid-2010. In August 2004, two life settlement underwriters were asked to provide conservative projections based on the old outdated medical records. Using these projections and SLC's own projection techniques, SLC then estimated the life expectancy of the surviving insured at between 70 months and 105 months. On the basis of this range, policy maturity was projected to occur between June 2010 and May 2013. The actual maturity of these policies by death of the insured occurred in October of 2010.

Given the maintenance strategy, which included paying all premiums by borrowing from the cash value of the policies, the net death benefit has decreased predictably from the $5,413,471 in July 2005 to an estimated $4,568,764. The carrier claims for death benefits are being processed as this is being written.

The Bottom Line

The capital invested by SL3 was at work for seventy-one months and that initial investment - which was the ONLY investment and was reduced to less than $900,000 within five months - created an internal rate of return of 25% per annum. By their willingness to take on a challenge that other life settlement providers would not, the professional staff at SLC has given the children of the insured financial security, the participants in the transaction reasonable compensation, and the investors who put their trust in SLC, an outstanding internal rate of return on their investment.