Valuation Dilemmas in Life Settlements

Have you ever wondered why so many life settlements funds vary in expected returns? During your due diligence have you found it difficult to compare returns of what appears on the surface to be apparently similar life settlements funds? Valuation risks are possibly one of the key administrative dilemmas facing the asset class and one which many industry players struggle in mitigating. This phenomenon has resulted in investor disappointment particularly among the less sophisticated players.

There are of course a number of approaches to valuation. Different funds with differing types of investors and objectives may well use differing valuation methodologies. The principal question an investor needs to ask is “Is the Valuation methodology employed by my fund valid for my circumstances and do I fully understand both its uses and limitations?”

This issue is one of the main reasons why life settlements have been allegedly “miss-sold”, if you can believe certain regulators, to “retail” investors.

First let us set the scene by understanding the nature of the asset.

A life settlement is defined as the sale of an unwanted traditional US Life policy by its original owner to a third party investor at a discount to its “face value” for an immediate cash settlement. This settlement is well in excess of the policy’s “surrender value” from the issuing insurance company. The new owner assumes full responsibility for paying future premiums until the benefit is claimed. The type of life policy typically sold in this transaction is any one of a variety of what are called “Universal Life Policies” (these are known technically as “Non-Participating permanent Life Insurance contracts”).

These policies therefore have fixed benefit amounts (face value) and a high credit quality, somewhat like a bond, but the term is uncertain, they have a negative coupon stream (premiums) and the mechanism for sale is complex (unlike a bond).

Occasionally these secondary market policies may again change hands among investors in a tertiary market transaction but do not be fooled, life settlement policies are certainly not “Trading Assets” like stocks or bonds. While this demonstrates a limited level of liquidity/ saleability, remember life insurance policies are also not “Trading Assets”, changing hands instantaneously in a deep liquid market of a vast supply of identical securities, through centralised exchange mechanisms.

Therefore the concept of “Market Value” is not nearly so clear.

There are a number of reasons for this.

  • Life Settlements are not homogenous or identical securities.  Their value is derived significantly (but not exclusively) on the characteristics of the underlying insured life. Every life is different.  However, even two identical insurance policies with the same benefit amount, issued by the same insurance company, insuring the same life may have differing economic values if they were taken out at different times when the insured life had a differing health status.
  • Selling a policy into the market is relatively cumbersome and time consuming process requiring due diligence and research including updating health records and life expectancy estimates.
  • There is no centralised exchange with a consistent deep pool of prospective buyers.
  • Rather selling a policy is typically done by an informal auction process with at times few if any prospective buyers and some of whom are of variable expertise and means. Hence this illiquidity premium should be given considerable attention in your return estimates.
  • The industry has never settled on a sufficiently robust grading system to get groups of policy data into meaningful subsets to begin to allow comparison.
  • Hence any talk of benchmarking or even rudimentary comparison is problematic at best at this point.

Where do we go from here?

Therefore a life settlement as an investment play is most logically, strongly skewed to a buy and hold strategy only.

Therefore how do you “value” a financial instrument that may never “trade” again and may have no identical direct or sufficiently similar proxy for comparison?

The short answer is of course that the industry continues to evolve on this issue. It seems not that long ago that the eminent Deloitte-University of Connecticut 2005 Actuarial Perspective on Value used among other things a “Finance Theory” approach which was essentially a discounted cash flow calculation based on a “Life Expectancy” date i.e. a fixed term duration. Prior to that there was the old ASB ruling that life policies could only be held at the lesser of their surrender value or cost. This now seems almost like a “stone age” approach.

One solution of course is to use the “cost” method and simply accumulate the original purchase price plus any premiums paid along the way. This makes cost accounting upon collection of the benefit quite simple. You must fully realise however, that despite your intention to hold the policy to maturity, if you ever needed or wanted to re-sell it, the realisation price may bear no similarity to your accounting value.

The second popular method that “tries” to equate “fair value” is to use a probabilistic valuation methodology. This method needs to use a Mortality Table (Which one do I use?) as well as make a number of assumptions like discount rates (Which one do I use as there may be no sale with directly comparable results as mine?). Obviously the output is only as good as the assumptions that have been made.

Do I despair at this point? No! Resoundingly No! We simply need to embrace the characteristics of this investment class (Lack of Correlation, Risk/Reward proposition to name a few) and manage it accordingly.

We believe that the Valuation issue will continue to evolve as it has done so in the past and by necessity will continue to do so in the future as the industry itself has evolved.

A recent empirical study by Juanuário & Naik (2014), ‘Testing for Adverse selection in life settlements: The secondary market for life insurance policies’, suggests that “the primary determinant of returns across life settlement contracts is not adverse selection relative to underlying life expectancies, but other economic phenomena such as cost-benefit trade off, bequest motive, convexity of premiums, diversification of unique risks and mitigation of life expectancy estimation risk.Additionally through testing a sample of 9,002 life insurance policies the authors suggest that even if the life expectancy estimates were extended by 36 months the sample still showed a positive return for that portfolio sample."

Without stating the obvious, but we will anyway, the success of a life settlements portfolio has everything to do with the policies and not just the LE’s. We are talking about how each individual policy has a role to play in the success of the fund. Each life insurance policy which is added needs to be considered on a policy by policy basis and how it complements other policies in order to play a fundamental role in returns.

Clearly traditional forms of evaluating a performance of an investment will not give you the best assessment of investing in a life settlements fund. By not displaying a more holistic and asset specific valuation of the investment you are not doing the asset class any justice.

Although it appears to be a simple asset class there is a lot more involved to constructing a successful portfolio then just the LE’s. Don’t make simplistic assumptions and find an experienced fund manager willing to assist you in the right direction.

There are a few successful managers in the life settlements industry who have successfully mitigated the struggles of valuation in the industry and hopefully we have managed to outline the complexities of valuations in the life settlements market.

As always we wish you well with your life settlement investment opportunities and if you want to learn more about investing in this asset class please contact us.

 

Contact Stephanie Nolan (COO & Director)

Contact Stephen Knott (Director)

 

 

 

Disclaimer: This information is intended for qualifying investors only and was correct at the time of preparation. It has been prepared to provide general information only and should not be considered as a “securities recommendation” or an “invitation to invest” in any jurisdiction. Potential investors should consider the relevance of this information to their particular circumstances. Before proceeding investors must obtain the prospectus and take their own legal and taxation advice. If you acquire or hold one of our products we will receive fees and other benefits as disclosed in the prospectus and relevant offering documents.

Tags: Valuation, Policies, Portfolio

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