The life settlement industry received two jolts this week that show the positive and negative nature of the industry.
Earlier this week the Wall Street Journal reported that Danny Pang of Private Equity Management Group Inc. (PEMGroup) was the target of accusations that losses the firm made on life settlement contracts were being covered up by paying off old investors with new funds: essentially turning the firm into a Ponzi scheme.
Later in the week it was announced that AIG had successfully securitized an $8.4 billion pool of life settlement contracts through its Risk Fiance unit. Proceeds from the deal — ironically — will be used to pay off part of what AIG owes to the U.S. government through the Federal Reserve Board credit facility.
Industry professional argue the while both issues are wildly different they reveal the need for increased due diligence among all parties in a life settlement transaction.
“Clearly, a lot of the problems that have occurred in the industry could have been prevented if the appropriate due diligence was conducted at the beginning,” says Craig Seitel, president of Abacus Settlements in New York.
The losses that PEMGroup incurred on it’s life settlement assets may become commonplace as the industry absorbs changes in the life expectancy tables that took place last year. Managers with large pools of settlements will either disclose the losses or look to unload the contacts in the secondary market at a steep discount.
With losses becoming painful, it’s more important than ever that life settlement professionals trust their counterparties to be upfront regarding how potential losses are impacting the nature of the relationship, says Seitel.
“We can create a pretty big picture of who we are dealing with when it comes to our due diligence,” Seitel explains. “When we do a transaction in life settlements we conduct due diligence on all parties involved, including the broker, agent and the seller.”
Seitel said that his due diligence includes a check of all parties through the Office of Foreign Control Assets and criminal and civil checks with a paid Lexis/Nexis database. The firm also requests references from attorneys and escrow agents if they are used.
“My background is in investment banking and before we would engage a clients and we would do an enormous amount of due diligence,” Seitel says. “I brought that over to my settlement practice.”
Buyers and sellers of life settlements should also have a complete understanding of how the policies were originated and if the agents and brokers have run afoul of state-based Stranger/Investor Oriented Life Insurance (STOLI) regulations, says Mark Keenan, an attorney with Anderson Kill & Olick in New York.
“The risk to investors is that when the event takes place the life insurance company is not going to pay [because of a STOLI violation],” says Keenan. “There are a lot of less than-sophisticated players that are violating these statutes unknowingly and the insurance companies will refuse to pay.”
Securitization Ups the Ante on Due Diligence
Pooling life settlements and securitizing the proceeds only increases the need for due diligence around the originators and the policies, says Keenan.
“One or two or three [compliance] screw ups can dramatically effect the loss ratios on these securitizations,” Keenan says.
Industry practices will need to change as large pools of life settlement become more prevalent as the economics of the industry push managers to get old policies off their books, says Emmanuel Modu, managing director and global head of insurance-linked securities for A.M. Best.
“These are costly assets to hold, so there is a good amount of people looking to get these policies off their hands,” says Modu. “Just like credit cards or mortgages, you need to securitize and get them off your balance sheets.”
But each life settlement pool will need to stand on it’s own merits and there are no short cuts to success.
“You need to look very carefully at each policy. But [the AIG deal] proves that it can be done on a purely economic basis,” Modu adds.
Seitel adds that as securitizations become more prevalent, institutional investors will push the due diligence envelope beyond current industry practice.
“Right now don’t think most players are doing the appropriate level of review,” he explains. “But an indirect result of securitizations will be increased due diligence on the part of new institutional investors that enter the market”