Every investment carries risk, both in the preliminary phase, when you are assessing your options, and in the constant maintenance and adjustments needed to keep your portfolios in check. Life settlement investing is no different.

Life settlements in their purest form are actually quite a simple asset class. The details, however, can be complex. To get the highest returns, a good understanding of how the asset works is needed. Knowing and planning for the risks before investing will help make sure that your ultimate portfolio returns are close to the expected return.

It is widely recognized that life settlement performance is uncorrelated to other asset classes. With a life settlement, it is known what the payout will be. The real question is when it will occur. With the following risks in mind, you will be able to build a portfolio of life settlements with a higher degree of predictability of its performance.

A simple phrase to remember is “COLLAR your risk.” Managing the Custodial, Origination, Longevity, Lifestyle, Analytical and Rescission risks can dramatically reduce potential hits to the return.

Custodial Risk
Custodial risks involve the maintenance and continuing servicing of a policy once it is originated in the secondary market. Perhaps the most important aspect of servicing is the strategic payment of premiums to the insurance carrier. If a policy lapses, all economic value is lost. So it is vital that the contract remain in good standing.

Mortality tracking is another function of the custodian. When done correctly, mortality tracking will keep you current on the status of the insured, ensuring you realize your settlement as soon as possible. There are firms specializing in this area that, for a fee, will ensure each of the proper steps is taken.

Origination Risk
The origination of policies to the secondary market is crucial because it affects the overall quality of the investment. If the settlement contracts are compromised and the agreements between the buyer and seller are not legal, insurable interest and ownership may be in question. The carrier may contest the contract, leading to long delays in realizing the death benefit.

Effective ways to mitigate origination risk include working with a certified escrow agent; conducting criminal and financial background checks on the owner and insured; and verification of ownership status and structure. Policy tracking systems must be set up also, to assure each step of the process is followed and all parties, contracts and signatures are ready.

Longevity Risk
Life insurance underwriters tend to be pessimistic about longevity, while life expectancy providers who service the life settlement industry tend to be on the optimistic side.

For example, an individual with a serious illness may not be able to obtain significant insurance due to the potential that the illness would worsen, shortening their life expectancy.

The same individual could be a good candidate for a life settlement, where the concern would be about the potential for the illness to subside. Industry-accepted pricing models allow for these concerns through factors that are presented with the life expectancy reports. Thus, the accuracy and thoroughness of life expectancy reports along with an understanding of the data they provide are paramount in the overall yield of the contract. Obtaining and blending two underwriter opinions is one way of mitigating possible bias.

Lifestyle Risk
A critical factor with life expectancy is the lifestyle or demographic profile of the insured. Underwriters don’t entirely consider this factor when projecting life expectancy. Traditionally, the life settlement industry has tended to focus on insureds with large policies. These so-called “healthy wealthies” are generally considered to have access to quality medical care and enjoy a healthier lifestyle than do other demographic groups.

At the other end of the spectrum, insureds with small face policies may have irregular or even no medical checkups until they become ill. These insureds also may have lived a relatively high-stress life due to a number of reasons. Lifestyle risk can be significant and is not to be overlooked.

The mortality tables used by the industry to assess life expectancy are based on averages. This would suggest, then, that owners of high face policies would tend to appear on the high side of the life expectancy curve, while small face insureds would appear on the low side.

Assuring your portfolio has a significant investment in smaller face polices, then, will help to further mitigate the risk of prolonged policies.

Analytic Risk
Analytics provide the essence of all investing. The investor must understand the details of the life insurance illustration, know how to properly value the premium reserve and have access to at least one industry model to get valid pricing.

Currently, there are quite a few portfolios of life settlements available for purchase. Investors are looking for great deals and quoting pennies on the face dollar amount for these portfolios. Analysis has shown that a larger portion of these portfolios than might be expected contain policies that have not gone through proper risk management. In fact, these portfolios, although sounding cheap, have actually less economic value than one could achieve through buying and developing a portfolio of individual policies.

Rescission Risk
Finally, rescission risk must be considered. The investor must show there was an insurable interest when the policy was put into force. In addition, origination must be clean and premiums maintained. If there’s a default on any of these points, your investment may not be realized.

Stranger-originated life insurance (STOLI) has become synonymous with these concerns. In addition, various other schemes have been seen to manufacture life insurance contracts for sale to the secondary markets.

If the policy was engineered for resale, the rescission risk is significant. Typically, these engineered policies produced large fees for the producer and were for large face amounts. These policies have been put in force relatively recently. In fact, most of this activity has taken place since 2003. Perhaps the best way to lessen these risks is to be aware of how premium finance and investor-owned programs work and of the loopholes they use to carry out their activities.

Underwriting is one of the key aspects to successful life settlement investing, either through funds or custom structured portfolios. Whenever a secondary market exists for any contract, it improves the overall efficiency of the entire marketplace. Life settlements provide great financial benefit to both the insured and the investor. The market has flourished primarily due to high insurance carrier premium levels and the number of insureds who find it difficult to maintain the policy through maturity.

Some funding organizations have taken the market to a level where the risks are considerably elevated through STOLI, synthetic, derivative and other types of contracts. Focusing on COLLAR risk-mitigation factors ultimately will result in a successfully managed outcome. As the life settlement industry matures and the underwriting becomes standardized through the aggregation of actual results, mainstream investors will embrace this transaction. Life settlements deliver a choice and an exit strategy for the life insurance policyholder.

Mark Engelhardt is CEO of Life Policy Group L.L.C., New York. His e-mail is mengelhardt@lifepolicygroup.com.