Life Settlements Are Settling In as an Alternative Asset Class

In the 1980s, men being treated for AIDS began defraying hospital expenses by selling their life insurance policies for less than the death benefit. The practice became known as life settlement.

By the early 2000s, banks had accumulated portfolios of life insurance policies from healthy senior citizens. Packaged and marketed as life settlement funds, the holdings appealed to institutional and high-net-worth investors interested in an alternative asset class uncorrelated with stocks, bonds or real estate.

The past year saw a surge of interest among investors who were hungrier for yield than at any time since the subprime bond crash of 2007.

“The hunt for yield is back on,” says Jeremy Leach, CEO of Managing Partners Group (MPG), which is headquartered in London and manages $64 million in U.S.-issued life policies in its High Protection Fund. “Investors are looking for real rates of return that are going to be higher than the risk-free rate.”

MPG said in January that it was adding life settlements to its Melius Fixed Income Fund, targeting up to a 50-50 split between life settlements and corporate and high-yield bonds.

Tallying Returns

The U.S. Dollar Growth Class of the High Protection Fund, a Cayman Islands-regulated mutual fund, delivered a net return of 8.46% between January 1 and November 30, 2023, and an average annualized 15.16% since its July 2009 inception. By comparison, Fed funds were in a range of 5.25% to 5.5%. The 30-year Treasury yield was 4.045% in mid-December 2023.

In a May 2023 survey of 100 institutional investors and wealth managers in Switzerland, Germany, Italy, the U.K. and the U.S. conducted for MPG by research firm PureProfile, 45% of respondents expected “dramatic growth” in investments in life settlement allocations over three years; and 37% expected slight increases. 

According to the 2022 Life Settlements Industry Report published by Harbor Life Settlements, which refers people who want to sell their policies to brokers, 3,241 life insurance policies were sold to investors in 2020, at a median return of 12.4%. That number of policies nearly doubled from 1,707 in 2016, when the median return was 13.1%.

Tracking Risks

The asset class comes with a unique set of investment risks.

The main one is longevity risk – that is, that the person named in a policy will live longer than the fund manager who bought the policy expected. This is related to risks involved in calculated net asset values and rates of return, which may be more correlated to interest rates than investors are led to believe.

There is also a risk that a policyholder fails to disclose information about a medical condition, fraudulently or not. Default of the insurer that issued the policy is another concern, but that risk is considered low-probability.

Fund managers rely on the opinions of medical underwriters to predict life spans, which can vary, and a miscalculation can be costly. “It’s the investment manager’s responsibility to determine how to assess the differences in opinion," says Tim DeMars, vice president and principal at actuarial consulting firm Lewis & Ellis.

The moving target of life expectancy makes it a challenge to value the assets and calculate rates of return. People typically sell their policies for as much as 60% of the death benefit, according to Harbor Life Settlements, but fund managers don’t disclose their pricing methodology. Their net asset value calculations are “a little black-boxish,” as Brian Casey, a partner at Locke Lord, a law firm that advises life settlement fund managers, puts it.

 Brian T. Casey, Partner, Locke Lord

There is also the possibility that a life settlement fund’s performance becomes more closely correlated than anticipated with other financial markets. “At the end of the day, a life insurance policy is somewhat correlated to interest rates,” Casey adds.

Another risk is cash flow: A fund manager must pay premiums every month to the insurance company that issued every policy in a fund for as long as the people named in the policies live.

Managing the Risks

Fund managers spread out longevity risk by assembling portfolios of policies that were issued to people from different age groups with varying life expectancies. Life expectancy in the High Protection Fund, for example, ranges from under 40 months to 120 months, with people in the 70 to 99 age range,

Fund managers revalue portfolios regularly to ensure smooth, predictable performance. “For every month that goes by, we have to assume that we will be holding a policy for a fraction of a month longer than we did before,” says Leach of MPG. “We are continually pushing out life expectancies so we don’t end up with a sudden change in value.”

That’s why assets under management in life settlement funds reflect the current value of policies in the fund, as opposed to their value at maturity. The High Protection Fund reported total assets of $64,194,997 on November 30, which compared with the policies’ maturity (or “face”) value of $90,365,015.  

To make sure they can keep up with premium payments, fund managers maintain a sizable percentage of their assets in cash – 15% in the case of the High Protection Fund.

Leach buys policies from market makers at a deep enough discount to achieve a 12% compounded annual growth rate until their expected maturity dates. A discounted cash flow calculation is used to predict how long he is likely to hold a policy to achieve that growth to maturity.

For an eye on fraud, lawyers are employed to conduct due diligence, Casey says. But it’s often too late to allege fraud by the time a fund manager buys a policy, because in some states, regulators allow insurers only two years after issuance of a policy to contest its validity. (Other states make an exception for fraud.)

Diversification

Default risk is diversified by buying policies from a large number of insurance companies with high credit ratings.

The High Protection Fund currently has policies from 52 insurers. Measured by current value, 28.22% of the policies were issued by John Hancock Life Insurance Co., which has an S&P Rating of AA-; and 11.07% by Nationwide Mutual Insurance Co., which has an A.M. Best rating of A+.

In years to come, some of these risks will get easier to manage with the help of artificial intelligence, Casey contends. And 10 years from now, says DeMars, the market “should be much bigger.”