It’s not unrealistic for institutional, end investors to expect – and receive – double digit IRRs from their allocations to third party life settlement fund managers; there are a range of stochastic probability curves that support this view. In addition, these investors are not only receiving additive gains to their broader portfolio, but they’re getting uncorrelated returns to traditional economic asset classes, something which is attractive in bull or bear markets, in the short or long term.
But where might it go wrong? As someone who has spent more than a decade in the life settlement market, I’ve seen many reasons why a fund manager might not deliver what they are capable of delivering, but I also think it’s contingent on the investor to ask more cerebral questions during the due diligence process to help them determine whether those double-digit returns are realistic or not.
Longevity risk is the key valuation risk and can be split between mis-estimation risk – a systematic issue with the calculation of the insureds life expectancy (LE); volatility risk – this naturally emerges from the nature of a probabilistic cashflow calculation with a single event pay-out; and mortality development risk, something that impacts the LE or mortality curve, like unforeseen medical developments, or more recently, the Covid-19 pandemic.
Longevity risk can be mitigated by avoiding LE providers who are unwilling to give transparency on modelling or won’t partake in due diligence. Make your own judgement on LE providers and get as much information as possible from them. Don’t be swayed from a particular one because market sentiment is that “their LE’s are too long”.
This is the risk of insufficient cash being available to pay premiums. Cashflows in the life settlement market are volatile, which may lead to distressed sales, or even surrenders and lapses.
The fund manager should be able to demonstrate the liquidity stresses that the fund can withstand. This can be very simple, for example the number of months liquidity with no cash inflow from claims. A documented plan of steps to manage liquidity breaches’ defined limits is key here.
If there is an external lender, it’s important to know the details of when they can intervene, how they would respond to further extension requests, and what the loan terms are. Managers should keep valuation parameters regularly updated, monitor marketability, and their liquidity profile should be made part of their regular communication to their investors.
Legal Risk is a multi-faceted one, which includes potential issues with the purchase and sale of policies, claim payment and ownership litigation, cost of insurance increases, and retrospective litigation.
The fund manager needs to be able to show the documentation, review and auditing process needed to support a purchase. There is a considerable amount of transaction documentation needed, but there is substantial information publicly available on standard requirements. Investors need to ask what the fund manager’s approach to premium finance policies is. If they are part of the purchase criteria, has the premium finance programme been legally reviewed?
How is past and on-going litigation monitored (e.g., external and/or in-house US lawyer) against the portfolio, and how is this information used by the fund manager? For example, is there an impact on policy selection criteria, are there policies currently held that are impacted positively or negatively. Which policies fall under jurisdictions with the highest likelihood of a legal challenge that negatively impacts the fund, and how is this reflected in purchase criteria. How diversified is the portfolio against actions?
Is there a risk of challenge by the carrier or seller after a claim has been paid to the fund? Overall, fund management engagement of an external lawyer for on-going updates is strongly encouraged.
Concentration risk is another multi-faceted risk.
In terms of the range of face values of policies in the portfolio, how were these limits derived, and, if there is a particular focus, what are the drivers? For example, funds may target smaller face value as a proxy for an insured’s net worth and socio-economic status. This also increases the policy count for a given fund size, hence reducing volatility.
What is the number of years between policy inception and first sale? The risk of challenge is expected to reduce further, the greater the period. It also increases the time since the policy was underwritten. Although the VBT select curve addresses this, there will be more smoothing of the curve for older ages. Ideally, the portfolio will not be concentrated on 2-5 years since policy issue.
What is the minimum age at purchase, targeted average age, and targeted gender diversification (this is likely be similar to the insured market, approximately 70% male / 30% female)?
What is the range of insurance carriers and credit ratings? This diversification helps to reduce risks from cost of insurance increases, carrier litigation risk, carriers that may have been anticipating the likelihood of policies moving to the secondary market.) What is the LE at purchase? They need to be a minimum of two years to avoid viatical settlements. What are the mortality factors and conditions? Is the manager targeting a range of conditions and impairment levels?
The bottom line with regards to concentration risk is that diversification is the key.
Cost of Insurance Risk
Cost of insurance (CoI) is the part of the premium covering the mortality costs. However the fund should have assessed the specific conditions for reviewing premium costs, which can vary by policy.
When I first became involved in the life settlement industry, and asked to prepare a summary of potential risks, the risk of premium charges being increased by carriers was sometimes questioned. There were a range of responses: “In theory the premiums can be increased but only if mortality experience is worse than expected, and so highly unlikely”; “Insurance companies won’t do that as it will damage their future sales”, “They won’t because they’d be admitting to mispricing the policies”; “They’re not allowed to do that”, …
For investors new to life settlements and not experienced with universal life policies, this feature may be a new one. Cost of insurance increases were emerging at a time of risk-free rates being much lower than the guaranteed rate on cash in the policy. If these increases are justified by the policy conditions, they can’t be avoided. The fund manager will need to monitor the observed changes and ensure diversification by insurer and anticipate further increases. It’s important to note that some carrier’s CoI changes do seem to impact the age range typical for the life settlement market.
The most critical operational risk is that of lapse risk; insufficient premiums have been paid, the insurance company has sent a payment reminder, this is not responded to, and the policy lapses.
Managers should maintain a buffer of cash to cover, for example, an approximate future three months cost of insurance. The precise premium needed to keep the policy in-force is not known and is derived by the fund manager from the policy contract details of expense charges and surrender charges, together with an illustration projecting the policy based on a fixed level premium. One issue for the fund manager is that the illustration may not be complete, as the carrier is unable to provide a full projection if it would trigger tax status changes for the policy. They should have methods developed to develop a proxy for the future CoI’s, for example based on past CoI increases, taken from account statements, and the CoI’s from the partial illustration. If the premium is not enough to cover the months CoI and costs, the policy owner will receive a “grace notice” informing the amount and deadline for payment to keep the policy in-force. The fund manager will be able to detail the response procedure. The critical part is to follow each stage of the chain from receipt of the notice, communication to the policy servicer, fund manager, and if applicable investment advisor. Importantly, the process should ensure all relevant parties are informed, but also that this does not allow an assumption that another party is addressing the issue.
Communicating to the investor why the fund’s longevity experience is not precisely as expected is a natural part of risk communication. Informing them that a policy has accidentally lapsed is not so easy.
Life settlements, like any other asset class, has nuances that can affect the alpha that an asset manager generates. One of the key differences between our market, and traditional ones, however, is that more investors are less familiar with these , which leads to a less effective due diligence process. All life settlements asset managers should have plans in place to mitigate these six key investment-related risks. Investors should be asking related questions, not only in the initial due diligence basis, but on an ongoing one as well.
Richard Morris is an Actuary and Independent Consultant