CAYMAN 2012 - HFMWeek

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<strong>CAYMAN</strong> <strong>2012</strong> LIFE SETTLEMENT VALUATIONS: A US PERSPECTIVE TO BE ACCURATELY ASSESSED, LIFE SETTLEMENT CONTRACTS, LIKE MANY OTHER ASSETS, REQUIRE A NUANCED APPROACH. MUZAFFAR SOOMRO OF BDO AND CORWIN ZASS OF ACTUARIAL RISK MANAGEMENT, AN INDEPENDENT MEMBER OF THE BDO-USA ALLIANCE, EXPLAIN Muzaffar Soomro has more than 17 years of experience in the financial services industry. He has worked in various capacities in investment funds including audit, fund setup, fund administration and accounting, transfer agency, custody, liquidations, and compliance. Corwin Zass principal and a US life actuary with the BDO USA Alliance firm, Actuarial Risk Management, brings close to 20 years of insurance and risk management experience, from customisable risk transfer solutions to design of insurance-linked investments, to a global set of clients. For this class of asset, guidance contained in auditing standards issued by the Auditing Standards Board of the American Institute of Certified Public Accountants and accounting standards contained in Accounting Standards Codification are: • AU Section 328 (AU§328): Auditing Fair Value Measurements and Disclosures; • AU Section 329 (AU§329): Analytical Procedures; and • FASB Accounting Standards Codification (ASC§820): Fair Value Measurement and Disclosure. Equivalent International Financial Reporting Standards (IFRS) guidance issued by IASB and the International Standard of Auditing (ISA) issued by International Auditing & Assurance Standards Board, is as follows: • IAS 32 Financial Instruments: Presentation; • IAS 39 Financial Instruments: Recognition and Measurement; • IFRS 7 Financial Instruments: Disclosures; • International Standard of Auditing 540 (IAS§540): Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures; and • International Standard of Auditing 520 (IAS§520): Analytical Procedures. FASB ASC§820, formerly FASB 157 and 159, lays out the framework for the fair value hierarchy and prioritises the inputs to valuation techniques. The inputs are determined by the lowest level, Level One to Level Three, in which the fair value measurement falls. Life settlements fall into the Level Three category since the fair value is based on an unobservable future event – the death of the insured. Furthermore, any Level Three assets where value is dependent upon a future unobserved outcome (the insured’s THE KEYS TO A SUCCESSFUL AUDIT ARE DRIVEN BY THE LEVEL OF CLARITY AND TRANSPARENCY OF THE SUPPORTING WORK PAPERS ” death) requires the use of the best information available in the corroboration of the valuation methodology. The outcome of these methodologies must then be reconciled and disclosed by the asset holder. WHAT OPTIONS ARE AVAILABLE TO AUDITORS Independent auditors rely on AU§328 to understand the processes used to produce the balance sheet entries, including fair value estimates, along with their respective controls. The objective has not changed over time and simply requires the auditor to assess the completeness, accuracy and consistency of the methodology, assumptions, and data used in those balance sheet computations. Another option open to auditors is to independently produce a valuation using relevant fair value data and compare the results with the entity’s estimates. However, the estimates of the entity are generally open to challenge only when they fall outside a ‘reasonable’ range of outcomes as assessed by the independent auditor. Audits of life insurance based assets (or liabilities), which covers mortality derived programmes like life settlements, require an actuary to be part of the audit team, to help review the approach and computations of the entity’s estimates and to assess the reasonableness of the assumptions used in such estimates. The keys to a successful audit are driven by the level of clarity and transparency of the supporting work papers along with the completeness and thoroughness of the underlying controls, which affect the computation of any estimates, regardless of the type of asset (or liability). Best practice has an entity producing formal quarterly valuations to minimise the impact of potential material changes between the fiscal year-end and the preceding quarter-end. If an entity relies on outside consultants to produce the estimates, the entity must take responsibility for the values posted in the balance sheet and therefore have thorough documentation on how they used the consultants’ estimates. The entity must coordinate with the consultants to ensure proper resources exist to answer any audit inquiries. Lastly, the entity must have supportable documentation outlining changes in method- 6 HFMWEEK.COM
FINANCIAL SERVICES ologies used between financial periods. Beyond consistency, the audit client needs to support what changes were made but more importantly why they made the change. HOW DO PORTFOLIO MANAGERS PREPARE FAIR VAL- UATION ESTIMATES Under these new fair value accounting standards, the life settlement fund would be required to prepare fair valuation estimates for audited financial statements. The key point is ASC§820 requires the estimation of what a third-party participant would pay to purchase the life settlement, not what the entity itself would pay. The key to a good valuation is whether it produces a reasonable estimate of what a third party would pay, and whether there is sufficient support for the assumptions and methods used in deriving the estimate. Historically, life settlements have been priced using two methods: the point-to-point method and the actuarial method. The point-to-point method assumes the policy will mature on the valuation date plus the determined life expectancy (LE) of the insured. Premiums are paid until the maturity date and the death benefit is received on the maturity date. This method can significantly underestimate the value of policies which have large premiums after the LE date. The point-to-point method is not appropriate under fair value accounting. HOW DOES THE ACTUARIAL METHOD WORK The actuarial method is currently used by virtually all purchasers of life settlements. This method assumes that a portion of the death benefit is received and a portion of the premium is paid at each interval in the valuation. The benefit amount received is based on the probability of the insured’s death in the interval, multiplied by the death benefit. The premium is based on the probability of being alive at the beginning of the interval. The net amounts are discounted to arrive at the value. Any life settlement valuation must deal with following variables: Mortality rates • What mortality table serves as the basis in the determination of the mortality multiple • How was each of the LE estimates used in the valuation How “accurate” are the LEs • How does the valuation handle future industry mortality table changes Discount rate • Does the valuation use a different discount rate for each policy and what methodology is used to select it • Does the valuation use a single discount rate regardless of length of the LE, or are multiple rates used based on the duration Is there any reflection of a risk premium over a risk-free rate • Does the rate incorporate credit risk Expenses • Does the valuation reflect the cost of ongoing and forecast maintenance expenses THE ACTUARIAL METHOD IS CURRENTLY USED BY VIRTUALLY ALL PURCHASERS OF LIFE SETTLEMENTS ” Life Insurance Premiums • Has the valuation validated that the policies are currently in force and the premium schedules provided will keep the policies in force • Is the premium assumption consistent with the way in which the policies are currently administered WHAT ARE THE STEPS THAT OUTLINE A FAIR VALUE BASED ESTIMATION PROCESS Upon the successful purchase of life settlement policies: 1. The pool size dictates if there exists any credibility. There are a number of perspectives on how big a pool must be to reach “credibility”. Regardless of pool size, a best practice is the continual assessment of the experience as it develops. For life settlements, this is no different. The asset holder must compare “actual to expected” mortality results. 2. The other key point is to regularly update the LEs to current valuation date. Run two sets of portfolio valuations, one based on individual LE underwriters, which will define the bounds of the valuation, and another to represent the best estimate, which relies on a management chosen weighted average of the LE providers. 3. A valuation report should illustrate the weighted average portfolio value, as well as the individual policy values, and their associated weights (whether updated or not, as discussed above). 4. Other metrics or analyses provide insight into the assets movement from period to period. Examples include trend analysis, distribution profiles, like average age, average face amount and distributions by insurance carrier. 5. Finally, there must be a written document that accompanies the mathematical output of the valuation. We suggest the assembly of a document supporting the assumptions and methodologies used for the valuation. This document should be updated each valuation period and will provide some historical perspective to the valuation of the assets. WHAT CONCLUSIONS CAN BE DRAWN In the valuation of any asset, the presence of valuators who fully understand the practical and theoretical nuances of that asset is, simply, vital. Over the years we have seen meaningful differences with life settlement valuations, and related supporting documentation, which include as part of the valuation process, either in part or full, input from a reputable third-party actuarial consultant, versus those that exclude an actuarial consultant. The objective of a valuation for financial statement purposes is to develop a reasonable estimate of the amount a third-party would pay to purchase the asset. The valuation should reflect the riskiness of the investment and appropriately capture the volatility of its fair market price. A valuation process as described above should give an investor the means to understand risk-adjusted performance better, and to make better-informed decisions about whether to maintain, decrease or increase its position in this asset class. n HFMWEEK.COM 7
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