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22 April 2010

SL considers challenges and opportunities in the Life Settlement Market

On February 24th, the FSA selected the inaugural European Life Settlement Association's (ELSA) conference, as the forum to outline its regulatory priorities for the Life Settlement Industry. Peter Smith, Head of Investments Policy voiced the FSA's general areas of concern - in common with other asset classes - relating to:

  1. Volatility of returns arising where there is insufficient portfolio diversification
  2. Potential for  liquidity risk arising from fixed term product offerings
  3. Counterparty risk, with particular focus upon the risk of insolvency of policy issuers
  4. Potential for loss arising from deficiencies in the accurate estimation of mortality, as well the reduced ability to track mortality

Overall the FSA has commenced a thematic review of the market in the context of Treating Customers Fairly, particularly with regard to product design, suitability of intermediary sales, the disclosure of risk factors to potential investors, and the remuneration of intermediaries. This last point is particularly timely in the run-up to the implementation of the Retail Distribution Review, with regard to addressing the potential for adviser remuneration to distort consumer outcomes.

Patrick McAdams, Chairman of ELSA, and Investment Director at SL Investment Management Ltd, welcomed the comments made by Peter Smith, noting that the regulator has not objected to the asset class nor questioned its appropriateness for sophisticated retail investors. The FSA has outlined that obligations rest with both providers and advisers to deal with the risks faced by investors and explain these to investors accordingly, a stance fully supported by ELSA.

As a result of this speech, much media comment has focused upon these risks, possibly eclipsing a much more fundamental question that each potential investor should address prior to investment. That is, how is asset pricing and portfolio valuation determined within a portfolio of life settlements? Are valuations derived from a linear (formulaic approach) approximation of asset value creation over time, or via a more robust actuarially driven review, assessment and estimation of mortality?

The raison d'etre of ELSA is to promote transparency, a code of practice, and effective industry self-regulation, with the ultimate goal of building confidence in the life settlement market on the part of investors. To that end, the FSA speech has been welcomed by both ELSA and the conference attendees as a necessary and vital milestone in the ongoing maturation of the asset class.

The attention of the FSA in the UK compliments the ongoing regulatory development and acceptance in the United States. Over three quarters of US states now regulate the secondary market for life settlements, of which three states now formally endorse, within Senate Bills, the secondary market as an alternative to surrender for policyholders wishing to dispose of their policies. Indeed, the legislation which underpins the secondary life market, namely Grigsby v Russell (1911), is now fast approaching its centenary. It has been estimated that nearly 90% of eligible settlers now reside in states that have robust state regulation.

However, on the back of general market disturbance, 2009 saw a flood of articles published in the US accusing the potential securitisation of life settlements as both macabre and economically destabilising. These fears were echoed by American Council of Life Insurers, which stated that the securitisation of life settlements should be banned as it creates an environment in which fraud could occur.

In response, many observers including the Senate Finance Committee have suggested that these fears are largely unfounded, and that the securitisation market is beneficial as it would facilitate an increased demand thus raising competition for policies, thereby allowing consumers to obtain the most money for policies they legitimately wish to sell. In reality, the underlying economics and pricing associated with Life Settlements is not dissimilar to the Pensions market, which no-one would suggest should be banned ! Thus emphasising the need for sound actuarial modelling and review.

Underpinning all of this justified regulatory attention is a growing investor demand for low-correlated returns. Indeed, the global financial crisis since the summer of 2007 has provided grounds for further interest, especially from institutional investors with long-term time horizons. 

In 2010, the market received a marked increase in investor enquiries from a wide range of investors including pension schemes and family offices. One criticism from large non-bank institutional investors is the perceived absence of investment scale of the secondary market.

Research from Bernstein states that US seniors aged 65 and over currently control approximately $420bn of life insurance. Connings Research estimates that the death benefit value of secondary life settlements in 2008 reached $11.8bn in face value, resulting in a market penetration of around 2.8%. Data from the US Census Bureau indicates that this age group is expected to grow from 38m today to 71.5m by 2030. Assuming that the ownership rates and average policy death benefits remain static, and the penetration rate increases to 10% by 2030 due to growing awareness of the secondary market, we would expect the secondary market to grow to $80bn per annum by 2030: 

Whilst the above estimates will depend upon capital inflows into the market, coupled with further market innovations such as portfolio securitisation and longevity extension risk reinsurance, a more immediate challenge to pension investment in life settlements is the perception of relevance. That is, the importance of mitigating capital asset volatility has been eclipsed to some extent by risk of longevity extension: investment in life settlements is often perceived as an exacerbation of this longevity risk. However, this is incorrect: investment in life settlements can generate investment returns with a minimal degree of correlation to the economic cycle or traditional asset classes of fixed income, equity and cash.

A small number of players have decided to exit the market at the current time however we suggest that this is not necessarily indicative of the future of the market. Indeed, many alternative investment banks continue to push forward with product innovation, to address investor demands and a changing regulatory climate. To that end, many banks offer synthetic replication of a physical portfolio of life settlement policies, thereby minimising the effects of a ramp-up period, greater portfolio diversification, and increased counter-party security. However, whilst synthetic exposures are issued by large reputable banks, it is still good business practice to undertake a high degree of due diligence on both the issuance and the issuer to ensure that the product is fully understood.

So, is the FSA justified in its concerns? The answer is, predictably, yes and no.

It is true that suitably structured life settlement products can provide an attractive level of stable returns, characterised by low volatility and minimal correlation with traditional asset classes, within a well-diversified portfolio.

However, there are justifiable concerns regarding offering product to the retail investment space. Notable illustrations of this point are the Defined Income and Secured Income products marketed by Keydata Investment Services, in which the realised proceeds of life settlement policy maturities used to meet contractual income payment obligations fell short of expectations.

To successfully examine and review a life settlement-based investment product, financial advisers should ideally focus their analysis through the prism of transparency (particularly the remuneration of intermediaries), education (of investors, regulators, and market observers) and valuation (the appropriateness and actuarial robustness of the methodology used to derive asset value). If a proposition fails these "tests" - the simple rule is - avoid it.

Overarching these central tenets is the principal of a fiduciary standard extended by the product provider to the investor. By following these tenets, product providers and professional intermediaries can ensure that investors are fully aware of the risks, and the considerable opportunities of investing in traded life settlements.