In the last couple of years, U.S. life settlement funds have made significant inroads into the U.K. Last year, the U.K.'s securities regulator, the Financial Services Authority (FSA), began approving life settlement funds—opening life settlements to U.K. investors.
In the U.S., life settlements expanded rapidly in the early 2000s from less than $1 billion in 1999 to about $12 billion (face value) in 2008. Life settlements then contracted between 2008 and 2010 to about $7 billion. Although projection from before the financial crisis estimated that life settlements would increase to between $90 and $140 billion in face amount settled by 2016, it’s looking like those projections were far too ambitious.
As the market for U.S. life settlement policies expands into the U.K., Arbuthnot Latham—a U.K. investment bank—is cautioning investors that some life settlement funds may not be as they appear. In its Alternative Investments Thematic of July, Arbuthnot Latham provides a due-diligence primer for investment professionals evaluating life settlement funds. The report lists four primary concerns:
1. Funds over-promising on liquidity
According to the investment bank, “life settlement managers are offering short term (often quarterly) liquidity but allocating investors’ capital into a long-term and illiquid asset.” Despite the promise of liquidity, funds may halt redemptions or may be forced to borrow to meet redemptions.
When examining a life settlement fund, determine whether the fund can keep its liquidity promises without compromising the stability of the fund.
2. Lack of Valuation Method Transparency
Another significant issue with some life settlement funds is their lack of valuation method transparency. According to the report, many fund managers contacted by the bank were reluctant, or even refused, to discuss their valuation methodologies. A lack of transparency is compounded when valuations are not verified by a third party. "In our minds, this lack of transparency creates a conflict of interest and is by no means independent," according to Arbuthnot Latham.
When examining a life settlement fund, determine whether the fund is forthcoming with its valuation method and whether valuations are subject to third-party verification.
3. Increased Life Expectancy
The next problem is that "people are living longer and therefore the life expectancy assumptions being used are often incorrect." Life spans increased significantly between 1979 and 2007. And some research indicates that life expectancies among the wealthy have increased even more. Because life settlements usually involve policies with a face value of at least $1 million, insureds whose policies end up in the secondary markets tend to live longer than the U.S. average.
When examining a life settlement fund, determine how the fund is dealing with increasing life expectancies.
4. Shortfalls Jeopardizing Premium Payments
Finally, payment of premiums requires that new subscriptions be brought in on a regular basis. If subscriptions dry up, life settlement funds may be unable to pay premiums and may be forced to allow policies to lapse. "In short, life settlement companies are betting that insurance companies have got it wrong. We would argue, in contrast, that life insurance companies have been getting it right for many years and will continue to profit from the business of insuring lives."
When examining a life settlement fund, determine how the fund will stay current on premiums if subscriptions drop below their projected level.
Each of the above concerns can alert investors and their advisors to life settlement funds that may not be able to keep their expansive promises. Life settlements may offer above-average returns that are uncorrelated to the markets—but that doesn’t mean they don’t carry significant risks. Because of the relative youth of life settlement funds, extensive due diligence is essential.
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See also The Law Professor's blog at AdvisorFYI.