Saturday, September 12, 2009

Our phones are ringing off the hook

If you are a small rating agency trying to compete with the Big Three oligopoly, how would you go about doing it? PR of course is the best way - get into a top financial publication, get attention, and maybe get some calls. And what would make a major financial publication write about you? It needs to be a hot topic, yet should sound new and different. Derivatives, structured products, bankers making money - at least one reporter should take the bait.

And that's what DBRS has recently done. DBRS, which stands for Dominion Bond Rating Service is a Canadian based rating agency that is trying to grab business from the Big Three. A recent article in the NY Times describes life settlements securitization as though it's a new product. And of course DBRS is there to rate this "exotic" paper.
The idea is still in the planning stages. But already “our phones have been ringing off the hook with inquiries,” says Kathleen Tillwitz, a senior vice president at DBRS, which gives risk ratings to investments and is reviewing nine proposals for life-insurance securitizations from private investors and financial firms, including Credit Suisse.

Yes, investors are clamoring to get exposure to life settlements portfolio - the hot new product. In reality however, life insurance pools have been structured and sold for years. There are several companies who use thousands of brokers to purchase life policies from individuals. The trade works because the "surrender value" (termination payout) of a policy that an insurance company offers is generally lower than the present value of the expected payout (based on the person's life expectancy). An individual who no longer needs her policy can get quick cash by selling it to one of these firms (see overview from the NYTimes).

There are a few reasons the life settlements market hasn't become a large business such as some other asset classes (like premium finance, student loans, etc.) Some banks are trying to avoid the "reputational" risk of becoming the beneficiary of an elderly person's (these are usually very well-to-do individuals) life policy. The media could do a job on them. Another reason is that it's not just the initial purchase that needs to be financed, but also the ongoing premium payments. That requires incremental financing and potentially a credit line.

Investment firms also get a bit skiddish thinking about a potential for a major medical advance that would extend average life significantly, requiring many more premium payments than anticipated before the "payoff". One way to mitigate this risk is by combining a life policy with an annuity, making the combination "self financing" (the annuity pays the premiums). The final payment may get delayed, but the annuity would continue paying longer as well (acting as a hedge).

Insurance companies are ambivalent about this business because on one hand they can potentially sell more policies if individuals know they have liquidity. On the other hand they miss out on some of the profits.

A portfolio of these is tricky to manage because life policies can be over-funded by payments that are larger than the minimum. Many policies pay fixed interest on the "over-funded" amount (variable life) or allow it to be invested in mutual funds. The portfolio has significant interest rate risk that needs to be managed as well as credit exposure to insurance companies, which these days is not insignificant.

Of course when it comes to the securitization of this "new and exotic product", DBRS wants you to be confident (via the NY Times reporter) because you would be in good hands:
To help understand how to manage these risks, Ms. Tillwitz and her colleague Jan Buckler — a mathematics whiz with a Ph.D. in nuclear engineering — traveled the world visiting firms that handle life settlements. “We do not want to rate a deal that blows up,” Ms. Tillwitz said.

hat tip Ed
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