FW speaks with Corwin Zass, the founder and principal of Actuarial Risk Management, Ltd, about the outlook for life settlements in 2014.
FW: What major trends have you seen in the life settlements market over the last 12-18 months? How would you describe general conditions, opportunities and investment activity?
Zass: Just as we have seen within the larger insurance-linked investment space, investors continue to reach for yield given the continuation of historically low interest rates. The life settlement market is no different and as a result our firm has seen a noticeable uptick over the last 24 months in new players investigating this market. While there is this renewed interest, the last four years has also seen a continued decrease in the number of smaller investors since this asset class best rewards large investments in the same vein as the law of large numbers rewards those with larger life settlement portfolios. Recently, a couple of large institutional investors have expressed very bullish behaviour and continue increasing capital positions to expand their asset buying programs. The last couple years has seen the rapid disappearance of the distressed owners as their exits have contributed to a number of larger tertiary sales. On the opportunity side, we believe distressed owners continue to exist, however the number of easy arbitrage plays are becoming fewer and fewer, likely as a result of the less sophisticated investors simply bowing out of this space.
FW: How would you describe the performance and returns generated by life settlements funds over the last year or so?
Zass: Before commenting on the last year’s returns, we need to discuss perceived returns from this asset class. An average hurdle rate of 20 percent IRR contains a large risk premium – over a risk free return – to account for various inherent risks, including the imprecision of predicting life expectancies. Many investors have simply, and incorrectly, accepted the life expectancy (LE) as a certainty so they thought a 20 percent discount rate – used for computing the discounted cash flows – would allow the investor to realise that return. The reality is that this asset class has a long period with negative carry as a result of continued premium payments. This negative carry is not dissimilar to capital intensive investments like oil exploration or building toll-roads. Overall, a well-diversified life settlement investment can produce an attractive gross long term risk-adjusted return of 10-plus percent. Now to discuss current era returns. Many of the funds have continued to be haunted by their past acceptance of life expectancy accuracy which meant that these funds simply paid too much for their assets since the actual number of mortalities fell below false expectations. In our view there are two main drivers causing the ultimate over-paying for policies. One driver being the general acceptance of shorter life expectancies – which means the investment return diminishes rapidly if longevity extends. The other driver, which we offer with some bias, is that many of these funds did not use an experienced and qualified actuary to aid during the acquisition and management phases. As an actuarial firm, we continually evaluate mortality, which given this market, such expertise does materially mitigate the key risk of this asset class.
FW: What key trends have you seen in the way life settlement funds are being structured and domiciled?
Zass: Let us start with the latter point on domicile. Over the years there appeared a lot of misunderstanding in attempting to avoid the US withholding tax. On the other hand, the investor community definitely has evolved and now readily understands that an Irish or Luxembourg based structure are the two viable jurisdictions of choice to eliminate the effects of the US withholding tax. There have been rumblings in the recent past that other new locales are also viable. We prefer to have our clients, with reputable tax attorneys, work through the merits of selecting the appropriate location. On the structuring side, there seems some recognition that a single ‘bucket’ containing all the policies dramatically improves the risk profile of the fund over the carving up effect under a sub-fund framework which goes against the law-of-large number principles.
FW: Could you outline some of the tax implications and offshore considerations that come into play when structuring life settlements funds?
Zass: As just mentioned, there are sound tax planning approaches to mitigate – thus avoid – the US withholding tax. The US withholding tax focuses on foreign life settlement investors who have not structured their investment program to meet certain exceptions allowable under the double tax treaties with Ireland and Luxembourg. The US withholding tax is very costly as the US Internal Revenue Service forces US life insurers to haircut death benefit proceeds by 30 percent withholding prior to being paid to the investor, unless there is an exemption as allowed in certain jurisdictions by treaty, such as Ireland and Luxembourg.
FW: What portfolio valuation challenges tend to arise in this industry, and how should they be addressed?
Zass: Unfortunately, this asset class will more likely always be on the smaller size which creates difficulties for the development of a robust observable market. This means fair value computations cannot easily use observable trades and the valuation method likely continues as a quasi mark-to-model framework in which the assumptions reflect market conditions. Just as we are seeing in the primary life insurance market, the future likely has the valuation be underpinned by prudently determined stochastic models that reflect the impact of the actual portfolio size. On the assumptions, the discount rate has generally been based on perception of ‘current’ discount rates used to transact a policy. Within the last year, there have been a couple new vendors selling a snapshot of their monthly research that attempts to provide a monthly summary of secondary market transactions. This open and transparent approach should be applauded and is a move in the right direction. The other key assumption is the life expectancy. As an actuarial firm who very regularly advises in the broader life insurance industry as well as the life settlement space, the analysis of mortality and the development of longevity projections is not an easy exercise. Our firm continually recommends that life settlement life expectancies be updated frequently since older persons can quickly experience downturns in their health.
FW: Have there been any major regulatory developments affecting life settlements? How are industry players responding?
Zass: The only real substantive regulatory development is the one allowing Medicare eligible seniors to sell their life insurance policies and use their sales proceeds as a supplement for their long term care costs. The state of Texas has taken a lead in this area with the expectation that a large number of states will endorse a similar approach. This means that the life insurance market will ultimately see less policies lapse and more death benefits being paid out to investors.
FW: How would you describe activity in the secondary market for life settlement funds?
Zass: Let us first discuss why these funds have a tough time in the tertiary space, which we bifurcate into, first, those tertiary policy owners more-than-likely in an underwater position with their policies but who have yet to – or been forced to – write-down their value; and, second, those investors happy with their policy acquisitions and not really looking to sell unless the “price was attractive”. This implies the only investors successfully chasing tertiary policies are those offering an attractive price developed with such assumptions as a lower discount rate (IRR). This event can only happen if such buyers accept a lower return profile – or a decrease in fund fees somewhat akin to the investor demands on the hedge fund market – which in the fund space is more unlikely. This leaves the fund looking solely at the secondary market which in itself has shown some competitiveness from multiple buyers. In today’s environment, in our opinion, the fund model’s hurdles remain as they must reach for yield to offset the generally unattainable fund returns promised to the fund investors.
FW: Have you seen an increase in disputes and litigation involving life settlements? What types of issues are causing conflict, and how are they being resolved?
Zass: Disputes and litigation in any asset class are simply a fact of life in periods with less regulatory framework. The life settlement space is a perfect example. In the early part of the last decade, the number of manufactured life insurance policies – that is, those arranged solely to sell – was a robust part of this shadowy market, which became known as ‘stranger owned’ life insurance (STOLI). To a certain degree, all sides of the STOLI transaction had a hand in those cases. This era ignited a highly litigious period where the carriers were challenging the insurable interest transfer in the hope, at best, to void the payment of the death benefit, or walkout with a half-smile by only having to reimburse a portion of the premiums collected on those policies. Historically, our firm has little involvement in those STOLI cases, and according to recent conversations with our strategic partners at a prominent law firm, in fact those disputes continue to shrink. One area of disputes where we have a cursory involvement is our ability to reconstruct UL policy values to assess whether a carrier improperly computed the reported values. In the end, there will always be litigation albeit recently enacted tighter rules amongst the origination parties certainly appear to decrease the number of open cases.
FW: What advice would you offer to prospective market players who might be considering involvement in the life settlements space?
Zass: This asset class rewards those with patience, dedicated capital, and the openness to recognise that mortality predictiveness skews to the luck side if you only have a small investment position. In other words, investors committing to at least eight to 10 year horizon will ultimately realise respectable gross risk adjusted returns of 10-plus percent. Those who want to invoke an active investment strategy will realise 200-400 basis points higher returns. We make the comparison to life insurers who have been around for 50-plus years that have been able to build up surplus – that does not happen in five years. This space will not produce long term returns over a short period, like five years, unless you can arbitrage someone.
FW: What are your predictions for life settlements through 2014 and beyond? Do you expect to see continued market growth?
Zass: On the supply side, our firm has forecasted for a few years that the next 12-15 years will see a large transition of US baby boomers – with life insurance policies – moving from their 60s to upper 70s and lower 80s, which is the sweet spot that, in general, enables the life settlement math to work. In order for this increased number of policies to move from the primary life insurance market into the secondary market, there must be a solid agent and provider network. We do anticipate some ‘growing pains’ dealing with compensation arrangements for insurance agents who facilitate these secondary transactions. The life insurance industry has pushed for years to level the agent compensation and thus move away from a front loaded arrangement. In our opinion, there appears a solid argument to spread the at-closing compensation over a subsequent few years. This produces a win-win-win for all respective parties, from the consumer to the facilitating parties to the investors. In order for the market to benefit from the maturing baby boomer population, there needs to be an efficient process to get those policies to the investors. Our firm has explored some of those very avenues that attempt to align all parties which are a must to flourish over the long term.
Corwin Zass is the founder and principal of Actuarial Risk Management, Ltd. (ARM), an independent Member of the BDO (USA) Alliance since 2006. For more than 20 years various sized US life insurers have sought Mr Zass and/or his team’s collective advice on M&A, product management, capital strategy, and financial reporting paradigms. His life actuarial training rests on a foundation blending common-sense, business views and actuarial technical aptitude enhanced by his direct experience in roles of appointed actuary, auditing actuary and consulting actuary. He can be contacted on +1 (512) 345 5200 or by email: email@example.com.
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