Outlook for the life settlements market in 2017
April 2017 | 10QUESTIONS | FINANCE & INVESTMENT
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FW speaks to Corwin Zass, the founder, principal and consulting actuary at Actuarial Risk Management, about the outlook for the life settlements market in 2017.
FW: Reflecting on the last 12 months or so, how would you characterise the state of the life settlement space?
Zass: The life settlement market continues to build upon the efforts of the last few years. One of the US life settlement associations has worked diligently on consumer awareness, in terms of informing consumers that they have an option to deal with unwanted or unaffordable life insurance policies. On the regulatory side, they continue to show that the life settlement market has heavy governmental oversight. The life settlement association further explains that this settlement money – typically greater than termination amounts offered by the insurer – can also supplement the insured consumer’s three main pillars of retirement – government pension, private pension and personal savings – while providing a new source of funding for long term care and escalating healthcare costs. Whether it is a dedicated life settlement conference or an alternative asset conference, each year seems to attract new interested investors who have observed the market for some time and saw some large institutional buyers do more than dip their toe into the pond. Arguably, the line has been crossed and the inherent value of this asset class is recognised, yet there will always be those looking for a quick return, which we believe is not an appropriate strategy for this asset class. The adage is that patience and steadfast long tenor views are critical to realising value in this asset class, but what is much more important is the willingness to understand that betting on death requires trustworthy and experienced professionals to guide investors through the pitfalls and the opportunities.
“The ways to invest are heavily influenced by your risk aversion and whether you are an institutional investor.”
FW: Have you seen any new investment vehicles with a strategy focused on mortality and/or longevity?
Zass: There are various investments with primary exposure to the lifespan of some underlying population. There are also investments that implicitly have some exposure to the risks of mortality – or longevity. It is fair to say that some of these are more illiquid than others. Over the last couple years, firms have designed a few asset-backed securities (ABS) collateralised by cash flows generated by life settlements. Similar to mortgage backed securities, these new offerings appear as a new wave of opportunities for yield hungry institutions. In fact, two of these offerings received an investment grade rating.
FW: Could you outline the ways to invest in these types of vehicles?
Zass: The ways to invest are heavily influenced by your risk aversion and whether you are an institutional investor. The market has not blossomed into a size fitting of an active equity exchange, a bond market or the likes of a dedicated ETF that makes it easy to invest in instruments with mortality or longevity exposure. As with virtually any asset classes, the primary exposure is a result of the underpinning collateral’s direct or tangential exposures embedded in the assets strategy. For direct exposures, your investment options hinge highly on the amount of investable capital being allocated to this asset. The range covers the likes of a mortality centric equity fund – to a debt structured instrument like a bond or an ABS securitisation. The effects are virtually the same as other assets – you hope to receive some form of ‘interest’, or dividend, plus principal repayment, and, if possible, some above market accretion in the form of extraordinary payments or residual equity type sharing. Other investments with mortality risk exposure include holdings in corporates with unfunded defined benefit plans, and bonds issued by continuing care retirement communities (CCRC) that underwrite the longevity of the seniors buying into the community with unlimited access to healthcare costs. Other examples include the holding of stock in life insurance companies or asset holdings of stock in US government treasuries since the US government has its own and ever growing longevity exposure – the unfunded social security and Medicaid. An investment in any asset comes with risk that must be carefully vet the promises made, the parties involved and the track record of those investments.
FW: What are the investment return expectations? What about return volatility?
Zass: Mortality or longevity is a traditionally deemed minimally correlated risk as someone’s death generally does not link to the ups or downs of the financial markets. One might argue that if the markets crash – or correct depending upon how you deem the market levels – the additional stress placed on individuals could cause higher morbidity levels, which in turn increase the level of death rates. The ability to predict the mortality of any population is dependent on the need to leverage the law of large numbers philosophy. This law underpins the actuarial profession and its ability to derive usable predictive models. The most important part of this law, as it relates to mortality prediction, is the need for homogeneous risks. There are two considerations: mortality events can be predicted with reasonable accuracy, and the accuracy increases as the size of the group expands. Here the term group assumes common risk profiles. So, what does this mean? The underlying collateral supporting an investment must be evaluated to determine the number of lives and whether those lives have more dissimilar profiles. In our opinion, an investor must see how the returns vary under stochastic, or random, mortality simulations. The narrower this return band, the more certainty there is with that investment. Conversely, wide dispersion – or mortality volatility – should equate to a larger inherent risk premium built into the return expectations. Specifically a well-designed life settlement structure can produce an attainable return profile of 500-600 basis points over the equivalent tenor US treasury. Betting on mortality requires patience as even the biggest life insurers rely on the law of large numbers and a long-term view which measures in decades, not months.
“Betting on mortality requires patience as even the biggest life insurers rely on the law of large numbers and a long-term view which measures in decades, not months.”
FW: How accurate are life expectancy assessments? Has the underwriting process advanced over the years?
Zass: The ability to predict anything is heavily dependent upon a thorough understanding of its risk profile, then interpreting how each of the risk characteristics, and their interactions, produce empirical evidence to support such a hypothesis. Let’s take the large global life insurance space first, then the life settlement space. The evolution of life insurance underwriting has shifted over the last 80 years. First it was shown that mortality varies by gender, then many years later by smoking. In subsequent years, further refinement of risks by stratifying ‘good’ risks into categories like super preferred, preferred, standard and the residual standard, just to name a few. The ability to categorise the risks requires extensive analysis of the risk characteristics versus the mortality experience. The broader life insurance market is like a big ship, slowly transitioning to new approaches, like rules-based underwriting – less subjective decisions by human underwriters – plus consideration toward other predictive tests. The life settlement space currently relies on the traditional life expectancy (LE) underwriting methods of medical records, yet other methods are being explored, hoping for the proverbial ‘quicker methods with better results’. Typical LE assessment uses an insured’s medical records to assess the level of impairment versus that of a person of the same age and risk profile who is absent of impairments. The newer methods attempt to also stratify but base it on underwriting questionnaires that form a more simplified and quicker assessment. There is a heightened risk of fraud to lie for monetary gain by implying that their health is worse than it might otherwise be. These forms of ‘new’ underwriting even extend to other forms assessment where some hope there is clear evidence that DNA or genetic makeup testing increases the accuracy for predicting the mortality of such person. The key with any of these approaches is that any one person is also influenced by randomness which is why the law of large numbers of persons is critical to minimise those effects. Accuracy is measurable through transparency of the granular level actual-to-expected (A/E) ratios. Any results can be made believable if you can control what a reader is to interpret thus masking possible less accurate prognostications.
FW: The phrase ‘life expectancy’ appears in vogue of late, especially since the US has shown a recent retraction in life expectancy. How does this affect investments with primarily longevity/mortality risk exposures?
Zass: ‘Life expectancy’ is a very misunderstood metric or statistical measure. To properly appreciate the meaning of this terminology you must start with an understanding of the studied population, or ‘cohort’, which critically defines the profile of the studied persons. These characteristics essentially stratify or segment the studied persons by common traits, like age, gender, tobacco use, geography of residence, level of education and others. Within that studied cohort, life expectancy can be developed using the age as of the study start date and the study start date itself. Mathematically, the life expectancy for a person aged ‘x’ would start by tracking the number of such persons at the study start date then determine the age when half as many of those same persons would be deceased. Regardless, whether the investment is mortality or longevity themed, the key is understanding the risk profile of that specific population under study or similar populations that act as a reasonable proxy. So even though there has been a reduction in US life expectancy, one can point to numerous subsets of the US population with increases in life expectancy. This demonstrates the problem if the mortality of one group is representative of another. Another illustration discusses the uncertain effects of, for example, a severe virus primarily affecting three year olds only. While this would have the impact of reducing life expectancy at birth, it would show nothing about the unchanged life expectancy of those who are currently age 21, 65 or 85.
FW: Could you explain the other risks inherent in investments with primarily longevity/mortality risk exposures?
Zass: For life settlement investments, we see various risks, some with greater exposure than others. A sample of risks include losses that may occur at the time the insured settled the policies related to the transaction amount due to: mispricing or unknowingly paying too much at the time of the transaction; fraud, or sunk costs. Other losses due to underperformance of life insurance policies or the pool can be the result of: premium requirements being greater than expected, meaning a heavier carry, possibly due to COI increases; extended longevity of the insured, either isolated or systemic; failure to pay a required premium to keep policy active. Some operation risks include losses due to servicing issues of the pool; servicer negligence and unpaid premium, resulting in a policy lapse; the servicer going out of business and the transition creating a gap to pay premiums; losses arising from the collection of triggered benefits. Other risks range from contestability of policy sourcing, misrepresentation on a life insurance application; carrier financial difficulties resulting in partial, late or non-payment; and losses due to changes in laws or the regulatory environment creating uncertainty about holdings and future market conditions for acquiring or disposing. There are some basic diligence processes that can help mitigate this risk exposure, including a comprehensive actuarial and legal review, independent review of the health impairments which led to the underwriting view, and having solid controls in place regarding the vetting and approval process. Like the acquisition of any asset, the critical steps are: the know your customer (KYC) assessment that extends to parties involved.
“We expect to see a few large securitisations go through in 2017 which is good for the institutional investors looking for predictable return profiles above the current fixed income bond yields.”
FW: How does the aging of the ‘Baby Boomer’ population impact the supply of life insurance policies within the life settlement space?
Zass: This large subset of the US population has a significant amount of life insurance in place. Those insurance holders have a few behavioural options available to them: continue to pay premiums, evaluate the economics of settling their policy or walk-away, by either letting the policy naturally lapse or surrender for whatever cash value offered by the insurance company. With that said, education of this large age group must continue, detailing the options that are available. Even with the marketing campaigns, many insurance consumers do not know their options. To handle the tsunami of ‘baby boomer’ policy supply the market needs to leverage technology to improve and shorten, the time to underwrite for life expectancy. The market is at a crossroads knowing that the current supply will multiply due to the maturing in age of this large post World War II cohort.
FW: What advice can you offer to investors looking to enter, or already active, in the life settlements market?
Zass: Diversify. Rolling the dice and placing a large percentage of the assets in a mortality-centric investment programme is disastrous. Swallow your ego and hire a seasoned team of experts. There is a significant risk to investing in any space if there is not the appropriate level of due diligence of the assets and the individuals involved in the process. Over the years there have been many examples of investors finding out the wrong way that chasing the marketed high-teen return profiles is equivalent to throwing good money after bad in the hope of seeing the proverbial unicorn. Buyer beware.
FW: How do you expect the life settlement space to evolve over the years ahead?
Zass: It continues to evolve. We expect to see a few large securitisations go through in 2017 which is good for the institutional investors looking for predictable return profiles above the current fixed income bond yields. In 2018 we should not be surprised if there is another attempt to create a life settlement index which will allow for the creation of investments pegged to such an index. Underwriting will continue to transition to more automated approaches, much akin to the life insurance industry.
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: czass@actrisk.com.
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