The life settlement market won’t realize its potential until two things happen: (1) commissions on the transactions are much reduced, if not eliminated; and (2) reporting of closing prices and transactions costs of life insurance policy sales are available to the public.
This is the view of Dr. Lauren Cohen, professor of finance at Harvard Business School; and Michael Freedman, president, GWG Life LLC., a life settlement investor and provider.
To learn more about the market’s promise and continuing challenges, LifeHealthPro Senior Editor Warren S. Hersch interviewed the two experts. The following are excerpts.
Hersch: Dr. Cohen, what’s your assessment of the long-term prospects for the life settlement market?
Cohen (pictured at right): The life settlement market is, like other asset markets, governed by inertia. Without a significant external force — and exogenous shock — I don’t see the market remaining viable 10 years out. Life settlement transactions might still happen in small volume, but the market will not develop.
That’s not because the life settlement space doesn’t have the potential to become a large and important market. Life settlements aim to rectify what in economics we call a market failure: when the supply and demand of a product don’t meet.
The life settlement players endeavor to close this gap by creating a secondary market for life insurance policies. Yet, most life insurance policies that qualify for this market — contracts that policyholders no longer need or can afford — are instead lapsing or being surrendered for their cash value, an amount below that of their fair market value.
Hersch: I had interviewed advisors for National Underwriter’s April feature on life settlements. They noted that life settlement sales had increased by 15 to 20 percent during the past year. How does this rise dovetail with your pessimistic forecast?
Cohen: These figures are a bit misleading because you’re looking only at a percentage change in the market’s size. Since the early 2000s, the market has largely contracted, most especially during the economic downtown of 2008-2009. When the market size is small, as it is now, then an increase in year-over-sales can appear large in percentage terms.
Hersch: As I understand it, one factor contributing to the life settlement market’s contraction during the credit crisis was a decline in funding by institutional investors. But the advisors I interviewed told me that institutional investor money is coming back into the market.
One example: Life settlement provider Abicus, which recently secured $250 million-plus to purchase secondary market policies this year. Do you disagree with the advisors’ assessment?
Cohen: No, institutional investors are dipping their toe back into the water.
But you have to look at the larger picture. One of those advisors you interviewed, John Welcome, also noted that life insurance policies valued at some $100 billion lapse annually. I’ve separately heard estimates ranging from $80 to $100 billion.
These policies should be in the life settlement market. If you add to this all surrendered policies that could have gotten a better price through a life settlement, the $250 million you cite amounts to a mere fraction of a percent. So, I see the amount of institutional investor money entering this space as comparatively small in value.
I don’t think you’ll see serious amounts of money entering the market until there is a better benchmarking system. By that I mean financial returns of settlement transactions need to be audited so there is some way to assess the financial performance of the intermediaries and investors involved. This doesn’t exist now.
Hersch: Benchmarking aside, might macroeconomic factors observed by market proponents — growing savvy among institutional investors in valuing policies, low prevailing interest rates, the value of life settlements as a non-correlating asset class, among other factors — help the market to grow in future years?
Cohen: I agree — and portfolio theory would tell you — that life settlements are great assets to have in your portfolio, and for the reason you mention: they don’t correlate with other assets. Given current low interest rates and the market’s huge potential, it can also scale to meet investor demand. But all these points beg the question: Why hasn’t the market grown more, especially since 2009?
Hersch: Could one factor be opposition from life insurers, who don’t like life settlements because the transactions upset their assumptions about policy lapse rates and, therefore, how they price the products?
Cohen: That argument seems like a tough pill to swallow, given that the policies do legally belong to the policyholders. There are only so many roadblocks that life insurers can put up.
Freedman (pictured at right): Investor capital is coming into the market, but not to the same levels enjoyed in prior years. For the life settlement space to grow on the order that Dr. Cohen is talking about, there has to be greater market transparency. Investors need to see financials, such the cost of capital and the costs of acquisition, in order to determine return on investment. This is starting to happen.
Another development is the merging of investors with life settlement providers, or the parties that contract with the policyowner’s broker.
These providers previously had been independent, buying policies and selling them to third-party investors. A number of providers are now integrated with investors firms. GWG owns its life settlement provider, as do several other investor companies. That integration boosts market efficiency and the alignment of interests among the market’s participants.
Hersch: Dr. Cohen, do you believe that the market’s growth hinges on further integration of investors and providers?
Cohen: That’s a key component, but two other fundamental problems have to be addressed. One concerns the financial incentives: Life settlement providers, and their broker counterparts, are paid a commission when a close a sale, rather than on the basis of policy performance. The result is they’re often not getting the sale price right.
Paying a commission for doing a deal is an awful incentive in any type of market, but especially so in a bidding market. These bidding markets often create a “winner’s curse,” a tendency for the winning bid in the auction to exceed the fair market value of the item purchased. And that happens because the players transacting the sale don’t care if they have the price right. The winner in this case, the investor, is really the loser.
Freedman: To my earlier point, this issue is resolved on one side of the transaction when the investor owns the provider. The interests of the two parties, now one and the same, are aligned in respect to the cost of policy acquisition.
Cohen: Agreed. And in GWG’s case, there is such an alignment. But separate from this concern is a second issue, intermediation costs. There are currently two layers of intermediation: (1) the broker on the policyholder’s side; and (2) the life settlement provider on the side of the investor.
Both parties are paid generally high commissions. From all the anecdotal evidence I’ve seen, those intermediation costs can be huge — commissions so high as to retard the growth of the market. You cannot have a well-functioning market develop if the intermediation costs are astronomical and not publicly reported.
Hersch: So the solution to this problem is disclosure of transaction costs, yes?
Freedman: Let’s be clear: Disclosure is already a hallmark of life settlement transactions in that consumers are required to receive disclosure of brokers’ compensation. Statutes are now in place in most of the states stipulating mandatory disclosure of the gross and net offers on policy sales. So buyers and sellers can easily determine what’s being paid in commissions.
Hersch: So what are the intermediation costs?
Freedman: They range. To the point Dr. Cohen was making, these costs are still very high, and thus an obstacle to new investor capital if not addressed. Institutional investors are tackling the problem by, as we’ve discussed, purchasing policies through their own provider.
They’re also cutting transaction costs through direct-to-consumer marketing — thereby cutting out the broker. The trend aligns with the growing number of do-it-yourself consumers who are saying, “I don’t need a broker. I can sell my policy on my own.”
Cohen: These are positive trends, but to ensure fair market value and minimize intermediation costs of policy sales there has to be an additional step: public disclosure of sales prices and commissions. While sellers know the closing prices and transaction costs on their own policies, absent public disclosure, they don’t have such data on contracts sold by other policyholders. And because this information isn’t publicly available, policyholders can’t know whether the amount they’re receiving on a sale and paying in commissions is higher or lower than the market average.
If and when such public disclosure becomes the norm, not only will the increased transparency producer better policy benchmarking for investors, but also reduced costs for policyholders. That may happen either by cutting out one or both intermediaries — independent providers and sellers’ brokers — or by reducing their compensation. Hersch: GWG Holdings and like-minded companies aside, do you see the life settlement players as being receptive to these points?
Cohen: I don’t at this point. The main reason is that each player is individually a beneficiary of the current fee structure. So what you’ll need is either a new, disruptive player coming in and saying, “We’d all be better off if we could grow this market by [undertaking the aforementioned measures].”
Or you need to see some results. In other words, the life settlement providers who are incented to get good returns to pick good policies really do pick better policies. And there needs to be transparency across transactions that all capital investors and policy sellers can observe.