Why the Life Settlement Market Exists

Written by Andrew Walters

Conversations at my family gatherings tend to be stilted and the usual topics starters of ‘how are you?’ and ‘the kids?’ get quickly exhausted. However the other day over a lunch my brother-in-law asked how work was going and I said we, Guardian Management, were launching a new fund called ‘Life Fund’ and then we had a proper conversation and his questioning from an outsiders perspective was quite refreshing.
Saying that Life Fund is an asset backed longevity risk opportunity, needs further ‘unpacking’ for people outside the financial world. The starting point has to be an explanation of the underlying asset: US Life Settlements. These are American life insurance policies sold by the policy holder to a secondary buyer, who takes on the responsibility of maintaining the premium payments in return for receiving the death benefit sum on the maturity of the policy. Unlike other assets, the monetary pay-out, i.e. the sum insured, is specified, so the variability in your return depends on certain factors. Firstly the determination of a fair price for the policy and secondly the amount of premiums that you will have to pay until the policy matures. Guardian Management through its partners can source the policies at prices lower than the prevailing market price and will trade the policies to deliver a return of between 16%-18%pa net of costs.

He was curious as to how we sourced our policies and I detected some undertone of ‘is this legitimate?’ His demeanour changed when I pointed out that this is a well-established licensed market in America that has been operating since the 1990s with nearly $5 Billion traded last year. The entire process is driven by the policyholder wanting to sell their policy. An outflow of premium payments on your bank statement every month makes you occasionally reassess your life insurance requirement. The policy may have been taken out twenty years before as a means of financial protection for the rest of the family in case the main earner should pass away, or to cover estate tax, or funeral costs or mortgages or the children’s education. The insured may also find themselves in a different position now, for example maybe their economic circumstance has changed and they cannot afford the premiums, or they are divorcing or retiring. It may also be due to the fact that their children have left home and are self-sufficient, or maybe they have downsized their estate below the $13.61M threshold at which estate tax applies. For whatever reason, the insured may realise themselves or they are advised by their financial advisers that the policy is no longer required.

‘So, the policyholder no longer needs the policy but why sell it to you?’ he asked. The short answer is that we offer the insured a better return than his alternatives and we can transact quickly. If the policyholder stopped paying the premiums, the policy would simply lapse and they would get back nothing. Alternatively they may try to surrender the policy, if there is a savings element, but the payment tends to be very low. The most current figures for 2023 from Life Insurance Settlement Association (‘LISA’), showed that their members handled 3213 Life Settlement cases with a face value of $4.67B and that resulted in $707M more to the policy holders than if they had lapsed or surrendered the policy back to the life office. According to LISA, policy holders on average get six times the value for their policy than if they surrendered it to the life office and so it is clear why they would consider selling their policy.

My brother-in-law, then asked why the Life Office, who issued the policy, does not just pay more for the policy and “kill” off the secondary market. The answer is that firstly the secondary market is a fraction of the total insurance market, and the insurance company has priced into their financial modelling a certain degree of policy lapses. Life offices are also mandated by the regulators (such as the NAIC) to ensure that the insurance that is being sold is appropriate for the needs of their consumer and so they do not want to encourage higher surrender rates by offering more. The Life Offices are not required by Federal law to let the policyholder know of the existence of the secondary market, and even though some individual states do have that requirement, by publicising the advantages of selling policies directly to Life Fund, gives us a vast opportunity to source untapped assets.

’If the Life Office is not willing to pay a lot for it, where is the value to the Fund, as the purchaser?’ The value to the secondary market is to create an arbitrage opportunity in what was considered an illiquid asset class. The arbitrage exists because there may have been a change in the health status of the insured since the issuance of the policy. The Life Office gets one chance to price the policy, i.e. the cost of premiums, based on the life expectancy of the person seeking insurance. The purchaser gets to review the policy at some point in the future, when the insured is ready to sell, and at that point there might have been a change in the health status of the insured and their life expectancy maybe much shorter than originally forecast. The shorter the life expectancy the sooner the pay-out from the Life Office and the more certain the return and therefore the more valuable the policy.

‘So’, he then said, ‘the key question is how do you ensure that you get the life expectancy right? As part of the Life Settlement purchase process, the policy holder allows the buyer to access their medical records which are sent to an independent Life Settlement underwriter to make that assessment. Moreover, the policyholder is required to complete an extensive questionnaire as to their life style activities, with questions such as do they own a pet, do they play regular sport and is their spouse still alive – all of which could impact on the policyholder’s life expectancy. Equally, a social media search may be conducted to ascertain certain habits of the insured not disclosed in the medical records. For example the offer price for a policy of a 75 year old may at first look acceptable but a further search shows that he is a keen scuba diver. This could mean he is in better health than one would expect, but also care must be given to the details of the policy contract which may exclude a pay-out if death incurred whilst indulging in this stressful sport. The underwriters take all of these holistic factors into account to rate the specific insured’s health against the mortality experience of a cohort of individuals of the same age, gender and smoking status. The life expectancy they produce is expressed as a mortality distribution, i.e. the chance of dying over the coming years, which we then incorporate into our actuarial model along with details of the policy contract to estimate the value of the policy. The volatility in life expectancy that is displayed with one insured can be reduced by holding a diverse portfolio of many lives and it is experience that gives you that ability to source correctly.

‘What happens if you get the get the life expectancy wrong?’ he said with a cautionary glance. If the estimate is too short, then the purchaser will pay more to acquire the policy and ultimately will end up paying more premiums than expected reducing the returns. The purchaser may also receive the pay-out later than expected, which delays any reinvestment. Maintaining the policy to maturity then depends on the liquidity position of the purchaser. The purchaser rarely wants to let the policy lapse and so could be forced to get a credit line or resell the policy back onto the market at a lower value compared to what they wanted. Of course, the converse is true, if the insured should pass away earlier than expected then the returns will be much higher.

‘So, having bought the assets it is simply a waiting game?’ I was keen to point out that there is a lot the manager can do to maximise the potential return through reverse engineering the cost of insurance. The premiums quoted by the Life Office are designed to be consumer friendly presented as a regular monthly or quarterly sum, but they are not a true reflection of the cost of the insurance. Cost of Insurance is the minimum required to keep a policy in-force and usually increases from a small sum below the paid premium to a sum greater than the paid premium later in life. If the person insured passes away and there is an excess from premium overpayments it is not repaid on death. To maximise the return, the portfolio manager should only pay the required minimum fees to keep the policy in-force. The team at Guardian Management has been purchasing, managing and selling Life Settlements for over twenty years and know how to analyse the details in a policy document in order to maximise returns.

Finally he asked, ‘if the industry is established there must be others doing this, so what makes you unique?’ Our approach is unique in that we aim to source a large proportion of the portfolio directly from the policy holders and it is the shortening of the supply chain that will mean the assets are acquired below the prevailing secondary market value. Having made a purchase, we will actively monitor the policyholder to see if they has gone through any further deterioration in health, in which case it may be worth holding onto the policy to maturity. Otherwise the policies will be batched and regularly traded into the market to immediately crystallise the gain so mitigating longevity and liquidity issues.

My brother-in-law smiled and nodded, and we agreed that we should chat more often.