The life settlement industry is now worth over $16bn with market analysts predicting further growth over the next two years to $21bn ( Life Settlements – A buyer’s market for now 2009 by Conning Research & Consulting). The recent turmoil in the financial markets demonstrated that many of the more traditional alternative investments, such as hedge funds failed to provide investors with adequate portfolio diversification. Consequently there has been increased interest from financial advisers and asset managers looking for a different alternative investment product that will deliver low volatility and uncorrelated returns. This article aims to provide a brief overview of how life settlements work as an investment tool and to demonstrate how they can help to diversify an investment portfolio and both improve performance and diversify risk.
How does a life settlement work?
A life settlement is the term used to describe a life insurance policy that has been traded in the secondary market. These traded policies are bought from their original owners; usually US seniors aged 70+, who receive a cash sum which is worth considerably more than if the policy was surrendered. Life settlements are mainly purchased by institutional investors such as banks, pension funds and life settlement funds.
A life settlement fund holds a portfolio of individual policies with varying longevity expectations, which when combined in a portfolio aim to deliver consistent returns with little market volatility.
The key risks inherent in life settlements are complex and need to be thoroughly understood by both potential investors and their advisers before investing. In particular, understanding the intricacies of managing exposure to the various types of risk within a portfolio is critical to a successful investment in this asset class. Whilst the principal risk is that of longevity and the policyholders living longer than expected, requiring the fund to pay out additional premiums and therefore having to wait longer for the maturity values, other risks such as origination and liquidity risk also need to be considered when evaluating a portfolio of life settlements.
Why invest in life settlements?
Compared to other alternative asset classes, life settlements can provide attractive and predictable returns with low volatility and market correlation, which appeals to a wide range of investors, particularly those targeting inflation-beating returns and capital preservation.
By relying on the duration of the life expectancy of the insured and not on the market prices of a fund of stocks and shares, for example, a life settlement fund is not subject to the same vagaries of the financial markets, and therefore is more predictable. This predictability can be a particularly useful tool for financial planners when they are planning for education or retirement funding.
Using life settlements in an investment portfolio
Introducing life settlements into an investment portfolio can increase performance without increasing the risk profile. For financial advisers the key issues to consider are what is the optimum asset allocation to meet their client’s investment objectives and what effect is this going to have on the portfolio’s performance and risk profile.
So, in practice how does this work? The sample investment portfolios below have been modelled to demonstrate how life settlements can be incorporated into an asset allocation mix to obtain different results depending on the investor’s risk profile and investment objectives.
The asset allocation models contain the asset classes that typically would be held within a balanced portfolio with a relative risk rating attached to each as follows: Level 1.0: Cash & Gilts; Level 2.0: Life/Longevity; Level 3.0: Corporate Bonds; Level 4.0: Property and Level 5.0: Equities. The individual risk ratings are then weighted depending on the asset allocation to provide an overall risk rating for the portfolio.
The asset mix is based on different assumptions depending on the risk profile of the investor with more cautious investors holding a larger proportion of low volatility assets than a more opportunistic investor for example.
Portfolio 1 – Cautious
Our first type of investor is either approaching retirement age or has already retired and is looking primarily to protect his capital or at the very least to minimise any risk to his capital with a view to generating income either immediately or in the near future. The investment portfolio is therefore heavily weighted towards low volatility with a smaller element put into corporate bonds to mitigate the effects of inflation.
The performance chart below shows how the actual performance of the existing portfolio on a weighted basis can mitigate the effects of a downturn in an individual asset class performance.
By definition, the asset mix of a cautious investor will not provide a significant opportunity to reduce the risk profile so in order to introduce life settlements into the asset allocation, the exposure to guaranteed life bonds has been reduced, as these have a similar risk profile, to create a life settlements holding of 10%. The result is that whilst the conservative risk profile of the portfolio has remained unaltered, the performance has been improved by over 3% when back tested over the past four years.
Portfolio 2 – Opportunistic Balanced
The second model portfolio has been structured for a less risk adverse type of investor. Typically they are looking for investment opportunities based upon market timing and hence hold a higher than average level of liquidity.
