The current macroeconomic environment is having a significant impact on millions of people and businesses across the world, and in terms of the alternative investment industry, some hedge fund strategies are struggling, some private equity-backed companies are beginning to suffer, and start-ups promising the next great idea are finding it harder to secure venture capital funding.
The going isn’t as tough in the life settlement market. Inflationary pressures don’t impact this corner of the investment world like they do others; the passing on of costs to the consumer – in this instance, the fund which owns a portfolio of secondary life insurance policies, underwritten by the vendor (the life insurance company) – doesn’t work in the same way that a private equity-owned portfolio of a chain of restaurants does (in the sense that the latter might have to pass on higher food costs to their diners in the form of higher menu prices, for example). The carrying charge for the life insurance policy is its premium – paid to keep the policy in good standing – and buried within is the cost of insurance (COI). While the COI component increases, but that’s not being driven by inflation, rather it is the likelihood of mortality as one ages.
“The policy administration or servicing cost of a life settlement may be slightly higher because of increased inflation, yet that is rather trivial in comparison to the premiums,” said Corwin (Cory) Zass, Founder and CEO of Actuarial Risk Management, Ltd. “On one hand, over the past 25 years, life insurance companies realized diminished investment (asset) margins as market interest rates continued spirally lower. While the life insurance industry’s mortality experience has generally shown past actuarial assumptions overstated deaths. During the era of low interest rates, which seemed to suddenly dissipate in the last 6 months of 2022, increases in the life insurance premium levels for some life insurers were driven by their actions to maintain a positive profit margin.”
As such, the need for life insurance companies to increase the cost of insurance component of a life policy is arguably set to recede. Where inflation goes, interest rates follow. And whereas economic theory says that a rising interest rate environment should dampen demand for public equities and will drive poorer performance in existing bond portfolios, there are benefits to this for the life settlement market via the primary life insurance market.
“In a rising interest rate regime, life insurance companies are earning more on their assets which in turn means they can make more on the spread between what they earn and the interest rate they credit to the policy,” said Zass. “This makes them financially healthier, and, as they’re the counterparty to a life settlement, it further mitigates the admittedly lower risk of carrier default.”
Another area where the life settlement market could benefit from a rising interest rate environment is in deal flow. Some life settlement fund managers frequently grumble about the lack of deal flow coming to market, but a rising rate environment might further persuade policy owners, who are impacted by escalated cost of consumer goods, that they don’t need the policy anymore and thus will seek to cash it in to help with increasing mortgage costs.
The industry isn’t sitting back and licking its fingers, however. The industry’s marketing efforts will need to be sharpened, as the life settlement market faces the same challenge as other alternative investment sectors do – produce stable and attractive risk adjusted yields and not lose pace when rates rise.
“Alternative investment products, with a debt-like return profile, all face the same quandary; if you’re saying you can get me a return of 14%, and I can get this same return in some other perceived less risky investment, help me understand why should I place more invested dollars in perceived risky opportunities. That’s an extreme example, but in 1981, US treasuries were 19%. What happens if interest rates do rise 500bps? All fixed income strategies will need to be able to sell against that backdrop,” said Zass.
With respect to the tertiary life settlement market, current investors (holders) of these assets could be affected by the financial market calamity. Look at the need to sell assets to raise cash to meet collateral calls during the recent UK gilt market turmoil. With central banks reacting, these situations of forced selling may indeed become a norm. The need to dump life settlement investments could not certainly be immune.
With the last 30 years of easy money from global central banks almost disappearing in a flash in the major western industrial nations, rising interest rates are putting investors on notice with depressed investment market values. From the life settlement standpoint there are two considerations: how do the rate increases impact current investments in life settlements and how will the rate increases impact new acquisitions of life settlements. There is not complete agreement by life settlement participants that the prices to acquire a policy decrease (since the price is a by-product of a present value computation and thus acts like bond values – increased interest rate, lower value) are directly influenced by recent rate actions in the U.S.
Some in the industry believe that demand influences more of the price paid than interest rates, yet under fair value accounting concepts, this simply means that the biggest risk – longevity risk – is being compressed by buyers. This could end up being a return disaster in the long run if there is any extension or mis-estimation of life expectancy. Going forward, for new life settlement acquisitions, there is some similarity to the compression of the longevity risk situation, yet it is accepted that investors will simply demand higher returns so buyers will use higher interest rates in their present value calculations which produce lower prices.
Still, considering the lack of financial market influence on longevity, Zass remains bullish.
“The major risk of the life settlement market is longevity risk,” he said. “The trade-off from financial market risk has this asset class seemingly well positioned as a viable option to make it through the financial chaos that could still lie ahead.”