Outlook for the life and structured settlements markets in 2016
February 2016 | 10QUESTIONS | FINANCE & INVESTMENT
FW speaks with Corwin Zass, the founder and principal of Actuarial Risk Management, Ltd, about the outlook for the life and structured settlements markets in 2016.
FW: Could you provide an overview of key developments in the life and structured settlements markets over the last 12 months or so? What trends are having an impact in this space?
Zass: Over the last year or so, the life settlement market has dealt with both headwinds and tailwinds. The lobby group, LISA, has nicely ramped up its market awareness campaign to inform life insurance consumers that they can potentially monetise their life insurance policy for more than the surrender value available via the insurance company, and do it in a transparent transaction. Their efforts aid in expanding the supply of policies simply because a large segment of the life insurance consumer population does not know this is one of many options available to the insured. On the flip side, the life settlement market is now dealing with the impact of the insurance carriers executing their rights to adjust the underlying cost of insurance rates, subject to the guarantees in the policy form, which directly impact the amount of premiums that must be paid in the future to keep the policy in force. This situation will create lower returns for existing holders while also producing a lower purchase price on newly acquired policies. While this is a headwind to some, it is an opportunity for others. On the niche structured settlement side, into which we are grouping any product with an ongoing annuity stream, whether periodic in nature or recurring, it is a relatively quiet market. The one area that has a tangential possibility for expansion is the UK pension market, in which laws will grant pensioners the right to sell their stream of future pension payments. Regardless of the two markets, the underlying trend is to employ cost effective and legal means of assessing the health of those populations, since mortality and longevity are the biggest drivers as to the price to transact and the return.
FW: Briefly, what are the main benefits to investors involved in the life and structured settlements markets? Conversely, what are the overriding challenges and issues they need to consider?
Zass: Frankly, there are investors that participate in one or the other, with some recognising that having some of both provides some hedging aspect. The life settlement market provides large returns if the insured dies early and the structured settlement market provides large returns if the annuitant has a long lifetime. Investors choose one or the other – or both – primarily driven out of their strategy, their knowledge of the respective space, and return expectation. Any investment instrument that pays back sooner or on a more predictable basis tends to have lower risk than one that is paid upon some yet untriggered event. In my opinion, life settlements, due to the negative carry situation, are capital intrusive for a number of years; accordingly, the buy-and hold horizon to achieve realised returns is at least 12 years and ideally 15 years. On the annuity side, these products have a return of cash much sooner.
FW: In your opinion, what accounts for the increasing number of people turning to the structured settlements market? Likewise, why is the life settlements market experiencing an upturn?
Zass: The choice of which market heavily depends on what the investment is geared for. In other words, if an investor wants to realise some cash return sooner, they would accept a lower return profile from the structured settlement-annuity products. If there is a desire for higher return potential, then you go with a life settlement. However, with that larger return comes the considerable risk that you may not have the ability to finance or fund the paying of the life insurance premiums over a longer term. In general, if you are looking for high returns, short negative cash positions and shorter duration, you cannot rely on one or the other – rather you need to be creative in marrying these two asset classes along with an accretive cash management strategy. As to why the life settlements market is experiencing an upturn, the recent financial markets calamity and the long tenor of easy money have added to the fight for yield and with less volatility. In one way, we see these less known and more misunderstood asset classes being well positioned to aid in providing investors with one of the few uncorrelated choices.
FW: How has the role of the investment manager developed in recent years, as both markets have expanded? What strategies are investment managers employing to achieve higher yields?
Zass: Whether the investment manager is focused on real estate, commodities or equities, those that rise to meet or exceed their return hurdle follow two core principles: expectation and being proactive. On the former, investors tend to be more upset with a 12 percent return when “the return was less than proverbially advertised” than they are when a more realistic return is discussed. Maybe as an actuary we have looked at this in a ruin view. When we advise life settlement – or annuity – investors, we say things like “90 percent of the tested scenarios indicate that a yield of 7 percent is very achievable” or “there is a less than 5 percent chance that the return could be negative”. These forms of advertising help an investor recognise that nothing is certain yet some situations are more or less probable. On the contrary, by saying “we will give you a return of 15 percent”, we may give some false hope as it provides no sense as to the returns when things are not predictable. Even AAA corporate bonds have default risk, thus impacting the return. As to the strategy of managers, we are of the opinion that an active management philosophy is critical. We are not talking about ‘day-trading’ of positions; rather, we think of it as ‘opportunistically transacting’. If the marketplace has an appetite for something that you have and they do not, why not consider selling it at a premium and definitely over your hurdle rate?
FW: What steps should be taken to ensure that portfolio valuation is consistent for all investors and the price at which investors invest or redeem units or shares is fair?
Zass: This is a tough one given the lack of an observable market, as well as the subjective nature of the asset. The amount asked or offered by a willing buyer and seller is determined by many factors, including the inherent risks of the policy – for example, origination, carrier, product, insured’s health and longevity, circumstances or strategies of both the seller and the purchaser, and trends in the market. There are some guidelines to use to gauge whether the valuation appears reasonable or irrationally high – or low – of some benchmark. There are few that can ‘appraise’ a portfolio as it takes two key professionals – underwriters to assess the health of the insured and actuaries to perform a discounted cash flow calculation using the policy information, the underwriter’s view as to current health, a perspective on future mortality trends and a risk adjusted discount rate. There are a few third party vendors who produce benchmarks, though they come with caveats since not all policies have comparable characteristics, like large face amounts vs. smaller death benefit sized policies. Given the many components of the valuation we should not be surprised that there are different views of how to set those valuation variables. We believe that valuations should include multiple scenarios to show an investor the return potential as opposed to a single ‘point in scale’ required of a financial report. Those scenarios could include a shift up or down of future mortality trends, up or down by 100 bps of the discount rate, or a projection assuming the insureds are standard mortality and other variations. Let’s look at another subjective asset class – art. In 2013, the European Finance Association conference heard fine art returns were significantly overestimated while the risk underestimated. The research, based on the BASI auction database, shows the true annual return from 1972 to 2010 was closer to 6.5 percent, instead of the presumed 10 percent. Research indicated the value was heavily dependent upon the art era, the artist, and so on – which is not too dissimilar to life settlements, or annuities, where certain characteristics draw higher return expectations than others. So the world of life settlements, or any other non-observable asset valuation, comes with some degree of empirical evidence, some ‘average’ perspective, and the rest, inherent bias.
FW: What advice would you give to investors in terms of performing due diligence? How does the regulatory environment and increasing legislation impact at the policy acquisition/asset valuation stage, and beyond?
Zass: On the due diligence side, these assets are not inexpensive to assess prior to acquiring. Take a portfolio of 50 life settlements at $1m face each, which converts to the price of a small commercial building. It is not unforeseen that an investor will incur some five to six digit cost to perform the diligence on the real estate, yet when we come to the life settlement market there tends to be less focus on diligence by some market participants. We have legal and actuarial centric risks being the two core assessments prior to transacting. It is easy to have someone check the box as to whether you received all the necessary files from the seller, but it is another to determine if there are any hidden fraud or origination concerns. This requires legal counsel with experience in the marketplace and capable of performing many of these forms of review. We have worked with a few really good law firms on this. With some bias, I think the extent of the due diligence many market participants perform on the actuarial ‘side’ is to simply say “we priced it using a commonly used commercial software package so that is all we need to do”. Unfortunately, experience has shown that many do not recognise that a canned software program has its limitations, which it does with UL secondary guaranteed products, as well as the information being coded into the software. We have witnessed way more times than not that the adage ‘garbage in, garbage out’ is really in play. As to changing landscapes, again it does not matter what the asset is, you need to be on top of the environment you participate in. Sound risk management comes with identification and monitoring, and these asset classes are no different. This means that there is a cost for managing this effort too. Proper and thorough due diligence costs money; if an investor is not willing to incorporate those costs into the overall investment, then they need only look in the mirror when the investment underperforms, because it will.
FW: Is it fair to say that the methodologies for assessing the structured and life settlement asset classes require a greater degree of uniformity? If so, how might this be achieved?
Zass: In short, methodologies do require a greater degree of uniformity –but with a caveat. Aside from the legal diligence, the key is to understand the health profile of the insured or annuitant. It is their health and lifestyle that greatly impacts their lifespan. The Society of Actuaries has been increasing the number of seminars and meeting sessions around predicting mortality – and morbidity. The life insurance market has recognised that alternatives exist beyond invasive underwriting procedures to gain a better understanding of the risk characteristics. Everything from facial recognition longevity testing to basic questionnaires to DNA profiles is being investigated to assess their predictability. So in the end, it is the law of diminishing returns, doing multiple tests may do nothing more than add costs, yet some situations require the use of the traditional life expectancy underwriting with some combination of hereditary queries and a simple question “how would you rate your health – poor, fair, good”. Notwithstanding, this last simple question actually is a great predictor of longevity.
FW: To what extent are both markets hindered by reputational issues? How should those involved respond to suggestions that the market is open to abuse, such as the exploitation of vulnerable individuals?
Zass: The days of the stage coach are gone and all asset classes had early periods of troubling behaviour. It is unfortunate that such periods existed when the consumer sold their policy for much less than they could have received, to the investors who took faith that the snake-oil being peddled was better than advertised and to the professional firms insisting on best practice methodologies. Moving forward, today the market is more transparent with high regulations stipulated for those insurance providers and brokers. There is always room for improvement and we believe the lobby association for the life settlement market has done an excellent job at promoting these frameworks to push out the bad apples that were nothing but crooks and charlatans. These are further enhanced with the correct team of trained professionals assisting along the way.
FW: How do you envisage the outlook for these markets in 2016 and beyond? Are there any particular trends you expect to see?
Zass: On the trend side, we expect to see continued interest in the life settlement space owing to factors like the advancing age of the baby boomers, political instability in the global arena, which puts pressure on economic policy creating undesired market variability, and some continuation of the new norm long term interest rate levels. These two similar asset classes offer a refuge for institutional investors looking at an allocation of alternative investments, coupled with minimal correlation. In light of the too frequent financial market struggles, the investor community desperately needs safe and accretive returns; hence, these asset classes remain on the radar of some. In our opinion, we think long term risk adjusted returns of 7 to 9 percent from a prudently managed life settlement investment and 5 to 6 percent on the annuity-payout side is attainable, plus they come with less equity volatility and longer term fixed income stability. Just remember, life settlement investment, less so on the annuity-payout side, requires large capital investments to harbour the results of the law of large numbers simply critical to any chance of success. If the market chaos continues, there are other ramifications in that the insureds that never consider selling their life insurance policy may do so to aid in financing retirement as the markets have more than likely caused a haircut.
FW: What final piece of advice would you give to structured and life settlements players, in terms of utilising the best drivers to maximise investor return?
Zass: There are a couple of common threads here – understand the risks of the asset, recognise that none of us are soothsayers to predict the future and accept that returns could be higher, but worse yet, much lower. The next question is how to do this, namely by engaging trusted professional advisers who understand the risk reward nuances and have spent quality time in the trenches dealing with the pitfalls that can turn the investment into a nightmare. It is this collaborative team approach that enhances the likelihood for success – whether a solid group built internally or some reliance on external support, not having such a team can translate your strategy to luck and hope.
Corwin Zass is the founder and principal of Actuarial Risk Management, Ltd, an independent member of the BDO Alliance USA since 2006. For close to 25 years, Mr Zass, a trained life actuary, and his team’s collective advice were sought on topics such as M&A, product & risk management, capital strategy and financial reporting paradigms. His 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: firstname.lastname@example.org.
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