Life Settlements Investing
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[edit] What is a Life Settlement?
A Life Settlement is: "the sale, assignment, transfer, devise, or bequest of the death benefit or any portion of an insurance policy or certificate of insurance for compensation less that the expected death benefit of the insurance policy or certificate. Simply put, a Life Settlement is an existing life insurance policy sold to a third party for more than its cash surrender value but less than its net death benefit. Typically, these transactions involve individuals who, though not terminally ill, wish to sell a life insurance policy they no longer need.
There are a variety of reasons a policy would no longer be needed - perhaps it was purchased to meet estate planning needs that no longer exist, or perhaps a corporation owns the policy on an executive who has left the company. Whatever the reason, the policy has become a financial burden that the owner no longer wishes to bear.
[edit] History of Life Settlements:
The practice of reselling life insurance policies remained relatively uncommon until the AIDS epidemic heightened in the late 1980s. AIDS caused many young individuals with severely shortened life expectancies to suddenly be faced with a dire need for cash, both to pay for medical expenses and to allow them to live the rest of their lives with dignity. As policyholders stricken with this tragic disease realized that there was a value to their policies, many turned to their life insurance policies, cashing out the equity that they had built up.
Their shortened life expectancies caused investors to be willing to offer more than the cash surrender value of the policy in order to purchase the policy. In return, the investor becomes the sole owner and beneficiary of the policy in exchange for immediate money that was greater than could otherwise be expected by the policyholder. Put simply, the market for Life Settlements became established when the market price for insurance policies exceeded the regulated price offered by insurance companies.
[edit] 1990s - Present
Life Settlement firms fulfill the need-for-cash of individuals living with terminal illnesses by making lump-sum payments to them, matching their life insurance policies with investors. The Life Settlement industry has grown rapidly since the early 1990s. According to the Viatical and Life Settlement Association of America, between $1.8 billion and $4 billion worth of policies were sold by owners in 2001, up from $50 million in 1990 and $1 billion as recently as 1999. Incredibly, this is really just the tip of the iceberg - the total available market is an estimated $100 billion (as of 2004). Two facts are clear: the market is very large and will continue to grow very rapidly.
[edit] Trends
Investors in the United States are not the only ones taking a strong interest in this emerging industry. As reported in the May 15, 2003 issue of The Economist, after savings accounts and government bonds, life insurance may be the most respectable of investments due to the new secondary market for life insurance policies. The magazine reports that Life Settlement firms bought $2 billion worth of policies (by face value) in 2002 - ten times as much as they acquired in 1998, when the industry first started to emerge. Some estimate that the industry's potential, comprised of Americans over the age of 65 with life insurance policies, to be worth around $100 billion.
[edit] Future of the Life Settlement Industry
The future of the Life Settlement Industry is bright, with the potential market having barely been tapped. With the growing demand from both sides for pricing transparency and a more easily navigable system, it is possible that the next few years may see the creation of a Life Settlement Exchange. Such an exchange would likely take the form of an electronic communications network, similar to those that are used by today's stock markets. The credibility of the industry as a whole would be increased, raising awareness of and further legitimizing Life Settlements as an investable asset class to investors. An exchange (or exchanges) would also open up the market to even more parties, benefiting everyone involved by improving pricing and information transparency for policyholders, allowing them to shop their policies to the highest bidders, and allowing Life Settlement investment entities access to a much larger pool of policyholders.
[edit] Facts about Life Settlements:
• Financial advisers and planners use Life Settlements as a sophisticated planning tool - policies once considered all but useless are now used as tools to allow people (frequently retired seniors who need money and don't want to shoulder the monthly premium costs) to develop or bolster an income generating portfolio.
• The most common sellers of life insurance policies are affluent people over age 65. Typically, they have paid off their homes, and their children have moved out. Selling their policy gives them more options in generating funds for retirement. In addition, persons of this age group give the investor the largest potential return on investment, meaning that the investor will be able to offer them a much higher purchase price for their policies.
• The average face amount of the purchased policy is large, easily $1 million or more. Such high numbers are necessary for the policy to be considered investment worthy.
• Life Settlement financing typically comes from institutional investors.
[edit] How does a Life Settlement work?
The process that leads to a Life Settlement begins with a policyholder learning about how a Life Settlement might be an appropriate financial option for them. This knowledge can come from many sources, but is frequently recommended by insurance agents, accountants, financial planners, and lawyers. Often, policyholders interested in selling their life insurance policy will then contact a Life Settlement broker. The broker's job is to determine the policy's eligibility for a Life Settlement and to match the seller with a buyer, seeking to obtain the highest possible offer for the policy. Brokers are not always used, but there are many benefits for sellers in using a good broker. After a policyholder decides that selling their policy is in their best interests, the seller/broker they have hired would approach a potential buyer(s) (typically referred to as Life Settlement Companies). Most types of insurance policies can be good candidates for Life Settlements, including: universal insurance policies, whole life, and convertible term policies. Once presented with an application for a Life Settlement, those buying the policies then apply a broad range of criteria to the offered policy to determine its investment worth and decide if they wish to enter into a Life Settlement agreement with the seller.
The value of a life insurance policy for an investor can be determined by a number of things, including but not limited to:
• The age of the insured
• The life expectancy of the insured
• The medical condition of the insured
• Type of insurance policy
• Rating of the issuing insurance company
• The dollar amount that the policy will cost to maintain (premium payments)
Every company or investor uses different guidelines to make their decisions regarding policy purchases, but most policies must meet several general qualifications to be considered for further review5. Examples of these common criteria include:
• Is the insured over 65 years of age or has a serious illness?
• Is the face value (death benefit) at least $1,000,000?
• Is the policy at least 2 years old (see the points on incontestability below)?
Complicated formulas that combine disciplines from the financial and actuarial fields are often used to further determine how much the policy will be worth to the investor when the death benefit is collected. If the policy meets the criteria that the buyer must satisfy for the policy to be investment worthy, then the policy will be approved for purchase.
Next, based upon the calculations of the worth of the policy, an offer is made to the policy owner. Once a price that satisfies the buyer and the seller has been determined, closing documents are sent to the seller. Funds are then placed in escrow at a financial institution (or other mutually acceptable independent third party escrow agent), as required by applicable laws. After the change of ownership and beneficiary forms are received by the designated escrow agent, the owner is paid a lump sum of cash for their policy. At this point, usually 6 - 8 weeks after the start of the process, the transfer is complete, and all future premium payments are the responsibility of the purchaser. Upon the passing of the insured, the death benefit is then paid to the purchaser by the insurance company (also known as the underwriter).
[edit] Detailed Steps
[edit] Stage One
Acquiring a policy The policy must be evaluated and due diligence must be exercised by the investor. The following sections discuss some of the steps an investor should, at a bare minimum, consider when evaluating a policy for potential purchase. In addition, an investor must also be on the lookout for unusual information that would help to refine their analysis.
Reviewing the Application The first thing an investor must do after receiving an application is to thoroughly review it, gathering any and all necessary information. This is done to protect both parties from possible fraud, to ensure that the investor has all of the relevant data needed to make a proper evaluation of the seller's policy, and to decide if the policy warrants further consideration for purchase.
Verifying Incontestability The incontestability of the policy must be established. During the first two years of owning the policy, an insurance company may cancel a policy if it is found that the policyholder had supplied false or fraudulent information when purchasing the policy. After two years have passed, the insurance carrier may not cancel the policy for any reason. This is important, as it means that the policy cannot be cancelled by the insurance company after an investor has purchased the policy from a seller. While an investor can choose to take the risk and invest in a contestable policy or policies, we advise against doing that.
Valuation Requirements Once it has been established that a policy is a good candidate for a Life Settlement, the policy must then be evaluated as to what the policy will be worth to the investor.8 Many parameters are considered; no two investors do it the same way. Some investors would use an expected discounted cash flow analysis. Some investors base their calculations off of life expectancy scenarios. As the industry matures, we can expect different valuation methods to be deployed by different investors. In this inefficient market, an accurate valuation tool would allow the astute investor to earn extraordinary gains.
Verification of Coverage The investor must verify the terms of the policy that is being offered for sale. The policy must allow for Absolute Assignment of Ownership in order to be considered.
Obtaining Releases The investor should obtain from the seller signed releases to obtain medical and insurance records. The reason for this is fairly simple - should the investor decide to resell the policy down the road, they would need to be able to provide a medical report for the insured person. If the investor would be unable to do this, they would not be able to find a buyer. The investor must also be authorized by the seller to obtain a certificate of death upon passing of the seller (subject to local laws).
Premium Illustration A Premium Illustration is a roadmap as to what premiums will look like over the life of the policy, under varying scenarios. It is used to help the investor assess the future cost of the policy.
Beneficiary Waiver Everyone listed in the policy as a beneficiary (prior to purchase of the policy by the investor) are sometimes required by the investor to sign a waiver in order for the Life Settlement to proceed. The existing beneficiaries agree to give up all future claim to the death benefits when the policy terms. This is used to head off any future legal actions that could interfere with collection of the full death benefit by the investor.
Competency Statement The investor should then verify that the seller is capable of making the decision to sell the policy. This step not only protects the investor, but also protects the owner of the policy.
[edit] Stage Two
Medical Underwriting A thorough medical assessment and review must then be made of the seller.
Obtaining Medical Records With the releases having been signed by the seller, the investor must now obtain these records.
Life Expectancy Company Certificate Once these medical records are obtained, they are sent to a Life Expectancy Company. This company will produce a Life Expectancy Certificate, which represents an estimate on the remaining life expectancy of the seller. A licensed physician can also perform this function.
[edit] Stage Three
Policy Purchase Once the first two steps have been completed and the policy has been found acceptable for purchase by the investor, the policy is acquired by the investor.
Gather and Verify All Data/Information It is very important to ensure that all information has been gathered and properly recorded by the investor and to verify that everything is correct. Failure to do so can lead to the buyer overpaying for a policy or acquiring a policy that might not be as desirable as they had initially thought. Once the money for the purchase of the policy has been placed in escrow, the sale will go through even if the buyer has been negligent in this regard.
Make an Offer to the Insured Once the investor has decided how much they are willing to pay for the policy, an offer is tendered to the seller. Negotiation as to the amount that the seller is to receive is handled at this point, until an amount satisfactory to both parties is agreed upon.
The Insured Signs a Sales Contract The seller has accepted a price for their policy and agrees that the investor will become the sole owner and beneficiary for the policy. The agreed upon dollar amount is then placed in escrow by the investor at an appropriate financial institution, to be received by the seller upon completion of the deal.
Change of Beneficiary/Ownership of Policy The necessary paperwork is filed with the insurance company, officially making the investor the sole owner and beneficiary of the policy. The investor then becomes responsible for the premium payments of the policy. It is important that the investor becomes both the owner and the beneficiary of the policy, not just the beneficiary. The reason for this is simple - if the investor does not have ownership of the policy, it doesn't control the policy.
Receive Change Confirmation from the Insurance Company upon filing of the paperwork and the changing of the policy information, the insurance company then sends the investor confirmation that they are now the sole owner and beneficiary of the policy. Pay the Seller Once the escrow agent has verified with the insurance company that the new owner and beneficiary of the policy is the investor, the money that had been placed in escrow is released to the seller.
[edit] Stage Four
Policy Maintenance At this point, the upkeep of the policy becomes the responsibility of the investor. The seller is no longer in the picture, except that their status must be monitored by the investor. Above all, do not let the policy lapse.
Tracking of the Insured The investor either keeps tabs on the seller themselves or hires a third party to take care of it, with the purpose of knowing when the policy has matured. There are several common avenues used to keep track of the insured: • Insured's physician • Social security database • Obituaries • Insured's family /list of contacts
Premiums The investor is responsible for premium payments and must ensure that these are paid regularly and on time to avoid lapse of the policy. Decisions on whether to hold on to the policy or resell it to other investors can be made once the investor owns the policy. Such a decision can be made by monitoring the health of the seller - are they doing better or worse than expected?
[edit] Stage Five
Policy Maturity Upon death of the insured (maturity of the policy), the investor needs to claim the death benefit from the insurance company.
Obtain Death Certificate The first step is to obtain a Death Certificate, verifying that the insured is deceased.
Filing the Claim Once the Death Certificate is procured, the investor must then file a claim with the insurance company. Once the insurance company has processed the claim and verified that the policy has termed, the death benefit will then be sent to the beneficiary of the policy, the investor.
[edit] Investing in Life Settlements
[edit] Individual Policies
Investors can have a predictable return if their expectations on the Individual Life (L.E.) on the Contract Holder turn out to be correct. Once a policy has been purchased, the return on the policy is almost solely determined by how long the insured lives. The longer the insured outlives their predicted life expectancy, the smaller the return for the investor. In other words, accurate predictions on life expectancy equates to good estimates on return. It is impossible to get an exact prediction on the life expectancy of the insured, a diverse portfolio, combined with reliable will still allow an investor to realize a predictable return on investment. The key here is that when talking about many different policies, the average percentage of return that you collect is predictable, as long as your prediction methods are reliable. The level of return on Life Settlements can vary based upon many things, but the reliability of life expectancy forecasts is one of the most important determinants of the expected return on investment.
[edit] Questions any investor should ask before investing in a Life Settlement
Q: Are the initial investment and return on my investment guaranteed? A: No. Nothing is guaranteed. As discussed, having a diverse portfolio and making solid life expectancy predictions will do much to ensure that you not only recoup your initial investment, but see returns when the death benefit is collected. Q: How is the return on my investment calculated? A: The most appropriate measure for the return on investment is called the internal rate of return. Though the formal definition is much more complicated (see below), we can take the internal rate of return to represent an average annual return for the entire investment period, from the time of policy purchase to the time the death benefits are received.
Analysis: Life Settlements vs. Traditional Asset Classes Life Settlements are a relatively new asset class for investors to consider. Initial signs as to the long-term viability of the industry have been very promising, with the near future looking bright. It therefore makes sense to see how investing in Life Settlements stack up compared to more traditional asset classes.
Investing in the stock market has traditionally been one of the most popular forms of investment. An investor can buy in with as little or as much money as desired. Stocks can easily be sold should capital be immediately required, giving this option a high degree of liquidity. Also, with thousands of stocks to pick from (not even counting foreign exchanges), the opportunity exists for the savvy investor to reap enormous rewards.
Unfortunately, such success stories are the exception rather than the norm. While the potential for enormous returns exists, the stock market is subject to high degrees of volatility, which directly impacts the earning potential of any such investments. The stock market crash of 1929 (triggering the Great Depression) and Black Monday of 1987 are some of the most extraordinary examples of stock market volatility, as well as the dot com boom and subsequent crash. The value of any equity is heavily influenced by market forces and trends, and individual company performance. Other factors, such as a company's internal situation can have drastic effects on stock value. On any given day, millionaires can be made and billionaires bankrupted.
Life Settlements are a more stable form of investment than equities, with market fluctuations having little to no bearing on the return on investment. Your return is almost solely dependent on how good your life expectancy estimates are. While having a diverse stock portfolio can guard against individual stock devaluations crashing the value of your entire portfolio, the market as a whole can frustrate the best efforts of even the savviest investors. Life Settlements returns with diverse portfolios of policies and accurate life expectancy estimates can be considered safer or less volatile than equity investing. The tradeoff is less liquidity.
Life Settlements vs Bonds Bonds have traditionally been looked upon as a "safe" investment. Depending on the time that you commit your money (for example, 5, 10, or 20 year bonds), you can expect a certain percentage of return on a specified maturity date with near certainty. The return potential isn't as exciting as other asset classes, but the low risk is an attraction all its own. Bonds are also relatively liquid for certain bond types (e.g. treasury bonds) should capital be needed, and are widely accepted as collateral for loans.
The advantage that investing in Life Settlements has over investing in bonds is the potential return on investment. As mentioned, the Life Settlement industry is still fairly young, and as a result, higher yields are possible with the relatively noncompetitive marketplace, with managed funds typically showing 10%-20% or higher returns. Individual policies can show tremendous return on investment.
[edit] Life Settlements vs Currency Trading
Currency traders are often day traders that try to take advantage of currency and market fluctuations over very short time periods - the period between buying a currency and selling it can be mere hours or even minutes. They are attracted to currency trading for numerous reasons, including:
• the almost perfect liquidity of the currency market
• the currency market is "open" 24 hours a day
• currencies can be traded with no brokerage charges.
For the savvy speculator, the rewards can be enormous. With any asset class so heavily dependent on speculation and predicting often uncertain market conditions and trends, the potential for huge returns is balanced by the potential for huge losses. Life Settlement investing compares to currency speculation in much the same way as to equities - good yield, little to no dependencies on market trends and fluctuations, and much less dependence on good trading.
[edit] Life Settlements vs Commodities
Trading on commodity futures is another investment type that has the potential for the reaping of huge returns. As with equity and currency trading, commodity trading is largely dependent on market forces and an experienced, savvy trader. The income generating ability of Life Settlements is not dependent on market forces. Your ability to realize a good return on an investment is principally based on your ability to select policies at a good valuation.
[edit] Life Settlements vs Real Estate
Real estate is a very good inflation hedge. During periods of high inflation, real estate prices tend to keep pace, meaning your investment, should you decide to liquidate, will be unlikely to lose buying power. With long term loans common in the industry, significant amounts of money relative to your equity can be borrowed toward real estate speculation.
Life Settlement investing has two distinct advantages over investing in real estate. Typically, Life Settlements will provide a higher return over rental yields (although it should be noted that real estate value appreciation can easily exceed Life Settlement returns because of leverage effects, which is generally not available to Life Settlement investors). Also, even though compared to other traditional asset classes, Life Settlement investments are relatively illiquid, they are considered more liquid than real estate investments. Though certain regions of the country may be the exception that disproves the rule, this will for the most part hold true.
[edit] Valuation of Life Settlement Policies
Valuation Model The valuation model used for evaluating Life Expectancy investments is similar to that used to evaluate bonds. The estimated life expectancy is treated as the maturity date. A technique called the Net Present Value (NPV) is used to determine if a policy is worth investing in. The NPV model is useful, as it takes into account the time value of money, uncertainty, and project risks associated with the implementation of a project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. In other words, the NPV model compares the value of a dollar today versus the value of that same dollar in the future, after taking inflation and required return into account, as well as any other costs that may impact the internal rate of return. If the NPV is negative, the investor would be wise to pass, as money would actually be lost in the long run. Investments with a positive NPV can be considered; the investment opportunities with the highest NPV can then be selected. Some firms treat the NPV as the maximum price that they will pay for a policy and will turn down purchase of even positive NPV policies if the asking price is too high. Currently, Treasury Bond yield curves for different maturity times are used as the base percentage for the discounting of Life Settlement investments. Discretionary percentage points can be added by the investor in an effort to more accurately calculate the NPV of the potential investment. The discretionary percentage points added is to capture the required return of the investor. The goal is to accurately determine the maximum price an investor should pay based on his/her own unique requirements, and thus avoid overpaying for any given Life Settlement.
Liquidity Premium Life Settlement investments are less liquid than Treasury Bonds. It is therefore appropriate to add an additional penalty to the NPV of a Life Settlement. This penalty is applied because the secondary insurance market is still relatively new, with few outlets to resell the policy should that become necessary. As the market matures and more Life Settlement investors come into the market, this penalty will shrink. The percentage used is discretionary and varies across investors.
Credit Spread Consideration is given to how likely a debt is to be paid by the debtor (for our purposes, how likely the insurance company is to pay out the policy's death benefit). An additional penalty is added, due to the fact that insurance companies do not have as good of a credit rating as the United States government. The credit spread varies little across investors, as at any time the credit rating of insurance companies can be found with very little effort. A.M. Best, Standard £t Poor's, Duff and Phelps, Moody's, and Weiss Research are the most reliable firms that are used to discover this information. When searching for this information, it is important to remember that each organization employs its own technique for determining the rating of an insurer. Areas considered vary from company to company and can include:
• leverage
• management stability
• recent performance
• financial situation
External factors such as competition, diversification, and market presence can also be factored in. Each organization provides a description of its analysis and defines its rating scores, so that investors may make their own decision on which analysis to use.
Maturity Uncertainty Spread This penalty is assessed because while predictions on life expectancy may be based on as accurate information as possible, they are just that- predictions. The actual date that the death benefit is received cannot be known with absolute certainty. This level of penalty used can vary widely from investor to investor.
[edit] Life Settlement Funds:
The roles of a Life Settlement fund management firm, the brokers, and the pros and cons of investing in a Life Settlement fund.
• Fund firm
• Brokers
• Advantages vs. Disadvantages
Investing Through Securitization of Policies The most direct form of securitization of policies is in the form of managed Life Settlement funds. Similar in principle to a mutual fund, a Life Settlement fund is dedicated to investing in Life Settlement policies, with investors buying shares of the Life Settlement fund. These investors are referred to as shareholders and for the purposes of this chapter we will use this designation. These funds then purchase policies from policyholders, generally through a brokerage representative. The main difference between investing with a fund and an investor purchasing a single Life Settlement policy is that the policies purchased will be owned by the fund, with the fund also being the sole owner and beneficiary. When the insured person dies, the Life Settlement fund will file a claim, and the insurance company will pay the death benefit directly to the fund. A Life Settlement fund has a number of independent service providers, including the auditor, fund administrator, legal counsel, investment manager, and custodian.
Fund Administrator The role of the fund administrator is to provide all periodic reporting, accounting, and shareholder services. The fund administrator is the shareholder's interface to the fund and the source of most of the information regarding the fund's performance.
Auditor The auditor provides an independent opinion on the reported financials of a Life Settlement fund. The auditor ensures that what is reported by the fund administrator matches the actual performance of the fund while also monitoring the feasibility of performance forecasts.
Legal Counsel The legal counsel provides all legal services to the Life Settlement fund. This can include the creation of bylaws, articles of incorporation, contract drafting, and providing legal advice and defense should that be necessary.
Investment Manager The investment manager provides the investment management service, which would principally include the selection of Life Settlement policies for inclusion into the fund. The investment manager is also responsible for tracking the insured person, and the maintenance of the Life Settlement policy.
Custodian The custodian is responsible for the safekeeping of the fund's assets. Typically, the custodian is a bank.
Individual Policies vs Life Settlement Funds It is worth taking a look at the advantages of investing in individual policies versus investing in a managed Life Settlement fund. Within the realm of purchasing individual policies, there are also two options - investing in fractional shares of an individual policy or purchasing the entire policy. The following is not meant to be a complete comparison between these options, but rather a high-level look at some of the fundamental differences.
[edit] Ownership of Shares
When investing in fractional policies, usually investors will only own a fractional share of an individual policy under a trust account set up by the Viatical broker. The investor is solely dependent on the broker for the proper maintenance of the policy and tracking of the insured - this kind of "nominee" service will result in more uncertainty should there be problems with the broker. The broker or anyone operating the trust are not required to be licensed (note: brokers frequently have licenses for their "other" businesses, but not for the purpose of operating the trust). Another potential problem with fractional ownership is the risk of any single insured person living substantially longer than expected, thus exhausting the premium reserves for that single policy. For Life Settlement funds, the fund managers usually purchase the entire policy with the investor holding a fractional share of the fund. Furthermore, the custodian, legal counsel, auditors, and fund administrator, all of whom serve the fund, ensure that all applicable rules, regulations, and securities laws are strictly upheld. Policy maintenance is formalized by internal procedures, minimizing the possibility of unintentional lapse.
[edit] Life Expectancy Estimates
Some companies use their own in-house staff for life expectancy estimates. The risk for the investor is one of bias, with estimates being underestimated in the interest of making a policy more attractive for sale.
Life Settlement funds typically hire independent medical examiners (both licensed physicians and life expectancy companies), leading to an assessment that is free from bias.
Continuous Management The investor and the broker are responsible for the continuous management of the investment in the case of purchasing fractional policies. What this means is that the investor in part bears responsibility for the maintenance of the policy in order to ensure that the policy does not lapse. Also, this dual-responsibility (split even further in the case of fractional ownership) gives no flexibility in deciding on whether to hold or sell the policy.' The commission is paid to the broker upon the completion of the transaction (when the policy terms). A fund manager is paid on a recurrent basis, ensuring that quality continuous management is provided. The responsibility for the upkeep of the purchased policies lies solely with the fund. The fund's complete control over the entire policy also gives a high degree of flexibility should conditions change and a decision needs to be made on whether to hold or sell the policy.
Regulatory Restriction and Monitoring Individual life insurance policies are not generally considered securities. As a result, there are little to no regulation requiring brokers to act appropriately and in the best interest of the investor(s). For Life Settlement funds that issue shares for their managed funds, various securities laws come into play that protect the investors from unscrupulous activities. The investments made with managed Life Settlement funds are therefore much more protected.
Risk of Insurance Company Default In the case of an insurance company defaulting on the policy, the investor who invests in a single policy (whether fractional shares or the purchase of the entire policy) bears the entire risk. With a managed Life Settlement fund, the risk of insurance company default is spread across all investors.
[edit] Potential Risk and Return
When investing in a single policy, both the potential return and potential risk are much greater than that of investing in a managed fund. If, for example, the insured passes away much sooner than expected, the return will be very high. Conversely, if the insured lives much longer than expected, the return will be much lower and the investor could even lose money. In a managed fund structure, all return and risk potentials are spread out among the entire fund and as a result every investor in the fund. While this does have the effect of lowering the potential return on investment as a whole for each investor, the risk is also mitigated.
[edit] Risks in Life Settlements When Investing in Single Policies :
Types of Risk
1. Liquidity Risk
2. Regulatory Protection
3. Cross-border problems
4. Late Payout
5. Tracking Risk
6. Premiums Risk
7. Policy Fraud
8. Insurance Company Risk
Liquidity Risk
Life Settlement investments are not easily liquidated should an unanticipated need for cash arise.
Life Settlements are not a liquid investment. There is no return on investment until the death benefit is paid by the insurance company. Another contributing factor to the lack of liquidity is that there is currently no real organized or established secondary life insurance market with which you can resell the policy, should you decide to do so. It is estimated that there are no more than one thousand active investors in Life Settlements around the globe. This can make it very difficult to contact potential buyers for the policies you own; with the relative lack of competition, other investors can afford to pass up an opportunity that, while still a good one, is less than optimal. All of these factors increase the time it can take you to locate a purchaser who is willing to offer you the fair market value of your policy. In the case of fractional shares (where several people have bought fractions of a single policy), your investment is even less liquid. Typically, in such an arrangement, you have virtually no control over the fate of the policy because you do not own the entire policy. Not only are you forced to contend with the custodian of the policy (typically a Life Settlement broker), it may not be possible to reach a consensus on a plan of action with the other partial owners of the policy. The custodian of the policy is also not bound to follow the wishes of the owners and may elect to go against their wishes. Also, in general professional investors are wary of purchasing fractional shares, making the task of finding a buyer more difficult than it might otherwise be - institutional investors and more experienced investors simply refuse to invest in fractional policies.
Protecting Yourself From Liquidity Risks
The best way to protect yourself from an illiquid investment like Life Settlements (aside from approaching such an investment with a long-term investment horizon mindset) is to understand what your current needs are, to anticipate future needs, and to exercise patience in your search for policies to invest in. It is very important to understand that if a situation occurs in which you need cash within a very short time frame, you will probably not be able to turn to your Life Settlement investments. Even if you sell the policy at a steeply discounted rate and are immediately able to find a buyer, the closing period can still last weeks. Another way an investor can minimize illiquidity is work to establish a network of other Life Settlement investors and brokers. Down the line, if you should need to sell your interest in one or more policies, knowing other investors can drastically shorten the time needed to find prospective buyers. If possible, avoid purchasing fractional shares of a single policy to begin with. The even greater lack of liquidity, shyness of other investors to purchase fractional shares, and lack of regulation makes them less desirable, making it more difficult to sell your interest should the need arise. Institutional investors and investors with more experience do not purchase fractional shares of individual policies.While there are many disadvantages to owning illiquid assets, it should be noted that a savvy investor can turn a lack ofliquidity into an advantage and even profit from it. In order for a seller to entice an investor, the seller will have to offer a higher return in exchange for the investor's sacrificing of liquidity. Being patient and exercising selectivity over the policies you purchase can lead to you finding policies with a higher potential yield for less money.
[edit] Regulatory Protection
Few laws exist that specifically protect Life Settlement investors. Current regulations that govern the secondary life insurance market exist primarily to protect the relationship between the insured and the broker (which can also be a Life Settlement company). There is no national regulatory body or set of laws that governs all aspects of investing in Life Settlements. Investors purchasing single policies are not nearly as protected by law as investors who buy into a Life Settlement fund" . While there are general laws that protect investors of all types (i.e., laws against fraud), there are no laws that specifically protect investors in Life Settlements who purchase single policies. The broker has no fiduciary responsibility toward the investors, only the insured - there is no requirement for the investor's interests to come first. There are three main types of risks that investors face from lack of legislated oversight:
• Transparency Risks
• Information Risks
• Fair Dealings Risks
[edit] Transparency Risks
The Broker is not required to share information concerning policies. Investors face transparency risks when investing in fractional policies - complete disclosure by a broker regarding the policy or the insured is not required by law. Also, brokers are not required to disclose everything about the company or themselves to an investor. When it comes to fractional policies, little to no disclosure is required - often the bare minimum is supplied. There is no prospectus, as you might receive when investing in stocks and mutual funds.
What can you do to protect yourself from Transparency risks? Comprehensive due diligence is your best bet. Research every angle that you can and find out as much information as possible about the broker, company, or insured. Try to find any historical performance data on the company or broker if it exists . Above all, be discerning when selecting policies.
[edit] Information Risk
The policyholder may not have revealed pertinent information about their policy. Protecting yourself against information risk can be tricky. In this case, the seller may have relevant material on themselves that could affect the price and return of a policy, but they are not required to share this information with prospective investors. The broker may not even have this information. For example, the insured's health could be improving, which would drive up maintenance costs while pushing back the expected payout date. This would devalue the policy under normal circumstances - but if the insured does not inform anyone of this (and they are not required to), then the investors will end up overpaying for the policy. Your only real protection against these types of information risk is due diligence and patience. Make sure that the broker has done their homework regarding the insured, then do your own investigation regarding the broker. Don't just look at one broker or policy for investment - shop around.
[edit] Fair Dealings Risk
Brokers are not required to treat all investors equally. With the lack of legislation specifically designed to protect investors in Life Settlements, brokers are not required to treat all clients equally. What this means is that a broker can offer one client a very good deal while making up for this with other clients. For any number of reasons, a broker may favor one or more clients at the expense of others. Clients who have a high volume of investments with the broker can also receive a more favorable selection of policies. Your best bet in protecting yourself in this instance is to invest with multiple policy sources. Don't lock yourself in with one broker - they may use this controlling position to offer you less than optimal terms. By spreading out your investments across multiple brokers, you are assuring that even if you do come across a case or two of this happening, you will still minimize the potential harmful effects of this practice. Not only that, but in the interests of gaining more of your business, a broker could offer you more attractive terms.
[edit] Cross-border Risks
Life Settlements are regulated differently across states and may impede enforceability should disputes arise. What legislation that exists concerning investors in Life Settlements has mostly been left up to individual states to decide. Federal guidelines cover the very basics, but any specific laws governing proper treatment of Life Settlement investors can vary from state to state. Cross-border enforcement can be very difficult - for example, if an investor in California buys a policy originating in Florida and there is a dispute regarding disclosure or payment or any aspect, investor protection can vary and make sorting out a dispute very difficult. What is legal in one state may not be legal in another. Perhaps in the coming years, specific federal guidelines will be written to protect Life Settlement investors, but at this time your only protection is to thoroughly understand the laws in the states you do business and to contractually protect yourself, if possible.
[edit] Late Payout Risk
The insured may outlive their projected life expectancy. The annual return on a Life Settlement investment can never be guaranteed because it is impossible to pinpoint an individual's actual life span. While Life Expectancy companies and physicians can provide estimates, at best these calculations represent an educated guess as to how long the insured will live. Despite the best efforts of Life Expectancy companies, their analysis can prove to be grossly inaccurate. Improving medical technology and treatment breakthroughs can prolong the life of the insured far past what had originally been anticipated. For example, twenty years ago, AIDS had been a virtual death sentence to those diagnosed with HIV. Today, medical breakthroughs and a much better understanding of this tragic disease have lead to a whole array of medicines that can retard the onset of AIDS and subsequent complications. What this means for an investor is that if the insured lives longer than expected, the net return will be less than anticipated. Much care must be exercised when selecting policies for investment.
[edit] How can you protect yourself?
What can you do to minimize the risk of selecting policies with a longer time to maturity than expected and minimize your risk of paying premiums for too long?
• Monitor the insured persons closely. If you suspect that the actual maturity date of the policy will greatly exceed estimates, resell the policy to minimize your losses.
• Focus on senior Life Settlements. Life expectancy estimates are more likely to be in line with the actual life expectancy. Even if the senior insured person survives or beats a particular illness, their age ensures that you will not significantly go over your expected policy term date.
• Diversify. Diversify your portfolio of Life Settlements across different lives (insured persons). Some policies mature earlier, some later. On the balance, the mortality curve should be stable. Hence, by holding a diverse portfolio of life insurance policies, covering many lives, the investor gets to experience the return of the asset class. One easy way to accomplish such diversification is to invest in Life Settlement funds. Simply put, be smart about the policies you pick, thoroughly analyze each policy, insured person, and broker, and be diligent when you have made an investment commitment.
[edit] Tracking Risk
If you lose track of the insured, you may not know when they pass away. Investors are at risk for late payouts in the event that the insured is not properly tracked.
Protecting Yourself from Tracking Risks
Frequent and thorough tracking of the insured person will enable you to avoid this risk. Many different avenues exist for an investor to accomplish this:
• The insured's family
• The insured's physician
• The insured's friends
• Third party trackers can also be hired.
Due diligence is your best bet when it comes to preventing tracking risks. Before your purchase, analyze how easy or difficult it will be to maintain tabs on the insured. Don't become complacent after the purchase of the policy - that's merely the first step in your investment.
[edit] Premiums Risk
Policy premiums must continue to be paid to the insurance company until the insured individual dies or the policy is sold or surrendered. The investor is responsible for paying the premiums on time. If the investor forgets to pay the premium, the policy can lapse and be cancelled.
Selecting policies with high premiums can lead to serious consequences. It could turn out that you do not have enough cash reserves to continue paying premiums beyond a certain time, which could lead to reselling the policy at a loss, or even policy lapse if no buyer is found.
Best Practices to Avoid Premium Risks
In the first place, avoid policies that have high premium payments. If you do come across one that has a high enough death benefit to justify the high premiums, then make sure that you have sufficient cash reserves to continue making payments until the policy matures. Nothing would be worse than paying exorbitant premiums for many months or years, only to have to sell or surrender the policy because you had not adequately planned for the premium payments. A good idea is to run through some scenario testing - set up some hypothetical situations (i.e., the insured living a certain number of years past the estimates) and see if you will still be able to afford the payments.
[edit] Policy Fraud Risk
One risk that investors face is that the insured may have misled the insurance company when they purchased their policy. They could have lied about any small detail, from existing health conditions to other risk factors such as smoking. This can lead to the insurance company canceling the policy within the first two years of its purchase. After the first two years,- insurance policies are incontestable and may not be cancelled by the issuing company for any reason (as long as the premiums are paid).
[edit] Protecting against Policy Fraud
First and foremost, select policies that have passed the period of contestability. If you purchase policies that have not passed the two year threshold, you risk having the policy cancelled after having already paid the insured and possibly some premiums13 . This would obviously lead to a very big loss relative to the payout of the policy and should absolutely be avoided at all costs. If your research reveals or leads you to suspect that a policy was fraudulently obtained by the insured and the policy is less than two years old, invest in the policy at your own risk.
[edit] Insurance Company Risk
Though the risk of an insurance company failing is very rare, it does occasionally happen and merits discussion. Every life insurance company is required to maintain a claims reserve. If the claims reserve of a life insurance company drops below a certain level, state regulators issue a warning to the life insurance company. If this trend is not reversed and the claims reserve goes below a certain boundary, state regulators intervene and take over the operations of the life insurance company. If the state regulators fail to bring the insurance company back into a healthy operating status, the company will fail and the investor will experience loss.
There are safeguards built into the system in a situation like this, so all will (probably) not be lost15 . Each state has a State Guarantee Fund set up for insurance companies, which works for the insurance industry in a similar fashion to the FDIC (Federal Deposit Insurance Corporation) for the banking industry. You've probably seen those little signs at teller windows at your bank that say "All accounts FDIC insured up to $100,000" (or something to that tune). If insurance companies had little signs,they would read very close to something like this. For the investor, what this means in practical terms is that in the event of a catastrophic failure of an insurance company, the investor would receive the death benefit of the policy, up to the cap set by the State Guarantee Fund. Any amount over the upper limit would be forfeited. Obviously, investors are targeting policies with muchlarger payouts than the cap, so at best, an investor can hope to recoup a small percentage of their expected payout.
[edit] Protecting Yourself
Analysis of the insurance company that issued the policy is going to be your biggest determining factor when it comes to minimizing insurance company risk.. For example, a good measuring stick might be Standard and Poor's rating of the insurance company. According to one study, the ten year failure rate of a company that was initially assigned an AAA rating is 0.67%, while a company that was given a CCC rating during its first year is a whopping 44.23%. We're not suggesting that you rely solely upon ratings, however - examine a large range of criteria, including but not limited to:
• Years of operation
• Reserves
• Allegations of fraud
• Rate of growth
• Industry reputation
Diversification is also key to protecting yourself. Don't solely purchase policies that have been issued from a single company - if practicable, try to spread out the policies. It doesn't hurt to also purchase policies in different states.
[edit] Life Settlements Laws and Regulations:
The Life Settlement industry is not a self-regulating industry. It is a government regulated industry.
• Life Settlement Regulation Changes
• Court Cases
• State By State Update
• FASB
• CFA Institute B. National Association of Insurance Commissioners (NA1C)
• NA1C Viatical Settlements Model Regulation
[edit] Investigating and Verifying Life Settlement Materials
The Life Settlement industry is not a self-regulating industry. It is a government regulated industry.
[edit] Life Settlement Regulation Changes
The past few years (2003 - 2005) have been exciting for the Life Settlement industry. Institutional investors have begun to see the value of Life Settlement transactions and are beginning to invest in life insurance policies. As business continues to grow, many parties are taking an interest in it and helping to shape the future of the industry. For nearly ten years, those in the Life Settlement industry have worked closely with the NAIC (National Association of Insurance Commissioners) to effect consistent and intelligent regulation for this emerging industry. The NAIC has regularly supported positions and offered recommendations about how and to what extent the Life Settlement industry should be regulated. Though the recommendations of the NAIC are not law, the nature of current Life Settlement regulations make it one of the few sources of uniform regulation for this business. In June of 2004, the NAIC adopted a model that does not require separate licenses for insurance agents who recommend Life Settlements to their clients. One of the many advantages this model offers to those considering Life Settlements is the removal of a layer of bureaucracy for insurance companies, policyholders, and Life Settlement companies. It will also make it easier for insurance agents to give clients information about Life Settlements and even encourages this exchange of information. This position runs contrary to prior regulations that some states had which required a separate license for Life Settlement brokers or insurance agents who wanted to recommend Life Settlements to their clients. Government regulators had pushed for the regulation of Life Settlements as securities (and therefore falling under existing securities laws). Protection of consumers has always been at the heart of these debates. The core of the issue is simple - are Life Settlements securities, and should they be regulated as such? And should those purchasing life insurance policies or brokering such transactions be licensed accordingly?
Life Settlements are not securities. The reason for this is simple - the goods being bought and sold are life insurance policies. In the case, however, of managed Life Settlement funds or in the case of fractional policies where stocks of funds are issued to investors (shareholders), many experts consider such transactions securities. Funds and any type of financial instrument with Life Settlements as the underlying asset should also be considered securities.
The core argument that the NAIC has used to combat the compulsory licensing of those facilitating Life Settlement transactions is simple enough to understand - individuals who own life insurance policies should be free to sell these policies to whomever they choose and the service provided by Life Settlement companies is fundamentally an insurance product. In the United States, everyone has the right to sell their personal property at whatever price they choose and to whomever will purchase it. By forcing licensing of those involved in Life Settlement transactions, the government would be limiting the pool of brokers and investors, thereby limiting the owner of a policy by restricting who they may sell their policies to. This is, in effect, a violation of insurance policyowners' constitutional rights. In addition, as Life Settlement companies contend that they deal in insurance products, Life Settlements should not be regulated as securities. Putting aside legal considerations, not requiring licensing for players in Life Settlement transactions will give tremendous benefit to policyowners who wish to sell their policies. By not requiring licensing, many more investors and brokers will be available to the policyowner as resources. This will cause broker fees to plummet as competition for the policies increase. Ultimately, this will lessen the role played by Life Settlement brokers and will lead to increases in the size of settlements given to consumers. This is an important step in improving the efficiency of the Life Settlement industry. With drastically more people qualified to offer services with regards to Life Settlements, the public (as a whole) will become more aware of the industry, which will lead to more information being readily available to policyholders. This will lead to faster general acceptance of the market and maturity of the industry, which will then lead into increased benefits for policyholders, and so on and so forth. An added benefit to this is that as Life Settlements become more widely practiced, organizations (such as the NAIC) will undoubtedly increase their consumer protection directives.
[edit] Glossary of Life Settlement Terms:
Accelerated Death Benefit A feature of a life insurance policy that pays some or all of the policy's death benefit before the insured dies if the insured is diagnosed with a terminal condition as defined in their policy. It may provide a way to get cash from a policy without selling it to a third party.
Actuarial Value The risk-adjusted value of death benefits, taking into account future costs and inflation. Basically, this is the current "market value" of the death benefits, based upon the life expectancy of the insured person. In practical terms, the shorter the life expectancy of the insured person, the higher the actuarial value. If the life expectancy of the insured person shrinks rapidly (due to disease, for example), the actuarial value will rise.
Cash Surrender Value The amount available in cash upon cancellation of an insurance policy before it becomes payable upon death or maturity. Sometimes called cash value or surrender value.
Cash Value See Cash Surrender Value.
Claims reserve State regulators require insurance companies to maintain claims reserve funds to ensure that the insurance company will have sufficient funds to pay all expected incoming claims for death benefits to the beneficiary of the insured's policy.
Death benefit The dollar amount that is paid to the insurance policy beneficiary upon death of the policyholder
Escrow Agent A state or federally regulated financial institution organized under the laws of the United States or any state, whose responsibilities include accepting investor funds, transferring funds in order to purchase policies, paying insurance premiums and receiving death benefits for all policies where Life Settlement investors are not the beneficiaries.
Illiquidity An investment that is illiquid is one that is not easily withdrawn from if a sudden need for cash arises. For better or worse, you're pretty much stuck with it for the time being. Internal rate of return The internal rate of return (IRR) is the discount rate at which the present value of the future cash flows of an investment equals the cost of the investment. It's the break-even discount rate - the rate at which the value of cash outflows equals the value of cash inflows.
Life Expectancy The number of months the individual insured under the life insurance policy to be settled can be expected to live as determined by the Life Settlement provider, considering medical records and appropriate experiential data.
Life Settlement Investment The contractual right to receive any portion of the death benefit or ownership of a life insurance policy or certificate in return for a cash payment that is less than the expected death benefit of the life insurance policy or certificate. Also known as a Viatical Investment. Life Settlements do not include:
• Any transaction between a victor and a Viatical settlement provider
• Any transfer of ownership and/or beneficial interest in a life insurance policy from a Viatical settlement provider to another Viatical settlement provider or to any legal entity formed solely for the purpose of holding ownership and/or beneficial interest in a life insurance policy or policies
• The bona fide assignment of a life insurance policy to a bank, savings bank, savings and loan association, credit union, or other licensed lending institution as collateral for a loan
• The exercise of accelerated benefits pursuant to the terms of a life insurance policy issued in accordance with the insurance laws of your state.
The definition of a Life Settlement Investment is intended to include transactions in life insurance policies regardless of the age or health of the insured. Some states may have adopted insurance laws to limit the scope of coverage to insured persons who are terminally or chronically ill.
Life Settlement Provider/Issuer In the case of a fractional interest in a Life Settlement, any person who creates, for the purpose of sale, the fractional interest. In the case of a Life Settlement that is not fractionalized, any person engaged in the business of effecting transactions in Life Settlement Investments to which the victor is not a party. Life Settlement Provider does not include a broker-dealer, an agent of any person who sells a Life Settlement to no more than one natural person in a calendar year.
Life Settlement Purchaser/Investor Any person who purchases or subscribes to purchase a Viatical (Life Settlement) Investment. Life tables These are actuarial charts based on accumulated data that will give an estimate on the life expectancy of an individual.
Net Death Benefit The Death Benefit of the life insurance policy or certificate to be settled, less any outstanding debts or liens.
Net Present Value NPV is a technique used to evaluate the present day worth of a future payout, after considerations such as inflation and other costs have been taken into account.
Purchase Agreement A Contract or agreement entered into by a Provider with a Purchaser, to which the Owner is not a party, to purchase a policy or an interest in a life insurance policy, or acquire a beneficial interest, or a certificate issued pursuant to a group life insurance policy.
Sales Contract A written agreement entered into between a provider and an owner, the subject of which is a Life Settlement. A sales contract also includes a written agreement for a loan or other lending transaction, secured primarily by an individual or a group life insurance policy, other than a loan by a life insurance company pursuant to the terms of the sales contract, or a loan secured by the cash value of a policy. (Taken from the General Rules and Regulations promulgated under the Securities Act of 1933.)
Secondary Markets A market in which an investor purchases a security or asset from another investor rather than the issuer. These markets do not include a "Provider", a "Purchaser", a "Financing Entity", or a "Special Purpose Entity", but rather does include any Person who is a qualified institutional buyer or accredited investor (as defined, respectively, in Rule 144A or Regulation D, Rule 501, promulgated under the Securities Act of 1933, as amended).
Surrender Value See Cash Surrender Value.
Trading on margin Borrowing money to accomplish trades that you otherwise might not have been able to. In other words, trading with borrowed money. This is generally considered risky, but no guts, no glory, as the saying goes.
Viatical Investment See Life Settlement Investment.
Viatical Provider/Issuer See Life Settlement Provider/Issuer
Viatical Settlement The proceeds from the sale of a life insurance policy to a third party by an individual with a life expectancy of less than 24 months.
[edit] Various Rating Agencies:
Most trusted Organizations
• A.M. Best Company (www.ambest.com)
• Moody's (www.moodys.com)
• Standard Et Poor's (www.standardpoors.com)
• Fitch Ratings (www.fitchratings.com)
