June 01, 2021 at 04:08 PM
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What You Need to Know
The Great Storm of 2008 raised questions.
When the COVID-19 pandemic hit, some investors cashed out.
In the end, life settlement funds took a punch and kept on going.
What a difference a decade (or so) can make.
Roughly 13 years ago, the life settlements market suffered a massive dislocation. Changes to actuarial assumptions used by industry medical underwriters combined with the global financial crisis to create a confluence of events that left many portfolios in shambles and many investors wary of the asset class.
Today, however, with stock market valuations near record levels and real bond yields below zero, the central premise of life settlements — an asset class capable of delivering high single- to low double-digit annual returns with low correlation to traditional financial investments — is more relevant and appealing than ever.
With that perspective as context, it’s instructive to recall exactly what happened to life settlements late in the first decade of the new millennium and to ask whether today’s market is in a better position to withstand the next major financial shock. To the extent last year’s pandemic-related market swoon served as a stress test for life settlements, the early indications are reassuring.
The Great Storm of 2008
Thirteen years ago, a perfect storm affected life settlements, and the industry was not prepared. “Hot money” was pouring into a comparatively small market. Banks were loosening their purse strings to provide leverage and financing for policy premiums. At the same time, new buy-side players were entering the space, often with more capital than experience in the highly specialized asset class.
Two distinct events combined in short order to cause market conditions to deteriorate rapidly.
The first domino to fall was in late 2007, when two leading underwriters to the life settlements industry made changes to their data tables. This was followed in February 2008 by an update to the Valuation Basic Tables (VBTs), a key mortality input used throughout the life insurance industry to calculate life expectancies. These changes affected asset valuation levels for many portfolios more negatively than expected. In some cases the write-downs triggered by revised life expectancies meant financed assets were underwater, resulting in forced selling.
On their own, the valuation markdowns would have been a big development for the life settlements market. However, they were followed the very next month by an event that shook the entire global financial system — the March 2008 collapse of Bear Stearns (and, just six months later, by the even bigger collapse of Lehman Brothers). The ensuing financial crisis had major impacts on life settlements: The leverage that was financing premiums in many portfolios became much more expensive or dried up altogether and discount rates climbed sharply, creating losses on portfolios being marked-to-market. The natural desire to cash in “good assets” to pay for “bad assets” in difficult times also had a negative effect on life settlement funds, as redemption requests forced the liquidation of policies at distressed levels.
Thus, returns in the asset class broadly declined, which led some to question whether life settlements truly are less correlated to the financial markets. After all, stocks and bonds traded down sharply, and to a lesser extent, so did life settlement assets — at least on a mark-to-market basis.
A Key Distinction
Correlation, however, comes in different flavors. One is the “direct correlation” of returns between certain asset classes. For example, the returns of equities are often correlated to the returns of corporate bonds since both are linked to companies’ operating performance and the financial condition of company balance sheets. Similarly, international stock values frequently correlate to the strength of the dollar due to currency translation.
The other major form of correlation is what has come to be known as “embedded beta.” This is where assets with no obvious relationship nonetheless trade lower together in times of distress due to liquidity concerns and the very structure of financial markets. Notably, most of the life settlements markdowns 13 years ago had little to do with a direct, fundamental relationship to other financial assets and everything to do with embedded beta.
If the dislocations of 2008 were largely the result of macroeconomic forces, it is worth considering whether those factors are still operative. In other words, have life settlements reduced their vulnerability to embedded beta? If so, an investment in an asset class capable of generating above-market returns with low correlation to traditional financial assets may be worth a fresh look.
What’s Different 13 Years Later
Several distinct changes to the life settlements market make it better positioned to handle stresses than it was in 2008:
A larger and more stable asset base. The size of the life settlements market has grown significantly in recent years (as evidenced by the graph above), and that growth has been accompanied by increased stability. The rapid growth is also expected to continue, as some projections show market volume topping $60 billion by 2025 as the baby boomer generation reaches the prime age for settling their insurance policies.
The development of the institutional/tertiary market. One direct positive upshot of the 2008 financial crisis and related forced selling of life settlement assets was the development of a liquid trading market for entire portfolios. Consequently, tertiary trading volume in the life settlements industry is now substantially greater than secondary volume. This clearly indicates a market with better liquidity, increased standardization and improved opportunities for price discovery.
Greater specialization. Just as important as the top-line growth in market size is the nature of the investors driving it. Going into the global financial crisis, the end investors in life settlements often invested through multi-strategy hedge funds, where life settlements were one sleeve of a broad investment strategy. Since then, the market has seen a remarkable increase in stand-alone specialty managers focusing solely on life settlements, with asset class-specific investment strategies, capital raising, and investor relations functions.
A more sophisticated capital base. Institutions such as pension funds, foundations and endowments have also become more active in the space, which is good news for all investors for two important reasons:
They tend to demand — and, due to their clout, receive — greater transparency and sounder operational policies and procedures from managers, and
Their capital has historically been “stickier” in times of market stress.
Less leverage. Industry-wide leverage data for the life settlements market is scarce, but most market participants agree that there has been a significant reduction since 2008. It was not uncommon to see non-recourse premium financing of roughly 50% of NAV at that time. In contrast, today, the Loan-to-Value (LTV) of life settlement portfolios is typically 20-30%.
Better data that’s better understood. Life settlement fund managers have become more sophisticated consumers of data and proficient users of analytics than in 2008. A good test of this came about last year when two major providers of life expectancy data diverged sharply. Rather than mechanically writing down their portfolios as they did 13 years ago, most market participants took a measured approach that relied on multiple underwriter inputs, VBT tables, and statistical analysis that muted their reaction.
Valuation best practices established. The ingredients for a credible valuation system are now available and widely accepted within the industry: mortality tables that capture hundreds of years of data, a greater number of medical underwriters, and the increased use of software to analyze future cash flows.
Sounder legal footing. The regulatory foundation of life settlements has improved markedly. Of the 50 U.S. states, 43 now have specific regulations governing how individuals can sell their policies. Today, when most people buy life insurance, there is a prominent disclosure informing them of their legal right to sell it. Better regulations have been good for the asset class because they have discouraged bad actors from taking advantage of policyholders.
An image makeover. Perhaps due to shoring up of the regulatory framework, the public perception of life settlements has improved. Potential policy sellers can feel confident about monetizing their assets, and likewise, investors can feel good in the knowledge that their capital is helping seniors achieve financial independence. Indeed, one could credibly argue that life settlements should be designated as responsible investments, since they often help the sellers pay medical bills or fund retirement later in life.
The Pandemic as Stress Test
To be clear, March 2020 was not March 2008. Governments and central banks also learned some lessons from 2008 and quickly flooded financial markets with unprecedented liquidity this time around to staunch the bleeding. Nonetheless, the global pandemic was an important — and ultimately successful — test of maturity for life settlements.
When the virus first swept the globe, market participants were wary on two fronts. First, there was the health dimension; how would the market digest and adjust to any impact on mortality? Secondly, there was the financial market dimension; as the economic fallout of a global shutdown dawned on financial markets, would life settlements track traditional risk assets lower, or would they deliver on the uncorrelated promise?
On the health front, there were few surprises. While some observers initially speculated that the pandemic could provide a windfall by increasing mortality, managers of life settlement assets mostly assumed a prudent, wait-and-see posture. They quickly discerned that after the initial spikes in death, the population underlying their policies would not be significantly affected by COVID-19, primarily due to increased public health measures, less activity due to lockdowns, and restricted or controlled access to nursing homes.
In terms of correlation to broader financial markets, the asset class did experience some muted embedded beta effects as investors — similar to 2008 — required liquidity and requested redemptions from open end funds. Supply was also reduced at the beginning of the pandemic as potential sellers hunkered down to see how things would play out. But these factors primarily resulted in some increased volatility rather than the steep losses and carnage from the previous cycle, and the asset class continues to thrive. This is evidenced by both the steady market activity of today, and the continued performance of closed-end funds that aren’t prone to liquidity pressures.
In other words, life settlements took a punch and kept on going.
What It Means
Much has changed since 2008. The life settlements industry has grown considerably, not just in terms of assets, but also in its level of sophistication and ability to appeal to a broader group of investors.
The structural market changes discussed above may reduce the embedded beta typical of open-ended life settlement funds, create a general increase in market liquidity, and drive continued measures to bolster the market’s legal and regulatory framework. Therefore, it is a great time for investors, who are understandably nervous about frothy equity valuations and frustrated by appallingly low bond yields, to give this uncorrelated total return asset class another look.