Life expectancy reports are an important part of the life settlement process, and increasingly a growing concern as investors and other players in the transaction are seeing the effects of variances in life expectancies on the pricing of policies in the secondary markets.
Darwin Brayston, managing director of Life Settlement Consulting and Management LLC, spoke at the Life Insurance Settlement Association’s annual fall conference here. While the title of his presentation referred to life expectancies as a “growing concern,” he said a more accurate label may be “a ticking time bomb.”
Life settlement companies, he said, have become overly reliant on life expectancy models and need to reassess how they factor into pricing. If they don’t, he argued, the life settlement market may end up learning the same lessons that are currently being experienced by subprime mortgage lenders.
While acknowledging that few share his opinion, Brayston said there are strong similarities between the secondary life market and the subprime mortgage market. Both, he said, developed “in a world awash with liquidity” that has fueled their growth. “There has been cash available for almost anything,” he noted.
Additionally, he said that both life settlements and subprime mortgages make heavy use of “complex valuation models.”
Therein, he said, is where the problem lies. Subprime lenders, Brayston said, relied too heavily on models that proved to be incorrect. Currently, he added, many life settlement companies are putting too much of an emphasis on models in their pricing, which he referred to as “marking to model.”
The issue is of fundamental importance he said, because life expectancies are at the root of investing in life settlements. “It’s about when we’re going to get our money back,” he said, adding that life expectancy “is the most important factor in determining value and pricing” in a life settlement transaction.
“If they’re flawed,” Brayston said, “it makes a significant difference in expected returns.”
As an example of how significant the effects can be, Brayston calculated a life expectancy report using the same policy and the same mortality table. Two different models, he said, produced life expectancies that varied by 23 months. That difference, he said, can result in a pricing difference of 74% and a difference in expected returns of as much as 3% per annum.
Earlier in the conference, J. Mark Goode, CEO of Secondary Life Capital, LLC, also said “there’s nothing that impacts a policy’s value more” than life expectancy, adding that an underestimation of even one year can have a significant impact on the returns produced by a portfolio.
The experience with life expectancy reports, however, is getting better, he noted, saying “there appears to be standardization and convergences” in life expectancies.
While increasing accuracy in life expectancy reports is good news, he added that it can be troublesome for many closed funds that are nearing their end.
One of the main problems, Brayston noted, is that most life settlement companies, as well as the sellers and investors are more focused on the short term. Adding to that, he said, is that the different parties have competing interests. Selling agents, and the brokers they work with, are hoping for the highest possible price, which would come from a short life expectancy report. Investors, on the other hand, prefer longer life expectancy reports that result in lower purchase prices. “In each case, people are only interested in themselves,” he said.
In the middle, Brayston noted, are life settlement providers, who are “on the fence” between wanting to keep their investors happy and needing to compete in the market to obtain policies. To combat the problem, he suggested a system that would establish an independent rating of a company’s actual versus expected results based on life expectancy.
“We could actually set standards for actual to expected performance,” he said. One issue to be expected, he said, would be company’s claims that their models are proprietary information, but Brayston said that any such information could be protected and, ultimately, wouldn’t be what the ratings would be all about.
“I don’t care how you do your proprietary part,” he said. “I just care how good you are.”
Brayston acknowledged his proposal was “controversial” but said the importance of life expectancy reports in the process of life settlements makes it equally important that the industry “get this part of the business right” to attract investors.
“The availability of long term capital is at stake,” he said. If problems arise due to inaccurate life expectancy reports, he said the entire industry could be affected, even companies that have life expectancy models that have proven to be accurate.
Already, Brayston said, he has heard in conversations with attorneys that underperforming life settlement portfolios could provide a “work program” for the next generation of attorneys.
“When the tsunami comes, it takes everyone away in its wake,” he said.