Institutional investors looking to diversify their portfolios are increasingly attracted to an asset class that offers potentially substantial returns and cash flow: life insurance contracts sold by the original policyholder or insured to a third-party through a life settlement. But investors face steep barriers to entry, as well as a limited supply of product owing to existing legislation and a lack of consumer awareness about the benefits of life settlements.
These were among the chief takeaways of a general session of the 5th Annual Institutional Investor Life Settlement Conference, held at the Ritz Carlton-Battery Park on February 23. The session brought together a panel of institutional investors to describe their different business models, the attractions of life settlements, and their perspectives on the asset class.
The session kicked off with a discussion about whether new market entrants were better positioned as institutional investors or as lenders to such investors. On this point, two on the panel touted the relative advantages of the latter.
Rory O’Connell, a chief financial officer at Imperial Finance and Trading, said that playing the market as investors entails a steep learning curve. New investors, he noted, generally don’t know how to best build a diversified life settlement portfolio that will produce reliable investment yields. As lenders, they can count on more reliable returns and financial protections.
Lorraine Fusco, president and CEO of Crown Life Canada Ltd., agreed.
“If you want to get into this space and don’t necessarily want to invest in a life settlement fund, then there are lots of opportunities to lend to companies or individuals,” she said. “It’s not easy to manage policies — tracking and servicing them, holding them to maturity while maintain an adequate cash flow and collecting the death benefits.
“You have to go through a lot of mistakes before you get a proven business model that works and produces solid returns,” she added. “So becoming a lender is a great segue into this space.”
Those institutions opting to enter the market as investors should expect to pay a premium for policies that pay out sooner rather than later. That means funding upwards of 35 to 40 percent of policy face amounts on contracts insuring “older and sicker” lives.
One can pay less for policies covering individuals with longer life expectancies and entail a longer payout timeline. But such policies, cautioned O’Connell, should make up only a portion of an “efficient” asset allocation strategy.
An optimized life settlement portfolio will comprise policies with a range of life expectancies, thus ensuring a stable cash flow for the investor. A healthy income stream, in turn, will provide lenders the assurance they need to avail investors of premium financing.
“If you don’t pay more for policies with shorter life expectancies, then you risk depleting premium reserves and ultimately, defaulting,” said O’Connell. “So you have to pay a premium for older lives.
“You can’t get to an efficient portfolio only by paying 10 or 12 percent of a policy’s face value,” he continued. “You won’t be able to secure intermediate or long-term financing unless you can demonstrate an ability to protect your cash flow with early mortalities.”
To maintain a healthy balance sheet, investors must also adhere to sound financial guidelines covering policy acquisitions (e.g., not paying more than certain percentage of face amount). Time and again, said Fusco, investors have overpaid for policies they perceived to be a great deal, then burned through cash reserves when the policies failed to mature when expected (i.e., the insured individuals lived longer than the mortality tables forecast).
Turning to a comparison of the secondary and tertiary markets (the latter encompassing policies sold by one institutional investor to another), the panelists agreed that both are necessary, but differed in the approach to the two markets.
Jillian Conlon, a senior director of quantitative analysis and strategy at BroadRiver Asset Management L.P., said that tertiary policy portfolios are generally easier to buy, but the investment yields and payout horizon are less certain because the investor is acquiring older documentation (medical records, etc.). To boot, secondary market buyers may not have performed adequate due diligence, making investment yields more chancy.
Conversely, secondary market policies take more time to acquire —an original policy holder/insured might dither for months before agreeing to sell. And because the transactions are more recent, they necessarily entail longer maturity dates.
But secondary market policies are potentially more lucrative: If, say, an investor pays a low percentage of face for contracts carrying life expectancies of 10 to 15 years, but more than half of insured individuals die with 5 years, then the investment return could match or exceed that of a high-yield equity or hedge fund.
Fusco said that Crown Life Canada mostly restricts its acquisitions to tertiary market policies, notably “distressed portfolios” whose secondary market owners are having difficulty funding the premiums. Though less time-consuming on a per-policy basis, tertiary market transactions can still be a resource-intensive affair.
“We purchased a portfolio for $108 million and got a good deal on it,” she said. “From start to finish, the due diligence took us 60 days to complete with 16 lawyers involved across four time zones and two continents.”
She added that Crown Life generally favors holding acquired policies to maturity. The sole exceptions: cases where life expectancies have been miscalculated, leading to cash flow issues; and opportunities to sell policies for a sizable profit.
“If you buy policies with the intention of selling them, then you’re getting into a dangerous business,” he said. “All three of us on the panel have bought distressed portfolios from investors who thought they could make a good business in this space, but ultimately didn’t have the capital to stick it out.”
Helping to facilitate the flow of new capital into the life settlement market is a low interest rate environment that depresses yields on fixed income assets. Institutional investors — pension funds, endowments, private equity firms, banks, among others — are also turning to life settlements in growing numbers to diversify their holdings and mitigate equity market volatility.
“Institutional investors continue to be intrigued by life settlements as an asset class,” said Conlon. “The returns can be quite compelling. Life settlements are not suitable for all investors, but for the large institutions we work with, the vehicles offer a great investment opportunity.”
Large institutions, indeed. O’Connell said the biggest barrier to entry is capital: He pegged the market entry “fee” at $100 million-plus, an amount that might buy from $500 to $600 million in policy face amounts or about 200 contracts.
Spend less and you risk building a less-than-efficient portfolio. Alternatively, a lender to the market can create a well-diversified portfolio financing $30 million or less in annual premiums.
Fusco disagreed, insisting that an institutional investor can do as well with a much lower cash outlay by “having the right partners.”
And what of the supply side? Are life settlement providers and brokers generating enough new secondary market sales to feed the growing appetite of investors?
The panelists lauded the industry’s progress in raising consumer awareness about life settlements as an attractive alternative to a policy lapse or surrender. But more public education is needed if the industry is to reach its potential.
There are also industry and regulatory barriers to surmount. Many life insurers still prohibit their agents and brokers from facilitating life settlements. The transactions also remain off-limits in certain jurisdictions.
“Current law in Ontario doesn’t allow for life settlements,” said Fusco. “Of Canada’s 10 provinces; only 4 permit them.
“We believe that the other 6 provinces, Ontario included, will have to follow suit,” she added. “We don’t think the government should be allowed to dictate what individuals do with their [life insurance] assets.”