Institutional investors may be shaking off any reputational aversion they had to life settlements, desperate as they are for genuinely uncorrelated assets. MICHAEL BAILEY examines the current state of the asset class and its two means of access – synthetic or physical. The life settlements market has benefited from the entry of large investment banks, which have helped the industry shake its “cowboy” image, according to a visiting actuary and advocate for prospective investors in the asset class. David Fishbaum leads the actuarial unit of Oliver Wyman, a sister company to Mercer under the Marsh McLennan umbrella. He was in Australia last month to speak to a growing number of local institutions interested in life settlements, attracted by the promise of a 13 per cent annual coupon, but worried about the reputational risk of investing in a ‘death fund’.

This unflattering moniker was bestowed by the Fairfax press upon Australia’s hitherto leading player in the life settlements market, the Gold Coastbased Life Settlements Wholesale Fund, in a December article questioning Victorian Funds Management Corporation’s $600 million investment. It’s the type of media reaction that Fishbaum has seen before, but which hearkens back to a “cowboy environment” in the asset class which he believes is disappearing. A director of the Life Settlements Fund, Stephen Knott, suggests that investment banks can hardly be said to enhance the counterparty risk of investing in the asset class. “We own 570 life policies issued by 70 different insurers, most of which have higher credit ratings than the investment banks.

Why would you trade the credit rating of 70 insurers for a synthetic exposure to life settlements through one bank?” Knott asks. Life settlements is a peculiarly US asset class, as since 1911 Americans have had the right to transfer ownership of a life insurance policy. However the ‘surrender value’ paid by the life insurers for their own policies has always been low. The asset class came of age during the AIDS epidemic of the 1980s, when the relative certainty of a sufferer’s lifespan encouraged brokers to pay them more to take over their policy than life companies were willing to give. Fishbaum admits that as the life settlements industry has developed over the past two decades, any bad press has usually been associated with a particular death, when it is revealed what a broker paid to take over paying premiums on the deceased’s life insurance policy, and this figure is compared to the final (much larger) payout accruing to the life settlement investor. However, he says increased competition in the marketplace is closing this gap.

For example, a series of case studies from a major US broker shows that the amount a policy can fetch on the life settlement market can be as much as 40 times its cash surrender value. The individuals underlying the life settlements in Stephen Knott’s fund have an average age of 80, all of which have been purchased since the Fund’s inception two years ago, and he confirms that some individuals have been paid as much as 40 per cent of the face value of their policy to transfer them, while the average cash surrender value is more like 5 per cent. The broking side of the industry has also been cleaned up, Fishbaum contends, with investment banks driving many of the reforms. “The relationship between an investment bank and a person selling a policy is a retail transaction, so they have a reputation to protect.

The industry standard now is that brokers have to say how much compensation they are getting, and the beneficiaries of the individual’s policy being sold have to be notified and not object,” Fishbaum says, adding he knows of several brokers who have been blacklisted by institutional buyers of life settlements for failing to uphold appropriate standards. Fishbaum’s advice to institutional investors in life settlements is to emphasise the social benefits brought by the market. “This is plainly not about ripping off grandmothers. Many people take out life insurance when they are starting a family, for example, but then their children grow up and move out, they might retire from full-time work, they might have medical bills – in short, their circumstances change, and continuing to pay the premiums on a life policy may not best suit their needs,” Fishbaum says.

Knott also dismisses the mainstream media’s tendency to portray life settlements as somehow preying on the elderly and vulnerable. “The average face value of a policy in our portfolio is $US4 million. They’re often entrepreneurs who’ve had to take out life insurance as part of a ‘key man’ clause with their financiers. They go to the meeting with the [life settlement] broker accompanied by their lawyer, they’ve come to do business.” The life settlements market can be accessed through products which directly own a group of policies, at least 200 but typically more than 300 according to Fishbaum – as mentioned, Life Settlements’ fund has 570 – although investment bank entrants have instead offered derivative swaps which reference the market. Investors pay an upfront fee and an annual charge towards the cost of purchasing and then ‘maintaining’ (ie paying the premiums on) the policies, and Fishbaum argues that a swap reduces the impact of fraud related to any particular policy, or the cost of insurance increasing.

Knott counters that synthetic access can be more expensive and heightens counterparty risk, and says he is yet to see a life settlements-based total return swap gain any institutional investor support. Once the initial structuring of the investment is set, Fishbaum describes life settlements as a relatively passive asset class, suited to patient long-term investors – the incentive to trade is dampened by wide bid/ask spreads which reflect the amount of administration it takes to change the beneficial owner of a policy, which also means resetting the life expectancy of the underlying individual. On that front, Fishbaum says there was good news for prospective investors in life settlements late last year, when America’s Association of Medical Underwriters dramatically changed the life expectancy assumptions which underlie the creation of the deals. “In the early years of this asset class, some investors got burned because the life expectancies were not as long as they should have been, so they didn’t earn as much because they were paying premiums for longer.

But if you buy a life settlement now, the price will reflect a life expectancy which has gone up by 10 years on what it would have been 12 months ago.” Knott says the bump up in life expectancies was less for the Life Settlements Fund, more like one year given the older profile of its pool of lives. He says the reduction in the Fund’s unit price late last year (referenced in the aforementioned Fairfax articles) was more due to adverse USD/AUD currency movements, which the Fund has since addressed by fully hedging. The Fund’s ordinary units have since recovered to record a 26.14 per cent increase for the 2008/9 financial year (7.7 per cent since its 2006/07 inception), although it is yet to pay a distribution of income from the ‘maturation’ of policies.

Knott says that barring any major inflows or outflows (the Fund froze redemptions in the wake of the AIG bailout but reopened five months ago), he expects the Fund to pay a distribution in the next 12 months. Knott adds that US life insurance companies have varying attitudes to the life settlements industry. While he speculates that much of the negative press toward the asset class is fed to journalists by insurers, he points out that many of them, such as AIG and Swiss Re, own large books of life settlements (not their own paper, of course) which they use to assist in liability-matching for their investment portfolios.

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