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09 August 2010

A look at Life Settlements as a growing asset class

A look at life settlements as a burgeoning asset class: The market place has grown rapidly; from only $200m in 1998 to $11.7bn in 2008 -projections for 2017 are $31bn. BUT how can this asset class gain the credibility to become mainstream in the UK? SL looks at the key pointers to increased regulation (FSA response), transparency, consistency, and investor protection.

A truly alternative asset

Since the onset of the lending liquidity squeeze in 2007, adverse market experience in the more traditional asset classes of equities, fixed income, and property, has had a number of impacts on the fortunes of pension funds. The emergence of a positive correlation in the downward performance of these traditional asset classes has encouraged the exploration of alternative assets such as infrastructure and private equity, as well as hedge funds, as managers seek to diversify and explore new sources of alpha. Also, many pension fund managers have emphasised the role of the manager selection, in their pursuit of alpha generation.

In the last decade, an alternative investment opportunity has emerged, namely traded life settlements. The secondary market for life settlements originates from the consumer demand of US seniors seeking liquidity for life insurance policies that they no longer want or require. Investors in the secondary market identified early on that billions of dollars worth of life insurance policies were being either surrendered or allowed to lapse, at a considerable financial detriment to the consumer. The secondary market offers significantly higher resale values for policies held by individuals with impaired lives, when compared to the surrender values of the policies. Whilst the surrender of policies back to the issuing life office is deemed acceptable, surrender values are fixed by regulation and cannot be adjusted for health impairment. Therefore, on the demand-side, it represents an opportunity for investors to participate in a low-correlated asset that exhibits stable returns.

The evolution of the secondary market

The legislation underpinning the secondary market for life settlements is now fast approaching its centenary in 2011, whilst the secondary market itself is still relatively youthful. Due to this relative immaturity, a number of concerns have emerged in the early part of this decade, including lax and inconsistent regulatory oversight, the emergence of stranger-originated life insurance ('STOLI', in which a third party initiates a policy whilst having no insurable interest on the life assured, and subsequently profits from their mortality), the absence of a uniform approach to life expectancy assessment and asset valuation, to name a few.

However, as the investment opportunity for traded life settlements rapidly grew in size, from approximately $200m in 1998 to $11.7bn in 2008, a number of these concerns are being actively addressed, and the industry continues to evolve robust consumer and investor protections as it approaches the mainstream investment arena. Over 75% of the States in the US have now enacted consumer legislation designed to protect policy vendors and, following the life settlement legislation passed in New York in late 2009, nearly 90% of the US population now reside in States with effective life settlement regulation prohibiting STOLI, as well enforcing appropriate and effective licensing of policy sales intermediaries.

The scope of alternative asset opportunities

Whilst pension funds are not averse to exploring the opportunities presented by alternative assets such as infrastructure, many scheme managers have raised concerns as to the absence of consistency in the valuation methodologies used by various market participants, particularly given the absence of a centralised 'arms-length' market exchange.

An alternative view to the perception that investment in life settlements would exacerbate their already pronounced longevity extension risk would suggest that such investment offers an opportunity to generate stable returns with minimal correlation to the business cycle. Also, any longevity risk of life settlements involves the carefully medically and risk assessed mortality of US seniors over the age of 65, a distinctly different cohort of lives from those within UK pension funds.

The search for alpha

In recent years, there has been a growing focus by scheme managers to generate alpha via their asset allocation decisions and/or manager selection. In doing so, such decisions may impact upon the risk-return profile of the fund. That is, the drive for asset diversification may increase the potential for greater returns, but will also potentially exacerbate the level of risk borne by the scheme.

On the other hand, this increase in risk can be offset to some degree by greater due diligence in the process of manager selection. In the case of investing in life settlements, such due diligence will involve the appraisal of the manager as well as the asset class itself. Indeed, there is a fiduciary duty on the part of scheme managers to assess the asset managers' personnel, practices, internal systems and controls, and its adoption and engagement with 'Best practice' principles: all of these factors, and more, will need to be considered during the investment decision-making process.

The emergence of liability-driven investment

As we know, liability-driven investment (LDI) is an investment strategy in which the core objective of a pension scheme is to ensure that investment is effected in such a manner that the returns meet the liabilities of the scheme, without incurring excess risk.

As more scheme managers adopt the principles of LDI, the opportunity for such investment strategies to adopt non-traditional assets such as life settlements, as credible LDI solutions, is growing. Life settlements, where the maturity proceeds are known and certain, may offer a solution. However, as the timing of returns is not known with certainty, it is imperative that the scheme manager is satisfied with their understanding of how life expectancy is assessed and its impact upon asset performance. One solution could be the introduction of longevity extension risk reinsurance, whereby the tail risk of life settlement investment would be substituted for reinsurance coverage risk: the latter can be independently assessed, and then divested.

In the here and now

In spite of innovative developments in asset diversification, greater focus upon manager selection, and new investment strategies emerging, certain risk exposures remain when investing in life settlements. However, it is important to bear in mind that these risks can be identified, addressed, and mitigated, as they can with other more traditional asset classes.

To do so, scheme managers would also need to assess a variety of factors in their appraisal of the asset class. As the estimation of life expectancy of the life assured in a life settlement has a pivotal role in value creation, suitable due diligence on the life expectancy assessment is critical, involving an in-depth appraisal of their interpretation of the mortality tables.

Those asset advisers who execute regular on-site due diligence of these assessors can offer a greater understanding of the factors that contribute to this assessment. Market developments can also assist in this endeavour: the Life Insurance Settlement Association (LISA) has recently released a common mortality table, which will enable life expectancy underwriters to measure their actual-to-expected results using the same basis of measurement. This development will assist investors in their comparison of the accuracy of each of the underwriters assessments, a pivotal issue in the asset valuation process.

Demand-side: growing regulatory oversight

On February 24th, Peter Smith, Head of Investments Policy voiced the FSA's concerns about a number of issues in the context of Treating Customers Fairly, particularly with regard to risk disclosures to investors. However, in the speech, the regulator did not object to the asset class nor question its appropriateness for sophisticated investors: rather it has stated that obligations rest with both providers and advisers to deal with the risks faced by investors and explain these to investors accordingly. Those scheme managers who engage with a highly-regulated organisation, subject to regular audit and continuous regulatory oversight, can offer investors this necessary peace of mind.

Going forward

The principal factors in the habilitation of life settlements as a credible investment opportunity include increased transparency, regulation and consumer protection.

In the absence of a uniform valuation methodology at this time, it is imperative that scheme managers identify and understand the key determinants of asset value derived from a mark-to-model basis. To do so, those asset managers that execute regular in-depth due diligence of life expectancy assessors need to demonstrate how such due diligence is exercised.

Furthermore, those managers that source assets in a transparent and efficient manner, employing proven expertise to address the incidence of STOLI, can provide assurance to pension scheme managers that any legal title risk is eliminated.

On the supply-side, greater State regulation will underpin the valuable utility presented by life settlements to the vendor: the consumer. Growing Federal recognition of the consumer utility of the secondary market, as illustrated by the Senate Bills of Oregon, Maine and Washington State, will also augment investor acceptance.

On the demand-side, greater oversight of investment product creation by both UK and overseas regulators will ensure that investors are aware of the relevant risks involved in life settlements.

Underpinning the future growth of investment in life settlements as a stable, low-correlated investment opportunity is the future emergence of a uniform and transparent valuation methodology. In the meantime, those asset advisors and managers that exhibit a fiduciary standard to investors aligned with the implicit fiduciary duty held by scheme managers can offer a crucial source of asset knowledge and expertise based on the principles of transparency, consistency, and investor protection.

Sources:

  • Life Insurance Settlements Association
  • Conning Research & Consulting, 'Life Settlements: A Buyers' Market for Now', 8 October 2009
  • Life Settlement Review, April 2010
  • Life Exchange 'New York Enacts Comprehensive Law to Regulate Life Settlements', 18 Nov 2009
  • Insurance Studies Institute, 'Secondary Market of Life Insurance and Related Insurer Challenges entering 2009', January 2009