Today, according to research firm Conning, an estimated $22bn is currently “in-force” in the life settlement asset class. That is almost exclusively from so called real money investors, usually institutional investors with long investment horizons and plenty of patience.
Most histories recognize the life settlement market began in the 1980s, associated with the AIDS epidemic. The rationale behind such transactions seems sadly clear – policies of those suffering from AIDS presented a source of cash for a condition that was considered to be terminal, providing vital funds for the purchase of extremely expensive medication or the abatement of suffering.
But when we look back from the current standpoint, as an institutionally recognized asset class, another event surfaces as a more important moment of innovation. The first non-viatical policy is reported as having been traded in the late 1990s. The logic of settling a policy was applied to the context of an insured person of standard or moderately impaired health, without overriding concerns of terminal illness. An insurance policy could be settled for the more mundane purpose of simply extracting liquidity from an otherwise illiquid financial instrument.
This innovation opened the vast store of insurance policies on senior citizens who were not terminally ill to the mechanism of settlement. This is arguably the turning point that led us to where we are today, where the asset class is overwhelmingly occupied by institutional backers taking exposure to exactly this type of policy.
How has the profile of investors changed as the market has developed? How have institutional investors approached the asset class over the years, and what due diligence questions have they focussed on along the way?
Soon after the turn of the millennium, during the market’s earliest stages, questions understandably focused on transactional validity. Can you legally buy a policy? How do you execute a transfer in ownership? How do you settle it? Where is the ownership instantiated and held? Can you deploy a few million?
The question of legality was answered by the classic legal precedent from a 1911 US Supreme Court case, Grigsby v. Russell. In this landmark case, the U.S. Supreme Court found that notwithstanding the age-old principle that one cannot take insurance on the life of another person without an “insurable interest” in that person’s continued life (such as a family bond or financial dependency relationship), once a policy is issued it is legal to transfer an interest in that policy to another person who has no insurable interest. Additional answers focussed on the emerging mechanisms for transaction and settlement, including the development of escrow mechanisms and the role of securities intermediaries.
But at that time, there was a limited supply of policies and not enough volume for institutional players to become involved in a significant way.
As time passed, and as market trading volumes increased to levels that might support ticket sizes consistent with institutional appetites, we began to see more focus and attention on insurance underwriting, mortality projection methods, and policy origination methods. In parallel, there emerged a small coterie of sophisticated asset managers equipped to source, analyse and price these assets at a standard suitable for institutional investors.
A critical feature of life settlement investing is ascertaining the likely survival of the person insured under the policy. In the first decade of the 2000s, three or four “life expectancy underwriters” were the main source of data on these insured persons. In 2008, two of them, 21st Services (now named ITM 21st) and AVS Underwriting, implemented a substantial re-evaluation of their underwriting methodologies in conjunction with the release of the 2008 Valuation Basic Tables from the US Society of Actuaries. These re-evaluations resulted in a significant extension of these underwriters’ predictions of longevity for many types of insureds persons, with a concomitant reduction in the value of the polices on their lives. The 2008 extension, as it became known, sent a shockwave across the adolescent industry.
Asset owners absorbed these re-evaluations in their asset valuation with few reference points for marking assets to market. Some managers were affected more than others, especially those that consumed the life expectancy (LE) providers reports at face value, without their own internal tools for analysing longevity. For example, in Australia, according to reports, a Victorian state government pension fund manager, VFMC, invested over AUD$1bn of public funds in Life Settlements Wholesale Fund, a life settlement fund manager in the state of Queensland. VFMC booked an unrealized loss of AUD$500mn, sparking political turmoil and a formal state enquiry into the investment process.
After the 2008 extension debacle, we observed many more questions from institutional investors with intense focus on LE providers. How reliable are they? Is this likely to happen again? How much more is under the hood?
Over time, most LE providers did indeed release further extensions, as they gained more and more experience data from their own underwriting durations and insight into the relative strengths and weaknesses of their underwriting methods.
Concurrently, we also began to see states introduce legislation to cover secondary market transactions and more questions generally about regulation.
At the time of the first non-viatical settlement, there was a regulatory void covering life settlement transactions. Secondary transfers were not covered by existing insurance legislation, which focussed only on the primary issuance of policies. Further, transactions were not captured by financial markets and securities regulation, as policies are distinct from financial securities in the eyes of the law.
This created space for unscrupulous actors. With no obligation to disclose their fees, it was common for intermediary fees to consume 50-70% of the purchase price of the policy, leaving only modest amounts for the policy seller.
It also gave pause to institutional investors, who were understandably cautious about entering a market with an absence of regulatory ground rules and with incentives for originating unattractive assets merely for the purpose of distribution. Additional questions surfaced. How do you ensure consumer fairness and transparency? Are you betting on death and is that ethically sound?
During this time, numerous investment banks entered the market seeing a lucrative opportunity, and the chance to develop and professionalize the market along the way. Credit Suisse, Goldman Sachs, and Deutsche Bank, among others, all established desks in the market, first testing the water buying policies on balance sheet and moving further to develop structured products and financial derivatives associated with the market.
The global financial crisis made clear that bank balance sheets are not a natural home for life settlements. In the aftermath of the crisis, with life settlements treated as a level 3 asset under IFRS, these desks attracted increasing capital charges, whilst having risk limits cut by bank management. All the banks that were active during this time have since closed their active operations. Any legacy assets held are typically in run-off and held in non-core banking units.
Their retirement from the field notwithstanding, the banks helped the market grow in two ways. First, they put considerable resources into supporting a regulatory drive in the industry. Between 2000 and 2010, the most robust period of regulatory development, the number of US states that had active legislation covering secondary market transactions went from five to 40, according to the Life Insurance Settlement Association. Today, 43 states (along with Washington DC and Puerto Rico) regulate settlements, covering some 90% of the US population.
Second, while this regulatory framework was being crafted, banks added the weight of their platforms to developing market standards and investor norms. Credit Suisse and Goldman Sachs, for example, established their own provider networks, maintaining quality control over origination practices and standards. These and other institutional investors eschewed any settlement origination that did not involve full disclosure of intermediary fees to the policy seller, whether or not mandated by regulation. In 2009 a number of these organizations gathered to found ELSA, a trade association focused on developing best practice, education, and research in the life settlements industry. In so doing they did much to set a bar for consumer treatment and could make representations to institutional investors that may have been critical component of their decision to invest. Credit Suisse also established desks located in the UK, US, and Asia, drawing in institutional investors from London to New Zealand, who might not otherwise have been exposed to the asset class.
Insurers Push Back
In 2013 we began to see signs the market was doing something right, with sustained pushback by insurers to deter investment in their policies, accelerating in the next few years. The first barrage was a series of attempts to increase the Cost of Insurance (COI). This is the element of pricing construction for premium payments that reimburses carriers for absorbing the insured’s mortality risk and comprises the primary driver of the amount of policy premiums. Carriers began undertaking targeted campaigns to increase these costs, often on spurious legal grounds, as a means of placing roadblocks before investors. While these efforts rightly raised questions from investors about impact on returns, the impacts of COI increases have not been the panacea the carriers hoped. A market-wide legal response has led to the abandonment or wind-back of many of these practices and has taken the wind from the sails of future COI increases. We still receive questions about the current state of COI increases but these issues are well understood now.
Today, the preceding questions of regulation, longevity projection, and COI increases generally arise much less frequently, especially as they relate to transaction legality, consumer standards, or questionable practice in policy origination. Such issues are either long settled or their impact is well understood. And where they do crop up in due diligence, they tend to have little of the prior urgency of tone. It is this asset-class level maturity that has led to the presence of top-tier investment pools of capital in the market – PIMCO, KKR, Berkshire Hathaway, Apollo, Blackstone and an A-list of major corporate and public pension plans – are all life settlement investors.
The most common questions we hear today focus on portfolio construction, returns and deployment. Is the asset class performing as expected? Are market IRRs elastic to investor demand and capital supply, and by how much? Can you deploy the “typical” ticket sizes of an institutional investor without unduly hurting returns?
With the intrinsic illiquidity of the underlying asset, and its long duration, some investors are concerned about visibility of the anticipated returns. Where are the demonstrated fully realized returns? Can they be repeated? But then, these are questions that we associate with any mature asset class.
Additional questions we receive pertain to cashflow duration, often in the context of asset-liability management. The combination of excess yield and a medium-to-long term asset duration can be attractive for liability matching purposes. In BroadRiver’s case, most of our assets under management are sourced from investors with substantial long-dated liabilities, having a focus on liability-driven investing. We regularly field questions about cash flow weighted average life, and pool life expectancies, to inform such management.
Just over two decades since the first non-viatical policy was transacted, the life settlement market has come of age.
Brendan O’Flynn is Managing Director, Strategy at BroadRiver Asset Management