Universal Settlements International Inc.


Commentary on Risk and Return

It is universally accepted that every investment product that has ever been created has associated with it one or more identifiable risk factors which may cause that product to perform contrary to expectations. The uncertainty of an expected rate of return is a “risk” for which investors seek higher investment returns. Prospective purchasers of life settlement assets must be aware that like other investment products, there are risks associated with the life settlement asset class.

Risks Associated with Life Settlements

The following list is not exhaustive but illustrative of some of these risks:

Longevity Risk
The primary risk in a life settlement transaction is “extension” or “longevity” risk. Longevity risk is the variance between actual mortality versus expected mortality, resulting from the insured’s health management, medical advances and good fortune. Fundamentally, this risk is simply the probability that the insured individual lives well beyond his or her life expectancy. The risk presents two problems: (i) that the death benefit arrives later but does not grow with time and (ii) that the ongoing premiums drain the investment returns.

Underwriter (Mortality) Risk
Medical underwriter risk is the risk that the underwriter accurately estimates the life expectancy of the insured. More specifically, the risk is that a flawed methodology was used by the medical underwriter in either (i) how the mortality tables were constructed, or (ii) how the mortality tables were applied to derive a life expectancy estimate.

The life expectancy of an insured is an estimate only. If the insured lives longer than such estimate, the payment of proceeds by the insurance company involved is not at risk but the annualized return on an investor’s capital will diminish over time, as the pay out of proceeds comes later than expected.

Contestability Risk
Before purchasing a life insurance policy for settlement purposes, one must analyze the language of the life insurance policy itself, specifically with respect to contestability issues. Insurers will investigate the contestability clause in the policy when a claim is filed, and they may decide to dispute the claim on grounds of the information provided by the insured at the time that he or she originally purchased insurance. Smoking in life insurance is a leading example: there are different rates for smokers and non-smokers.

In most circumstances, the contestability clause will cease to have any effect after the life insurance policy is in force for a minimum of two years.

Origination Risk
Failure to meet state-by-state regulations, disclosures, and incomplete closing documentation may result in a transaction which can be voided.

Claims by Former Beneficiaries
There is the possibility that a former beneficiary or their family members could challenge the sale of a life settlement for a number of reasons including that the third party policy provider was not properly licensed or that there was duress or undue influence or that the seller was not of sound mind. If any such challenges are made, there is the risk that an investor will not receive the full proceeds on the maturity of such policy.

Measures are taken to ensure that this potential risk is addressed at the time of purchase from the insured. Many of the contracts relating to the policy sale need to be notarized so as to provide proof, if necessary later, that the insured knew the nature of the contract which he or she was entering into. Likewise, at the time of purchase, a document is required to be signed by the insured individual’s primary physician indicating that the insured is of sound mind.

Insurable Interest Risk
Insurable interest is one of the fundamental principles of insurance. Any person has a legal right to insure a life which could result in a financial loss, arising out of a recognised relationship at law. Thus, an insurable interest exists for the beneficiary who would suffer loss if the event insured against occurs. Without an insurable interest, an insurance company will not issue a policy. In the law of insurance, the insured must have an interest in the subject matter of his or her policy, or such policy will be void and unenforceable since it will be regarded as a form of gambling. An individual ordinarily has an insurable interest when he or she will obtain some type of financial benefit from the preservation of the subject matter, or will sustain pecuniary loss from its destruction or impairment when the risk insured against occurs. Therefore, there must be an insurable interest in the policy at the time of policy issue.

Life Insurance Company Insolvency Risk
There is a risk that the insurance companies could become bankrupt or insolvent, which could result in the inability of purchasers of life settlements to receive all or part of their entitlements to proceeds under a particular policy from the life insurance issuer. The topic of insolvency risk in connection with life insurance companies has recently attracted a great deal of attention. Since the 1980s there have been several defaulted life insurance companies in Europe, Japan and the United States. A few examples from the United States are First Executive Life Insurance Co., Confederation Life Insurance Co. in 1994 and Conseco Inc. in 2002 (the 3rd largest bankruptcy in the United States in the period 1980 - 2005).

Despite these insolvencies, other carriers took over the obligations of these life insurers or the insurers restructured their affairs so as to emerge from their insolvencies, with the net effect of not ever having a single death benefit denied in the last 150 years of the life insurance industry due to the inability of a life insurer to pay out. Life insurance is a cornerstone of the financial markets and if consumers have a perception that there is a possibility of a highly rated life insurer not paying out upon death of an insured individual, the result would be a disastrous loss of faith in the system, which would likely spell the end of the entire capital market and insurance system as we know it. The likelihood of the governmental and industry powers allowing a carrier to fail with the result being non-payment of death benefits for life insurance policies is remote.

Cost of Insurance Risk
There is the risk that the insurer may change their policy illustrations thus increasing the amount of premiums necessary in order to maintain a life insurance policy in full force and good standing.

Foreign Legal Systems; Legislation; Tax
The life settlement policies are purchased from sellers in the United States. Universal is a corporation governed by the laws of Canada. Certain rights and remedies available to investors under the laws of their jurisdiction of residence may not be available to them in other jurisdictions. Furthermore, such investors may not be able to effect service on parties in other jurisdictions, and even if a judgment were obtained in an appropriate jurisdiction, the enforcement and collection of such judgment against the assets of the applicable party may be difficult or impossible in these jurisdictions.

In addition, there may be new laws implemented, changes in law, or amended interpretations of current laws in any of these jurisdictions or the jurisdiction of the investor’s residence, or of international agreements and treaties that could result in different legal or tax consequences to an investor. It is possible such changes could have a significant adverse impact on the return to investors. In addition, changes in law may have an impact on the enforceability of contracts, the ability to locate and assign policies, or the prices at which such policies can be obtained. This may have a significant adverse impact on returns. Furthermore, given the emerging nature of life settlement regulation, there may be periods in which Universal may not be in compliance, or unable to comply with the effective provisions of applicable statutes and regulations which may prevent Universal from fulfilling its obligations or responsibilities.

The purchase of life settlements may have adverse tax consequences to investors under the laws of the United States and/or the laws of the investor’s jurisdiction of residence.

Misuse of Funds
The funds invested by investors are at times managed in third-party and/or escrow accounts, and there is a risk that such third parties may fraudulently or negligently misuse funds.

Risk of Fraud
In spite of Universal’s diligence conducted on a particular policy and use of third parties it considers reputable, there is the risk of fraud which includes the risk that the insured may misrepresent the status of their illness, may fail to disclose all beneficiaries or may purport to sell their policy to more than one purchaser. Any such fraud could lead to diminished returns on the investors’ capital or even a loss of capital by the investor.

Foreign Currency Risk
Since the investment is purchased in US dollars and the returns are paid to the investor in US dollars, significant changes in the exchange rate of the US dollar relative to the currency of the investor’s native currency may result in a material adverse impact on the value of the investor’s investment relative to their native currency.

Applying Portfolio Principles to Address Longevity and Underwriter Risk

Through aggregating life settlements into a portfolio, the impact of longevity risk can be better understood, managed and hedged, and thus, reduced. Institutional investors aggregating and owning portfolios of life settlements require knowledge and understanding of longevity risk. Accordingly, various management techniques and tools have evolved for managing longevity risk including: mortality indices, hedges, swaps, insurance guarantees and portfolio structuring.

In the event of underwriter risk, the systematic error becomes replicated across the entire portfolio regardless of its size. Thus, the affect of longevity risk can be reduced with portfolio management practices, but underwriter risk cannot be reduced other than by structuring a balanced diversity of life expectancy underwriters for each insured and/or for all insured individuals in a portfolio.

Additional portfolio risks:

Ramp Risk
Risk that the portfolio is unknown at time of execution. The expected composition and pricing is subject to available supply of life settlements and financial environment over lengthy ramp period.

Selection Risk
Portfolio selection is subject to available supply of life settlements in the market and manager’s discretion in selection process.

Stochastic Risk
This is dependent upon a portfolio manager’s ability to obtain large portfolio of diversified lives.

Draw Risk / Portfolio Lumpiness
Investor subject to “draw” risk; This occurs when uneven policy sizes may lead to variability in returns as each death contributes unequally to total return.

Liquidity Risk
Should there be a need to liquidate a portfolio of policies, liquidity could become an issue due to a naturally lengthy, operationally intensive process as, for each policy, prospective buyers generally: (i) examine policy docs, maturity conditions, reps/warrants, (ii) obtain updated policy illustrations, (iii) re-optimize premiums, (iv) potentially process change of ownership, and (v) ensure compliance with relevant state laws.

This is addressed by Universal as execution is based on simple, standardized documents which allow for superior flexibility during liquidation process.


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