An alternative strategy not tied to broader asset classes offers the predictability you may be seeking
Life settlements may not be a mainstream investment, even for investors accustomed to thinking outside the box. In today’s environment, more institutional investors have entered because the strategy offers low volatility and is uncorrelated to the stock and bond markets. As more institutional investors come into the market, sophistication, and liquidity are increasing.
The COVID-19 pandemic has profoundly disrupted the investment landscape worldwide. Institutions, Family Offices, and Financial Advisors seeking low volatility, uncorrelated investments, and typically double-digit returns should consider life settlements.
The Origin of Life Settlements
Life Settlements have a long history. In 1911, the U.S. Supreme Court ruled that a life insurance policy is in effect personal property. The ruling meant that the owner could sell the policy to a third party.
The Transaction Outlined
In short, life settlement investments involve buying existing life insurance policies from policyholders seeking a cash payout greater than the cash surrender value of the policy (if any).
In addition to the purchase cost of the policy, the fund pays all future premiums and becomes the beneficiary of the death benefit.
The return on investment is realized when the insurance policy matures and the fund collects the death benefit- typically a gross internal rate of return (IRR) of 12%-15%.
How it Benefits Policy Holders
In the past, if a person could no longer afford to maintain their life insurance, or if their situation had changed and they no longer required it, there were only a few options. People could let the insurance lapse, thereby wasting all the previous payments, or they may have been able to sell it back to the insurer for a mere fraction of what it was worth at maturity.
Now, with an established secondary market for policies, owners can receive a realistic sum for their policy, enabling a significant social benefit for themselves and their families.
“People benefit, and the insurance companies do not.”
Current Observations on the Industry
The market has grown steadily over the last 15 years.
More institutional investors have entered, increasing competition for policies.
There is now an active tertiary market where policies trade. The tertiary market is now more substantial than the secondary market and increasingly competitive.
Conning Analytics forecast over the period through 2024, the average annual gross market potential for life settlements will be approximately $182 billion.
The life settlements market is now fully regulated in 42 states.
Traditional long lock-ups are being replaced with shorter investment durations.
Factors of Valuation of Life Settlements
Numerous factors go into determining how much an investment fund might have to pay for a life settlement. These include, but are not limited to:
The death benefit (face value of the policy)
The monthly or annual premium
The age of the insured
The medical condition of the insured
Another factor that can impact the return on a life settlement investment is through which the policy is acquired. Initial outlays can be significantly reduced by avoiding brokers in the tertiary market. The broker space is highly competitive, and bidding between competing investment firms inevitably escalates the prices of life policies.
The Importance of Policy Acquisition
Institutional investors in the life settlements market can typically only buy pools of policies, grouped in single tranches. This is due to their size and the amount of capital they have to put to work. Within that pool, some policies will be good, and some are less attractive. In this environment, the smaller, boutique manager can benefit significantly from the ability to source policies directly from the policyholder. Not only can they be more thorough in their selection process, but they also avoid acquiring the undesirable policies that are incorporated into pools of policies.
Underwriting and Valuation Process
Rates of Return and Investment Durations
A life settlement investment typically can generate a gross internal rate of return (IRR) of 12% to 15%. The most significant driver of returns in the past has been the collection of the death benefit, which meant that most investment funds were purchasing the more expensive policies that had only a few years left to run on the life expectancy. This strategy worked well initially when the market was relatively new and lacked competition for policies.
Now, however, the emergence of more institutional money has led to increased competition for these policies, making them even more expensive. The rise of the tertiary market means that, for managers who have access to the secondary market, significant value can be derived from the purchase and trading of policies. Therefore, value is less reliant on the final death benefit. Significantly, it means funds can reduce the lock-up period for the investor, allowing for greater investment flexibility.
Diversification Within Life Settlement Funds
The rate of return is based on the mortality rate - when insured individuals mature within the timespan calculated by actuarial formulas. For that reason, life settlement funds typically purchase and own a large pool of policies, which is akin to following diversification principles used for many types of investment baskets, such as mutual funds. Owning 150 to 200 policies is optimal, as a large sample yields increased odds that death rates will track expectations and death benefits will be paid. The typical result is reduced volatility and increased cash flow, which can be an appealing objective when uncertainty is clouding the clarity of many other investment strategies.
Life settlement transactions most commonly involve insured individuals with health issues and a life expectancy of three to 15 years. It can cost hundreds of thousands of dollars to acquire such a policy. The relatively high investment price is accompanied by the increased likelihood of collecting the death benefit before the additional premium payments entirely erase the potential ROI.
In addition to owning a large pool of policies, one other way for a life settlement fund to diversify its holdings is by investing in policies of healthy insured individuals. The purchase price for these policies is lower as these individuals are statistically less likely to pass away before the maturity date and investors pay the policies’ premiums for a longer time. In these instances, however, the death benefit does not represent the sole potential return. As these healthy insureds age and their life expectancies decline, the policies become more valuable to other life settlement investors and can be sold for a net gain.
What used to be a niche strategy and industry is becoming institutionalized for the benefit of investors and policyholders. Life settlements offer low volatility and correlation with the ability to generate double-digit returns. In volatile times with equity valuations stretched and bond yields staying low for the foreseeable future for those who aren’t looking for mainstream investments, life settlements are an attractive asset
Special Thanks to Our Contributor
James Gallagher, CAIA
Griffin Capital Mgt.
Griffin Asset Management
P: +1 (773) 416-2686
HedgeACT was launched in 2014 with the goal of enabling financial advisors to easily add non-correlated, historically alpha-generating private placement alternatives to their existing model portfolios.
Griffin Asset Management LLC is an SEC Exempt Reporting Advisor (ERA)
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