Risk is a feature in any investment decision. There are risks that you can quantify and manage or mitigate and there are those that you cannot. First time investors in life settlements are often not aware of the unique risks and opportunities only present in life settlements.
It is reasonable to conclude that life settlements aren’t a risk-free asset class. Like any investment they contain risks associated with in this asset class alone. In addition to the normal investment risks a prudent investor would consider. There are the common operational risks such as longevity, credit rating, origination risk and a few more. However, investors also need to consider some uncommon risks as they too can affect returns and performance expectations.
Miss-placed expectations can cause some investors to make reactive decisions either at the beginning or end of an investment process.
1. Capital Outlay in Life Settlements
In the past, we have shone light on the contrasting funds’ experiences including poor initial performance. Discussing how, in the life settlements asset class, early under-performance is not necessarily the best indicator of future outcomes.
The normal expectation for a newly established portfolio is an initial period of small negative return, because of continued premium payments and initial capital in purchase of policies. Furthermore, there is a low probability of actual maturities in the first quartile of expected experience. An initial negative return profile similarly observed in investments like infrastructure or portfolio of un-developed real-estate.
Another factor limiting significant early maturities is the phenomenon of “Anti-selection bias.” Anti-Selection bias is the phenomenon where individuals with a positive outlook on their health are more likely to sell their Life Policy and those of a similar health status but with a negative outlook. Hence, the probability of experiencing early maturities by the new owner is reduced.
In contrast to this normal expected experience we have seen some funds report regular returns in an almost “Bond-like” display of nearly identical smooth monthly returns from day one. This defies the logic of anyone familiar with the behaviour of longevity based instruments.
Investors should be wary of funds; whose returns indicate regular and invariable positive returns from the very outset of a fund’s establishment. Initial negative returns are normal and a portfolio should be expected to experience lumpy returns.
2. Lumpy Returns for Life Settlements Funds
Life settlements can add value to investors’ portfolios as mortality is not influenced by the volatility of traditional financial markets. Although, it displays a low correlation and limited volatility, investors need to consider the unique return characteristics of this asset.
Investors wanting the best result from the asset should be prepared to have a long-term investment horizon. The most predominant strategy for a fund is to buy and to hold to maturity, physical life policies. Returns are primarily driven by mortality. The performance of a pool polices should have a Poisson type mortality distribution not a “normal” or bell-shaped curve. The shape of the curve will be determined by the mutually exclusive individual events reflecting the underlying insured lives. The potential shape can be modelled using the historical performance of similar insureds with perhaps an allowance for possible health improvement factors. (These types of factors vary with the age and circumstances of the pool of samples.
Consequently, investors should expect potentially lumpy returns in the beginning and end of the performance life cycle particularly in small portfolios. This is because modelling is usually based on a minimum of 1,000 samples in each case. The mortality experience should usually accelerate as the pool of policies progress into the second and third quartile of expected returns as these are typically the statistically most likely period of outcomes. The key for investors is not to miss the peak of maturities. Once the pool reaches its peak, the frequency of maturity may begin to decline as the number of remaining lives in the pool is reduced and the expected events enter the “tail” of possible outcomes.
By examining the GIS General Fund, the best times are yet to come. The conservative acquisition strategy has resulted in a modest return in initial years. The majority of the assets in the portfolio are now in the statistically likely second and early third quartiles of the curve
Life settlements (secondary / tertiary life insurance policies) are normally a relatively long-term asset and while they are high credit quality instruments, of course have an uncertain term. This lengthy “life cycle” gives an investor the opportunity to evaluate the performance characteristics of a portfolio.
Investors looking for a highly tradable asset are recommended to re-consider their approach to the asset class. The physical characteristics of the life settlements asset limit the liquidity and opportunities for trade.
3. Fake Returns in Life Settlements
Life settlements, do not trade identical instruments in deep liquid markets like more traditional stocks or bonds. This makes it difficult to accurately compare returns over fixed intervals. Additionally, the assets and market characteristics make frequent trading not recommended or logistically practical for this asset.
Consequently, it can be extraordinarily difficult to compare funds. Benchmarking and indexing of life settlements funds isn’t effectively developed and seems unlikely in the foreseeable future. Although, once familiar with the performance characteristics of the asset it is understandable why it can be difficult to compare portfolios and their published returns.
Additionally, as explained above a portfolio can exhibit slow initial performance and lumpy returns. In turn it can make this a very difficult asset class to sell. However, we believe that this asset is worthy enough not to be faked. Some funds however, seem to report solely positive or smooth regular returns. This seems technically very unlikely given the asset characteristics discussed earlier. The “smoothing” of returns by the artificial inclusion of unrealised valuation assumptions seems to be the only logical explanation for this.
Investors need to have access to regular reporting of the Attribution analysis of any published returns in order to have any confidence in published performance.
4. Management Fees
As in any asset class, reasonable fees should reflect skill and work done and should make sense to both the investor and the manager alike. Downward pressure on fees is a reasonable outcome of competition.
It should be noted however that this asset class is quite transaction based and non- automated. This requires a higher management fee than an index based bond or listed equity fund.
Investors should also take into consideration performance fees. Are performance fees based on maturities or are you paying fees based on artificial performance.
5. Cost of Insurance
This risk has gotten some headlines in recent years. With the well-known Insurance industry research house, Conning stating that, despite market conditions primed for growth of the market, COI on existing policies will challenge the growth trajectory of the market.
This risk is evident more in some life insurer issued paper than others, but requires the close attention of the manager or asset purchaser to minimise any potential risk to increased holding costs and thus reduced returns. The industry is closely following the outcomes of some litigation activities challenging the right of insurers to increase costs in an existing insurance contracts.
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.
