The return of life settlements stems ultimately from income exceeding expenses. The investment needs to be profitable, so it should be judged by its ‘cash-on-cash performance’. The net asset value (‘NAV’) performance, however, is different to the cash-on-cash performance, as various appreciations and depreciations of the portfolio are included in the NAV as well as the changing value of the cash account.
The NAV curve of a fund serves various purposes. While its primary objective should be the reflection of the true and fair value of the assets, it’s also used as a marketing tool; the attraction of new capital is often driven (to a significant extent) by the shape of the achieved NAV curve.
Many life settlement funds show, at least for some time, a smooth, upward sloped NAV curve, as can be seen in Figure 1 below. It is clear how this could be used as a marketing tool to attract new capital. Furthermore, the NAV curves give the impression of a low-risk investment, at least initially.
Figure 1 – NAV Curve of Three Life Settlement Funds
Source: AA-Partners (All three NAV curves are extrapolated from actual open-ended life settlement funds. The NAV curves therefore reflect the value of the life settlement portfolios including the cash portion on the balance sheet. Funds 1 and 2 were liquidated, Fund 3 is still running.)
Each of the three funds in Figure 1 above display an appealing NAV curve, albeit of differing durations. In each case, a steep depreciation and downwards or sidewards movements occur, interrupted sometimes by further, sudden depreciations.
The NAV curves raise questions as to where the claimed NAV performance is coming from and about the reliability of a life settlement NAV for investment decisions.
Valuation Is Key to Understanding NAV Performance
Life settlement asset managers need to determine the discount factors (‘IRR’) that they use for the valuation of the life settlements in a portfolio. To achieve a valuation in line with market prices the discount factors used need to be in line with the prevailing discount factor of a similar life settlement in the life settlement tertiary market where policies are traded between professional investors.
Life settlements are a non-standardized asset, i.e., every life settlement is different and comes with specific features, risks, deficiencies, and issues. It is therefore common sense that each life settlement transaction results in a different discount factor. Figure 2 below shows the distribution of IRR of recently closed life settlement transactions The discount factors vary widely. They account for the peculiarities that are connected to a particular policy etc.
Figure 2: Snapshot of Projected IRR of Recently Closed Life Settlement Transactions
Source: AA-Partners (The IRRs of closed transactions in Figure 2 above are widely distributed. The distribution reflects the unique features and peculiarities of individual life settlements. For instance, the transaction in the red circle (aged life expectancy of 57 months at the transaction date, projected IRR of 25%) refers to a policy with life expectancies from 2012 and no actual medical information available, so the shortcomings of the asset led to the high projected IRR.)
The vast distribution of projected IRRs illustrates that discount factors per single life settlement need to be used to achieve a valuation in line with market prices. However, using just one discount factor2 for the valuation of all of the life settlements in a portfolio, compare for instance the 12% line in Figure 2, could lead to an inappropriate performance presentation.
- The use of a single discount factor can lead to undue appreciations of newly acquired inventory if the discount factor used for the valuation is lower than the appropriate market IRR. This can create an upward sloped NAV curve that does not reflect the true value of the portfolio. The upward sloped NAV curve can be used as a marketing tool to attract new investors, which allows the fund to acquire new inventory which can be appreciated, and so forth.
- This holds for open-ended as well as for closed-ended funds during the rump-up phase. The NAV performance of funds using non-fitting discount factors changes when no additional inventory can be acquired due to a lack of new subscriptions or depleted cash accounts. The NAV curve is then determined by other factors, for instance, the contribution of ‘aging’ to the portfolio, the cash-on-cash performance, and so forth.
The importance of this source of NAV performance is high. The upward sloped NAV curve, that results from applying a single discount factor to newly acquired inventory, can give the impression of a seemingly, low risk investment with high return3. But the NAV performance is not ‘real’ because the gains are not realized. The life settlements can’t be sold for the value on the books since the applied discount factor for the valuation does not reflect the peculiarities and the features of the individual policies.
Furthermore, the appealing shape of the NAV curve, that results from the use of a single valuation discount factor and respective appreciations, can ‘mask’ the true performance. A life settlement portfolio needs to be profitable, the collected proceeds from life insurance policies need to exceed the expenses (i.e., premium payments and fees). A portfolio that uses a single valuation discount factor may show a great NAV performance but might have never been profitable. And the investors may therefore not ask for the relevant information (i.e. actual to expected ratio, cash-on-cash performance) since the NAV curve looks so compelling4.
Last but not least, the use of a single valuation discount factor can lead to various false incentives:
- The greatest risk in life settlements investing is that the life expectancies5 used by the buyer are too short on average. However, the use of a single discount factor for the valuation incentivizes the use of the shortest available life expectancies, even though they may be too short. The shorter the used life expectancies, the higher the projected IRR of a transaction on average. Accordingly, the use of short life expectancies offers higher appreciation potential. And the true performance can be hidden via the upward sloped NAV curve.
- The use of a single discount factor for the valuation incentivizes the purchase of policies with deficiencies (e.g., policies with outdated life expectancies or missing medical information, incomplete documentation and so forth). Such policies trade at higher IRRs when compared to similar policies without deficiencies. A single valuation discount factor does not account properly for such shortcomings. The higher average IRR of such policies offers greater appreciation potential.
- The use of a single discount factor incentivizes the purchase of policies with potential legal issues such as premium financed policies. Premium financed policies trade on average at a higher IRR than similar policies without premium finance issues. Thus, such paper offers greater appreciation potential than similar policies without premium finance status, since a single valuation discount factor does not account properly for this fact.
- The use of a single valuation discount factor can offer incentives to source policies in a way which allows to get paper at high IRR, via incentives for sourcing channels or counterparties and the suppression of lawful auctions, via a right of first refusal and so forth. Thus, it can offer incentives to deprive sellers of a fair price for their policies.
- The appreciations, although not realized, are performance-relevant and lead to an increase in NAV. The asset manager will earn management and incentive fees on the appreciated assets.
Life settlements are a non-standardized asset. Each life settlement represents a unique combination of features, risks, and impairments, which, as a matter of course, lead to widely dispersed IRRs.
The use of a single discount factor for the valuation of life settlements, instead of different discount factors that reflect the non-standardized character of each policy, is a blueprint to generate great NAV performance via appreciations of newly acquired inventory. The upward sloped NAV curve can be achieved irrespective of the true performance of a portfolio and irrespective of whether an asset manager is sophisticated – it is enough to acquire life settlements for higher projected IRR than the applied discount factor for valuation. But the NAV curve is not ‘real’ since it is based on the inflation of the value of newly purchased policies. Thus, such a NAV curve is misleading and unsuitable as a basis for investment decisions.
Conclusions
The use of a single discount factor for the valuation of a non-standardized asset is improper. Furthermore, it opens the door for a wide range of skewed incentives and misconduct. Thus, it should be a matter of fact for asset managers to use tailored discount factors for single life settlements.
The life settlement industry still lacks a robust set of performance presentation standards. The absence of such standards facilitates inter alia the use of discount factors for the valuation of life settlements that do not accurately reflect their peculiarities, or may not provide crucial information about the true performance of the investments. Thus, progressive market participants could state voluntarily whether they use appropriate discount factors per individual life settlement and whether they provide the actual to expected ratio analysis and the cash-on-cash performance data to their investors.
Beat Hess is a Managing Partner at AA-Partners
Footnotes:
1The article is an extract from the white paper ‘Sources of NAV Performance’, compare www.aapartners.ch/fileadmin/documents/White_Paper/Life_Settlements_-_Sources_of_NAV_Performance.pdf
2It would be a precondition for the use of a single discount factor in the valuation of a non-standardised asset that the discount factors of closed transactions are relatively narrow and consistent. However, the IRR of life settlement transactions don’t meet this basic requirement. Actually, the contrary is true — compare the IRR distribution in the chart. The IRRs differ widely, which makes sense based on the background of the various impairments, legal risks and shortcomings of this asset. Furthermore, there are other non-standardized asset classes such as real estate or private equity. It is generally accepted that each real estate or private equity transaction comes with a distinct discount factor which accounts for the peculiarities of a particular asset being transferred. And consequently, it is general practise, and it makes sense, to use different discount factors for different properties and different private equity holdings for valuation purposes.
3The shape of the NAV curve is sometimes taken as a proof of the uncorrelated character of life settlement. The argument is false given this source of the NAV performance.
4It should be a matter of fact for life settlement asset managers to include the cash-on-cash performance, the actual to expected ratio and so forth in every information to existing or potential investors (‘performance presentation standards’).
5The life expectancies are determined based on the health and medical information of the insured person by specialized companies (‘medical underwriters’). There is no standardized process for the estimation of life expectancies, every medical underwriter has a different approach. The life expectancies prepared by the various medical underwriters with respect to the same life settlement can, therefore, vary even though they all rely on the same medical information.
Any views expressed in this article are those of the author(s) and do not necessarily reflect the views of Life Risk News or its publisher, the European Life Settlement Association.