Life Settlements The Growth Rate Continues
by Harry Beck, CFA. CFP, CLU

Institutional buyers will purchase $15 billion in life insurance policies this year, according to estimates by Doug Head, the executive director of the Life Settlement Industry Association. That’s a 25% increase from last year and a 1,500% increase from five years ago. Will this growth continue?
The life settlement industry is no different from any industry with supply and demand components of its growth rate. The supply is from policy owners wanting to sell and the demand is from institutions purchasing. Most agents and brokers are already familiar with the supply component of policies to be life settled: Sellers want to receive cash from unwanted or unneeded insurance that would otherwise lapse. Sellers want to use the settlement proceeds to improve their insurance or investment program.
The less-understood demand side of the settlement industry warrants further explanation.

Institutions are always looking for efficient ways to maximize returns for a given level of risk. Investors seek out investments and investment combinations that give greater returns with lower risk. Many institutions believe that a life settlement is a defined asset class, which can provide more efficient portfolio returns.

An easy and entertaining way to explain the demand for policies is through a fictional conversation with the managing director of a successful multi-billion dollar hedge fund and a young analyst on his fixed income desk. The analyst thinks he found a great investment for the fund:
Young Analyst: Hey boss, I’ve been doing a lot of research on investing in life settlements. I found that they could give us an easy 18% or better return on a leveraged basis.

Managing Director: What the heck is a life settlement?
Young Analyst: It’s when an institution like AIG, Bluecrest, Citi, Deutsche Bank, or HSBC buys life insurance policies for an amount that’s greater than the cash surrender value. They make premium payments on the insurance. They collect a taxable death benefit when the insured dies.

Managing Director: Why should we do it?
Young Analyst: We can make a great return. Insurance carriers are purchasing policies through cash surrender at prices that don’t come close to the fair market value. Life insurance owners want a fair price. Since a life settlement is a non-correlated asset class, it offers unleveraged returns that are better than equities.

Managing Director: What is the market growth?
Young Analyst: Around 25% per year.
Managing Director: How do we make the money?
Young Analyst: We borrow some money at LIBOR plus a few basis points to purchase policies. Policies are generally priced to give the buyer an internal return rate of around 13%. Then we securitize the investment pool in a few years. We price it so the new investors get a 9% return, just like the big European banks and funds are doing. The profits would be mind boggling if we bought at 13% and sold in a few years at 9%.
Managing Director: I’m interested, kid. How much of an investment is necessary to give us appropriate risk control?

Young Analyst: Not much. People here can do accurate statistical calculations to manage the risk. We will also have to hire an underwriter and an actuary. The good news is that insurance industry wages don’t match what we pay on Wall Street. So, we should have no problem finding people.

Managing Director: Yeah, but what is our investment?
Young Analyst: We need around 250 policies averaging $1.2 million each to be well diversified. Three hundred million in capital is more than enough to buy the policies and have adequate reserves for premium payments. Heck, we can always borrow the money to pay premiums instead of reserving it.

Managing Director: So how do we maximize the rewards?
Young Analyst: We don’t buy policies outside of 12-year life expectancies. That is when the actual-to-expected mortality confidence drops off a cliff. We use two mortality calculations instead of one. We order a third if the two are 20% off. We also spread the range of life expectancies between three and 12 years for the policies we purchase. The early death benefits can pay the premiums on later policies. The other risk control comes from the carriers’ ratings; it comes from the quality of the mortality calculations, which is also known a life expectancy; and they come from the spread of years that we purchase the policies.

Managing Director: How good are these mortality calculations?
Young Analyst: A few years ago, they were horrible. Some investors barely earned LIBOR. The biggest provider in the industry sued some of the biggest issuers of life expectancies. Since the lawsuit was settled, the calculations are now accurate and statistically significant.

Managing Director: Who manages this stuff after it is bought?
Young Analyst: For a few bucks, we can hire one of the big banks to act as escrow agent and custodian. Wells Fargo is the 500-pound gorilla in this space.

Managing Director: How big is the potential market?
Young Analyst: It’s enormous. There is no perfect data, but we can estimate that 95% of term policies and over 80% of permanent policies lapse. Best of all, 85% of the life insurance agents have never settled a policy for a client. Eventually, they will figure out what is going on and help their clients. There is something like $14 trillion of life insurance in-force right now. The Baby Boomers are becoming seniors, so the supply of policies to settle keeps growing.

Managing Director: You got my interest, kid. Write me a white paper on this industry. I want it on my desk in 72 hours. Maybe we’ll throw $300 million at this and see what happens.

This fictional conversation highlights the benefits and relative ease of entering the settlement market by any large institution, which I define as a bank, corporation, hedge fund, pension fund, or large family office. These institutions are always looking for ways of earning more efficient returns. They are now looking towards an investment into a pool of life settlements to provide reasonable returns.

So what can stop the demand for policies? The answer is simple: Limiting policy supply through carrier supported anti-settlement regulation.

Will state legislatures or insurance divisions pass legislation, which the life settlement industry will spin as anti-consumer?
I think that is highly unlikely, particularly in consumer friendly states like California. Even the highly publicized NAIC Model Act supported by NAIFA didn’t ask to eliminate life settlements. The purpose is to curtail the stranger-owned life insurance schemes designed to be a conduit into a life settlement and only one state has adopted the model!

A well-known economist once told me that making money is as simple as finding a trend early and acting appropriately. The life settlement trend is certainly early and strong. The supply and demand components to this trend are growing. Therefore, the growth rate will continue. Are you going to be part of it?
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Harry Beck is executive vice president of Provada. For more information, visit www.provadasettlements.com.