By Neil O’Hara
Ghoulish perhaps, but not without gains. That’s the take of hedge funds trading life settlements, or the practice of purchasing life-insurance death benefits in the secondary market. Though somewhat illiquid and challenging to leverage, the life settlement trade’s attractive potential return, high Sharpe ratio and low correlation to other asset classes has recently drawn Fortress Investment Group, Plainfield Asset Management, Davidson Kempner and Highland Capital into the action. SilverPoint Partners and XE Capital are old timers, having been involved in the market from inception at the beginning of the decade.
The life settlements market is growing fast, up to $15 billion this year from $12 billion in 2008. But it’s still tiny compared to the U.S. life insurance market, weighing in at $27 trillion. Moves now afoot to securitize this emerging asset class could inject fresh liquidity and draw more hedge funds into the trade.
Already a few of these early participants have accumulated portfolios large enough to securitize, though the deals have not been tested in the public market. In February, Davidson Kempner filed a private offering memorandum in Dublin, Ireland, for notes to be issued by DK Life Settlements Acquisition, an offshore affiliate of the $9.6 billion New York City multistrategy hedge fund. It is unclear whether any notes were ever sold as the firm declined to comment. Meanwhile, in January, American International Group completed the first rated securitization of a life settlements pool, but it was an unusual transaction. The deal, rated by A.M. Best, was part of an internal restructuring in which the parent company sold the notes to a regulated subsidiary. No money was raised from outside parties, so it didn’t truly test investor appetite for the securitized bonds.
The concept of betting when people will die may seem distasteful, as if investors are cheering on the Grim Reaper. In fact, this trade is embedded in every life insurance contract ever written, a form of protection against financial catastrophe. As people age, however, their circumstances may change so that what was once an essential part of their financial plan becomes superfluous, especially as the annual premiums continue to escalate. In the past, consumers either let their policies lapse or turned them in to claim the cash surrender value, typically no more than 5% of the death benefit.
The life settlements arbitrage is structural, based on the fact that for some people, the cash surrender value of a life insurance policy is significantly mispriced relative to the death benefit. For example, a 76-year-old man who doesn’t smoke but who has had a heart attack has a shorter life expectancy than the number in the actuarial tables used to calculate the cash surrender value of his $3 million universal life policy when it was issued years earlier. Hedge funds and other investors figure they can afford to pay a cash sum to the policyholder of two to four times the surrender value in return for assuming responsibility for future premium payments and collecting the death benefit in due course.
“The policyholder is going to die sooner than the insurance company thought he would, so there is more value to the policy,” explains Larry Simon, chief executive of Life Solutions International, which develops and implements life settlement investment programs for hedge funds and other clients.
Life insurance companies frown on the settlement game, but not for altruistic reasons. People are living longer than the insurers assumed at the outset, which means universal life policyholders face higher premiums to maintain coverage as they get older.
The overwhelming majority of life insurance policies—at least 70%, according to industry sources—never pay a death benefit because policyholders either outgrow the need or can no longer afford the premiums. If someone sells a policy in a life settlement instead of letting it lapse, the buyer keeps the premiums current in order to collect the death benefit, which is the deal’s eventual payout. Life settlements therefore erode the lapse ratio, which cuts profits for the life insurers and could eventually cause them to raise premiums.
Howard Freedland, CEO of Global Life Underwriting, argues that the insurers exaggerate the effect. For new policies issued to people aged 70 or older, he says the lapse ratio is much lower, at 5% to 8%. “When a policy is issued to somebody of older age, the carrier assumes that policy was put in place for estate planning purposes and will remain in force,” he says. Freedland points out that life settlements are not a one-way street: The insurers collect more premiums than they would if the policy lapsed—and more than they assumed when the policy was underwritten if the insured lives longer than expected.
The life settlements market is too small to have a significant effect on carrier profitability anyway, says Mark Todd, vice president of capital markets for Maple Financial, a Bethesda, Md., firm that helps institutional investors acquire and service life settlements. Even if securitization takes off, the limited number of suitable policies will keep a lid on the business. Says Todd: “I don’t ever see it being as great as 1% of the total insurance class,” he says, “If it ever got too big, you would be concerned about the carriers making the payout because they had incorrectly priced the premiums. The business would eat itself.”
The huge spread between cash surrender and life settlement values stems from the fact that the life insurers, which are focused on volume sales, cannot afford to reassess individual policies. It isn’t worth the effort for the few high-face value policies they might acquire. “If a carrier could reunderwrite the policies we buy, it would probably pay the same amount,” Todd says. “We have more up-to-date medical information.”
The spread doesn’t guarantee outsize returns, however. The buyer must pay premiums until death occurs, so the return drops quickly if the seller lives longer than expected. Shorter life expectancies magnify the effect: An extra year on a five-year base represents a 20% increase in duration, twice the impact it has on a 10-year base—and the buyer also has to pony up another year’s premiums. That’s why most investors try to build a portfolio diversified by age, life expectancy, health condition, insurance carrier and region, even though the potential returns are highest on the shortest life expectancies.
In certain respects, the asset class is ill-suited to hedge funds. Liquidity is limited, and the unlevered returns don’t meet the minimum threshold many funds target. “It’s an investment-grade return without any structural enhancement. It’s hard to justify hedge fund fee structures,” says Scott Willkomm, senior vice president of business development at Coventry First, a major market player that both buys policies for its own account and helps third parties assemble portfolios. Hedge funds must leverage life settlement portfolios to bump returns into double digits, as they do in many other asset classes.
Getting that leverage isn’t necessarily easy. Borrowers won’t offer unlimited credit against an asset that has negative cash flow in the early years. Michael Krasnerman, CEO of AllFinancial Group in Stamford, Conn., finances his portfolios with 20% to 25% equity and borrows the rest, most of which he uses to finance premiums. “I am looking to make returns in the midteens,” he says, “Without leverage to pay the premiums, it just doesn’t work.” Another hedge fund uses similar leverage to boost unlevered returns to the midteens from a historical 9% to 10% range, although in today’s tight market for illiquid assets such as life settlements it has been able to buy policies at unlevered yields in the high teens.
Krasnerman began investing in life settlements in 2001. He only buys policies with large death benefits—the average in his portfolio is $7.7 million—from sophisticated seniors usually acting on the advice of their attorneys or estate planners. “Unless we buy the policy, it will lapse and the insured will lose everything they paid in,” Krasnerman says, “We are talking about millions of dollars.” In return for a cash purchase price, AllFinancial pays the future premiums and takes on the extension risk that the seller will live longer than expected.
Transactions can be customized to meet a seller’s particular needs, too. Krasnerman may buy just part of the policy and leave the insured with a reduced interest in the death benefit if, for example, the potential estate has diminished in value—an all-too-common occurrence in the past two years. “We have developed a proprietary methodology and pricing model that allows us to deal with the extension risk,” he says.
Because life settlements are not correlated to equities, bonds or any other financial asset and have low volatility, the risk-adjusted returns soar off the charts. “The Sharpe ratio is so high—6 or 7—that you think you did the math wrong,” says Coventry’s Willkomm. While those risk/reward characteristics have attracted some hedge funds to the market, the credit crisis forced others to pull back. For example, New Stream Capital reportedly suspended investor redemptions late last year as a result of low liquidity, including the commitment to support its life settlements portfolios.
Some managers have set up funds with alternative fee structures, liquidity levels and leverage in order to participate in the market. London-based Centurion Fund Managers began investing in life settlements in 2002 and now runs more than $400 million in open-end funds. Managing director David Rawson-Mackenzie offers investors monthly liquidity—but only after three or six months’ notice. “It is a semi-illiquid asset,” he says, “I’ll hit investors with a redemption penalty of up to 12% if they go in one month and come out the next.”
Despite all the talk about the impending securitization of life settlements, knowledgeable insiders are skeptical. Most life settlements portfolios are too small to support securitization. At a hearing of the House Financial Services Committee on September 24, Daniel Curry, president of rating agency DBRS, said that his firm had looked at 14 proposed transactions but had not rated a single one. Two were still under review, but the rest either failed to meet its criteria or did not go forward.
Emmanuel Modu, global head of structured finance at A. M. Best, dismisses fears that life settlement securitization could turn into a repeat of the subprime mortgage disaster as overblown. For one thing, investors in life settlements do not depend for the ultimate payout on individuals whose ability to pay may be adversely affected in an economic downturn. The death benefits are funded by corporate credits—and U.S. life insurance companies have an unblemished record of meeting those obligations in full. “Unlike mortgage-backed securities, these transactions should be self-contained,” Modu says, “Assuming you size the reserve account properly so that you can pay premiums, there should be no need for any external contributions.”
In addition, it would require at least 300 high-value policies to create a portfolio that would meet the stringent standards for diversification in Best’s rating methodology. That’s a tall order when AllFinancial, one of the top five players, has acquired fewer than 700 policies in its entire existence.
“It is a fantasy to assume securitization liquidity on the scale of mortgages,” Krasnerman says.
One danger with securitization may be that if packagers can’t find enough high-value policies to fill their pools, they will try to manufacture them through stranger-originated life insurance (SOLI), an unsavory business in which an investor offers a cash sum up front to wealthy seniors to take out life insurance policies they would not otherwise buy. The investor advances the premiums until the contestability period expires—two years in most states—and then takes over the policy in a life settlement. Highland and AllFinancial never buy SOLI policies, although it sometimes requires forensic due diligence to sniff them out when they are buried in a complex trust structure. Plainfield doesn’t rule out SOLI policies on principle but takes care to abide by applicable state law and to ensure it acquires a valid insurable interest.
If securitization does happen, it will provide a new source of liquidity to hedge funds already in the market and is likely to attract more players to the game.
“Hedge funds will be packagers and sellers,” says Freedland of Global Life Underwriting, “They will accumulate individual assets and smaller portfolios, aggregate them, apply securitization techniques and hold on to the excess upside free and clear of the rest.” To hedge funds, the longevity arbitrage—a death watch—is just another opportunity to generate returns.
