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July 25, 2010 at 08:00 PM
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.
