Outlook for life settlement funds
June 2012 | 10QUESTIONS | FINANCE & INVESTMENT
FW speaks with Timothy Allen DeMars at Lewis & Ellis, Inc about the outlook for life settlement funds.
FW: Could you provide a brief overview of the life settlement asset class?
DeMars: Life settlements are a financial transaction wherein a third party buys an existing life insurance policy, generally sold by an insured 70 years of age or older. The purchase price for the policy will be greater than its cash surrender value, but less than the net death benefit. Life settlements are viable investments because of regulatory constraints that create an arbitrage opportunity after a policy is issued. Insurance companies are not allowed to change rating class or insurance charges based on health changes for an individual after policy issue. Therefore, if an individual’s expected longevity changes due to health events, the policy may become worth more than defined by the insurance company.
FW: What are the main factors affecting the policy purchase price for an investor?
DeMars: There are three components that affect the policy purchase price for an investor. These three components are the life expectancy of the insured, the future cash flows (premiums, expenses and death benefits), and discount rate. The first component, life expectancy of insured, requires an analysis of the current health status of the insured to define a mortality curve for estimating longevity. The second component, future expected cash flows, requires a detailed analysis of the premium requirements specified by the insurance policy form. The third component, discount rate, is determined by the investor to account for the risks perceived in the particular case.
FW: How is life expectancy determined?
DeMars: The process of determining a life expectancy begins with the assessment of an individual’s health based on medical records and sometimes supplemented with other personal data. This information is typically assessed by one or more life expectancy underwriters that serve the life settlement market. Most life expectancy underwriters utilise a debit/credit system to assess the person’s health status. If the underwriter notices a health impairment that may reduce a person’s longevity, they will add ‘debits’ to their assessment. Likewise, ‘credits’ will be given for conditions that will favourably affect a person’s longevity. Once this assessment is complete, the net of the debits and credits produces a mortality multiple. An increase in the mortality multiple shortens the life expectancy, whereas a reduction in the mortality multiple increases longevity. When applied to mortality tables, the multiples allow a determination of life expectancy based on a mortality distribution keyed to the individual.
FW: What information is needed to model a policy correctly?
DeMars: Most policies in the life settlement market are Universal Life (UL) contracts which are similar to bank accounts wherein an account value increases with premium payments and interest credits and decreases when fees are assessed. To ascertain the required premiums, it is best to have the policy form – the contract with the insurance company – current policy illustration run by the insurance company and latest policy annual statement. Additionally, a verification of coverage statement from the insurance company and recent premium history may be important. Most illustrations assume level premiums to policy expiry; however, this usually generates unnecessary account value which can decrease policy value. Generally, it is necessary to model the policy by assessing the policy options specified in the information received to reduce the build-up of account value and optimise the policy value. It should be noted that many policies are quite complex and sophisticated actuarial systems are often needed to develop accurate models.
FW: What expertise is needed to properly model a policy and who has that expertise?
DeMars: To properly model a policy it is necessary to have a thorough understanding of the insurance contract and the pricing system being used for projecting cash flows. Because of the variety of insurance contracts and provisions, it is very important to be familiar with the policy specifications and design, created by insurance company actuaries. From a policy specification point-of-view, a qualified life actuary or a person with a great deal of experience in the UL market would be best at modelling a policy. It is also very important that the person has a thorough understanding of the capabilities and features of the pricing system being used. Some contracts seen in the life settlement market are very difficult or impossible to model with commercial systems available in the market. The key is to correctly assess any account or cash value and premium requirements to maintain the policy in full force.
FW: How do rates of return for this investment compare to other asset classes?
DeMars: Certainly it is difficult to make specific statements about rates of return for any asset class. However, in general, life settlements perform based on mortality curves as opposed to interest rate curves and thus, have a low correlation to other financial assets. Because of the newness of the asset and questions about the appropriate identification and management of risk factors, the asset has traded at returns more typical of high risk assets. Improper identification of risks related to modelling of policies and interpretation of life expectancies and mortality distributions led some early funds to underperform and these early results have influenced market opinions. However, with proper management of risks, which is entirely possible, the current market provides low double digit returns. However, portions of the current market trade at a higher return than this.
FW: What affects the discount rate?
DeMars: When pricing a life settlement policy, the future cash flows are first projected based on policy models. These cash flows are also weighted based on longevity expectations for the insured. Once this is done, a discount rate is used to calculate a present value. This discount rate can vary because of many factors. Possible factors include face amount, length of life expectancy, difference between two life expectancy opinions, credit-worthiness of the issuing company, state of issue, sensitivity of return, policy origination and certain policy provisions. For example, higher discount rates are generally applied in valuing policies with very large face amounts due to the increased volatility for a portfolio.
FW: What factors primarily affect volatility and how volatile is the investment?
DeMars: Volatility relative to policy dynamics is impacted by the size of the policy, pricing (proper or improper), life expectancy and premium schedule. Sophisticated investors will minimise volatility by looking at the sensitivity of the return for each policy during the risk selection process. Volatility can also result from portfolio or fund dynamics. For example, fund size and the distribution of the life settlement portfolio by age, gender, company, policy size and life expectancy will impact the volatility. If ramped properly one of the attractive features of a life settlement fund is the low volatility and low correlation of the underlying assets (insurance contracts) to other financial market assets. Sound portfolios can be created wherein downside risk is minimised with low exposure to loss of capital.
FW: News reports indicate many investments in this asset class have struggled – why is this?
DeMars: There have been many reasons for the failures that have occurred to date. In early days, a lack of regulation for the asset class led to unsound practices in process and structures. A lack of control of start-up costs for funding policy acquisitions along with excessive management fees and performance bonuses based on overstated NAV caused issues for many funds. For several funds, problems have arisen due to poor risk identification and mitigation and/or structures that did not accurately account for ongoing cash flow needs. Today, better regulation and legal cases have helped to promote ‘best practices’. Institutional investors and greater dependence on actuarial experience and expertise have helped strengthen process, risk identification and management. Nevertheless, this is a long term asset and past processes will continue to create news for selected funds.
FW: What should investors look for if they are interested in investing in the market?
DeMars: First, there are multiple ways to invest in the market. One way is to invest with an established fund wherein your investment may be segregated or combined with other investors, based on the size of commitment and parameters sought by the investor. A second way is to create your own structure or ‘rent’ a structure from an established fund. Either way, further background may be found through trade associations focused on the life settlement asset class. Two of these are the Institutional Life Market Association (ILMA) and Life Insurance Settlement Association (LISA). There are also several law firms that have specialties in life settlement structure and regulatory issues and actuarial firms that provide risk selection and management services for the investor.
Timothy Allen DeMars is a vice president and principal at Lewis & Ellis, Inc. Mr DeMars has worked with many investment banks, rating agencies, private and institutional investors, life settlement funds, tracking firms and life settlement underwriting companies. His expertise is in modelling of structures, pricing and valuation of policies and mortality studies. He is currently a member of the American Academy of Actuaries’ Life Settlements Investment Work Group and ASOP Task Force for Life Settlements. He can be contacted on +1 (913) 491 3388 or by email: TDeMars@LewisEllis.com.
© Financier Worldwide
Timothy Allen DeMars
Lewis & Ellis, Inc