An industry that had a meteoric rise in the first eight years of the 21st Century is now struggling to find its footing in a world turned upside down by continuing increases in life expectancies, the worst economic downturn since the Great Depression and the withdrawal by the same investment banks that fueled the rapid growth of the industry.
But there is another shoe that could drop in the future.
The life insurance industry acknowledges challenging the life settlement market at every turn, and its decline is allowing carriers to heave a sigh of relief. Part of the reason for that is the growth of “manufactured policies,” or stranger-originated life insurance, referred to as STOLI, which was of deep concern to the industry and raised legal issues. Unrealistic projections of mortality by underwriters are another factor that encouraged investors to flee life settlements, industry officials say.
“Without question, there is less capital available to this industry than there was before the recession,” said Michael Fasano, president of Washington, D.C.-based Fasano Associates, one of four major underwriters who advise potential investors on actuarial and mortality risk. Fasano said part of that is simple investment economics. “When there is a credit crisis, capital flees from alternative investment to the most secure investment.”
Yields on Treasury securities are at historic lows, but in relative terms, yields on alternative investments are at historic highs. The flight to quality played a role in the precipitous decline in the life settlement industry, Fasano said, but compounding that problem “was a lack of confidence in many of the players and participants in the industry.
“It may have been unfair to tar everyone with the same brush, but that is the way it is,” Fasano said. “There are not many positive investment stories if you look at the experience of the ultimate investors in life settlements,” he said. “If you look at the overall market, most [people] have not done very well.”
What the experts say
In a 2011 study, Conning, an insurance research and advisory firm, reported an optimistic outlook for the life settlement industry. Looking ahead to 2012, it noted, “We see an asset class where consumer demand remains strong. However, capital inflows remain weak despite the fundamental appeal of life settlements.”
Moreover, the study said that the fundamental appeal of life settlements remains. “Life settlements continue to offer a value added benefit to policyholders as long as insurers are unable to provide cash surrender amounts that reflect a policy’s mortality-adjusted economic value. Life settlements also retain their attraction as an alternative asset class for investors due to the low correlation with equity markets and competitive returns.”
But the market continues to struggle. Fasano puts it more bluntly. “All along the line – banks, investors, players, etc., etc. – there has been a decline.”
Darwin Bayston, president & CEO of Life Insurance Settlements Association (LISA), acknowledges a precipitous drop in the number of players, agents, brokers and employees of allied industries, such as the companies which advise potential buyers of the actuarial and mortality risk associated with life settlement acquisitions. He said LISA membership has declined by 40 percent since 2008.
An August 2013 case study by Professor Lauren Cohen of Harvard Business School contains a chart that is more specific. It says that the annual volume of new business in life settlements in 2002 was $2 billion, constituting $1.9 billion of policies in force; rising to $11.77 billion in annual volume in 2008 representing $31.78 billion of policies in force; and plunging to $1.25 billion in annual volume in 2011, representing face value of policies in force of $35.06 billion. Volume rose slightly in 2012, to $1.26 billion, but the value of policies in force continued to decline to $34.02 billion. (In-force life settlements are life insurance policies owned by third parties that had not yet paid out, Cohen said in her study.)
The American Council of Life Insurers (ACLI), which has battled the life settlement industry on various fronts for a number of years, submitted testimony to the Florida Office of Insurance Regulation in September 2013 that said, according to data gathered from state insurance regulators, the number of viatical life settlement transactions declined in 2012 by 11.8 percent to 1,187 settlements from 1,346 in 2011. And the total face value of policies sold declined to $2.12 billion from $5.06 billion.
Behind the downturn
Fasano said the secondary market is still very slow and there are several reasons for that. First, the market was larger than it should have been in 2006, 2007 and 2008 and the market grew larger than the fundamentals justified.
A combination of related factors led to this, Fasano said. “There was a significant component of manufactured policies, policies that were taken out with the intention of reselling them – STOLIs.”
Coupled with that was the fact that life expectancy estimates from some of the life expectancy underwriters “were just too short,” he added.
And, the “intermediaries took advantage of poor underwriting in the market,” Fasano said. The result? People were presented investment opportunities that merely misrepresented true economics.
In addition, the banks that were involved in making premium finance loans to fund these transactions – as well as the investors who purchased these investments – lost money. “That created a real public relations problem for the industry,” Fasano said. “At the same time, it produced more policies than were economically justified, so that those portfolios now overhang the market.”
The ACLI’s submitted comments to the Florida Department of Insurance hearing on life settlements supported Fasano. The ACLI said that “the life settlement market has been declining for years as the volume of large, premium-financed policies has been drying up.”
“The detection and suppression of STOLI policies lacking insurable interest has been especially important in adjusting secondary market activity to realistic levels,” the ACLI said. “The secondary market’s revision of life expectancy evaluations and the incessant revelations of fraud further demonstrate how the viatical settlement business suffers from problems of its own invention,” the statement said.
Fasano said the industry’s problems were exacerbated because of the entrance of German investors in 2004. “We had more investment dollars chasing this asset than was justified. That was what led to the some of the bad things; that was what led to some of the manufactured policies, the irrational pricing.”
He said so-called market players saw opportunities. Investors were chasing the asset, but there was not enough generic product to supply the market. That was where the manufactured schemes came into play. Fasano uses a manufacturing analogy to make sense of it. “If you are selling shoes and all of a sudden more people want to buy more shoes than you have in the store, then companies that make the shoes manufacture more of them,” he said. “It is appropriate to manufacture more shoes, but when you are in investments, it is not appropriate to manufacture life settlements.”
Regarding the future of the industry, Conning reports that, within the next eight years, the size of the industry will shrink from $35 billion to $10 billion (face value) of in-force life settlements.
But LISA’s Bayston holds a different view. He said the industry is working its way back, starting to grow because pension funds “are inquiring about life settlements and beginning to put some money into the business.” Bayston said they are seeking a higher return because of the low interest rates.
“We are coming back to basics by dealing with ‘organic policies’,” Bayston said. “That is awakening interest. Both public and private pension plans are re-entering the business, but not to the extent that was before.”
Managers of family wealth, otherwise known as family offices, are also resuming interest in life settlements. However, as Bayston notes, the volume is much smaller than it was, and the underwriting is much more stringent.
“My objective view is that there are more investors who have left the space than have entered the space,” Fasano said. “But that may not necessarily be bad. That may just be the market reaching equilibrium.”
Fasano noted that he is hopeful that as the economy continues to improve, more money will start flowing to this asset class, because the fundamentals are positive. “It is an excellent asset, particularly for life insurance companies and pension funds,” he said. “It makes all the sense in the world. There are some significant investors who see an opportunity here,” Fasano added.
The Conning study appears to be as relevant today as it was when written in 2011. It concludes that, looking ahead, the $35 billion of in-force policies will eventually begin to pay off to investors over the coming decade. Therefore, the study says, the challenge for the life settlement industry remains attracting capital to buy new policies. “While life settlements may be a small asset class, and one that currently may be out of favor with many investors, this does not mean the asset is destined for extinction,” the study says.
And, the study asks, “If capital does return, what would new investors need to know to avoid some of the mistakes made by the first generation of investors and fund managers?” It is clear that there is a niche in the marketplace for life settlements. It can be sold as a valuable tool in providing consumers with flexibility and investors with a reasonable return. However, all participants should get involved with their eyes wide open, and not see it as a get-rich-quick scheme. Moreover, capital will come to this niche market only if it is marketed this way.