Academic journal article Journal of Risk and Insurance

Incorporating Longevity Risk and Medical Information into Life Settlement Pricing

Academic journal article Journal of Risk and Insurance

Incorporating Longevity Risk and Medical Information into Life Settlement Pricing

Article excerpt

ABSTRACT

A life settlement is a financial transaction in which the owner of a life insurance policy sells his or her policy to a third party. We present an overview of the life settlement market, exhibit its susceptibility to longevity risk, and discuss it as part of a new asset class of longevity-related securities. We discuss pricing where the investor has updated information concerning the expected life expectancy of the insured as well as perhaps other medical information obtained from a medical underwriter. We show how to incorporate this information into the investor's valuation in a rigorous and statistically justified manner. To incorporate medical information, we apply statistical information theory to adjust an appropriate prespecified standard mortality table so as to obtain a new mortality table that exactly reflects the known medical information. We illustrate using several mortality tables including a new extension of the Lee-Carter model that allows for jumps in mortality and longevity over time. The information theoretically adjusted mortality table has a distribution consistent with the underwriter's projected life expectancy or other medical underwriter information and is as indistinguishable as possible from the prespecified mortality model. An analysis using several different potential standard tables and medical information sets illustrates the robustness and versatility of the method.

INTRODUCTION AND HISTORY

While the effect of longevity risk is traditionally thought of in terms of its impact on pensions, social security systems, individual quality of life in retirement, and the solvency of corporate defined benefit plans, there is another market that is vulnerable to longevity risk, perhaps even more than the above areas, namely, the life settlement (and life securitization) market. A life settlement is a financial arrangement whereby a third party (or investor) purchases a life insurance policy from the person who originally purchased the life insurance policy. This third party pays the insured an amount greater than the cash surrender value of the policy--in effect, the trade-in value of the policy as determined by the originating insurance company (1)--but less than the face value (or the death benefit). The investor also agrees to pay future premium payments in exchange for the right to collect the death benefit upon the death of the insured.

A life settlement can be a win-win situation, as the investor can obtain a return on his/ her initial investment and premium payments once the death benefit becomes payable (assuming the insured does not live too much longer than expected when setting the purchase price) and the owner of the policy obtains more money than he/she would if he/she had surrendered the policy for its cash value or allowed it to lapse (Doherty and Singer, 2003). (2) Life settlements are a part of the newly emerging and growing asset class of longevity- and mortality-related financial instruments providing investors with assets essentially uncorrelated with other market related assets in the investors' portfolio, hence increasing potential portfolio diversification effects (Cowley and Cummins, 2005).

This life settlement market, however, has a vulnerability to longevity risk as increased longevity implies longer periods during which investors are paying premiums prior to collecting their money, and hence there is a potential for losing money, going bankrupt, or seeing a severe reduction in the expected internal rate of return (IRR) on the investment. The rise and fall of the viatical settlement market, from whence the life settlement market arose, illustrates these dangers and the consequent susceptibility to increase in longevity. A brief history of the viatical settlement market illustrates the longevity risk inherent in the life settlement market.

The practice of buying and selling "viatical settlements" began in the late 1980s when a devastating medical AIDS epidemic presented a financial shock to thousands of previously healthy Americans (Stone and Zissu, 2006). …

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