Outlook for life settlements in 2019
March 2019 | TALKINGPOINT | FINANCE & INVESTMENT
Financier Worldwide Magazine
March 2019 Issue
FW speaks with Corwin Zass at Actuarial Risk Management, Ltd about the outlook for life settlements in 2019.
FW: Reflecting on the last 12 months, what trends would you say have defined the life settlements market, from both the investor and consumer point of view? What developments are set to shape 2019?
Zass: If there was ever a crossroads for this market, it certainly appears now. The areas of focus have not really changed over the years. First, can the market expand awareness that a person can monetise their life insurance policy? Second, can you continually evaluate, and segment, an insured by their level of impairment or health as a proxy to understand their implied mortality profile to more accurately estimate their respective remaining lifespan? And third, to what degree can you accumulate a large enough pool of insurance policies to lower the implied longevity uncertainty that increases when not following the principles of the law of large numbers? I believe the market splits between the larger and smaller investors will continue to widen, with more in the larger investor category with deeper balance sheets. This strength is also a disadvantage to the smaller players which generally rely solely on the commercial life expectancy underwriters, versus the larger ones which supplement the commercial views with their own views of morbidity. One of the trends to continually look at is real time assessments of health, as insureds in the older age category have a higher propensity to see higher rates of morbidity events which translates to higher anticipated mortality events. Both the broader life insurance market and those deployed by life expectancy assessors have been slowly moving away from the traditional processes of risk selection. However, from rapid technology advances, society wanting to see instantaneous feedback, and data mining of other risk predictors, expect more conversations about wearable devices, such as smart watches and blood glucose monitors, and behavioural science to evaluate human decision making.
FW: What benefits do the life and structured settlements markets offer to investors? Alongside the benefits, what do you see as the main challenges that investors need to be aware of in both asset classes?
Zass: There are two schools of investors’ thoughts on investing in this space: the belief in double-digit returns and the recognition of minimal correlation of mortality to the financial markets. There clearly are benefits from the lack of correlation, yet those pros can be displaced if you are not mindful of both statistical averaging and the requirement for diversification. Placing all the eggs of one type of basket brings different risk exposures. Participating in both the life and structured settlement markets can help hedge longevity – or mortality – risk exposure; more so if the profile of the lives has commonality. The main challenges of either investment class continue with the difficulty of putting large dollars to work to garner enough lives. Increasing predictability generally comes from a large underlying population with similar characteristics, since it is impossible to accurately predict a person’s date of death. We have advocated that the biggest risk – the idiosyncratic risk – is from the improper categorising of an insured into a particular statistically credible risk category. Simply accepting that a car behaves like a car when it is really a truck to begin with will create unhappy investors.
FW: As the life settlements market has matured and expanded, in what ways has the role of the investment manager evolved with it? What strategies are being deployed to achieve greater value?
Zass: The investment manager may wear multiple hats while acting in a near fiduciary role. What we are seeing is that managers want to become more transparent with their track record. An honest self-assessment is prudent for all professionals, but more so for stewards of other people’s money. Being able to explain why your expectations were or were not met is a start. Looking at the broader life insurance market, the actuarial profession takes on a quite prominent role in managing the core risks. At their disposal are complex projections, the many ‘what-ifs’ tests, and resulting unit metrics and value rollforwards that are the backbone of prudently measuring progress and strategy execution. For the life settlement investment manager, our wish is that these forms of analysis – which should include the likes of actual-to-expected on the number of claims in a period – is central for investors to have the trust that this investment team understands that winning every hand at the gambling table is not possible, but in the long run the strategy can reward. Lastly, the investment team must recognise that the quality of people involved easily trumps the quantity of people. In order to minimise your loss exposure and increase your return potential, you must have the right skillsets, either internally or via advisers. Those that surround themselves with smarter people with specific expertise tend to be those rewarded more times than not.
“As an actuary, I believe there is a need for more scrutiny into the health of the insured during the diligence stage.”
FW: What advice would you give to investors on performing due diligence? What areas of life settlements do you feel require the most scrutiny?
Zass: The three legs to the diligence of a life settlement policy are: legal, actuarial and underwriting. Whether the expertise comes from internal staff or assistance from advisers, there are different levels of diligence that one can perform. The lower the review, the more risks exist, thus translating into the need for a higher discount rate, which is used in the price computation of the discounted cashflow math, producing a lower purchase price to offset those risks. But that comes at a price, as this might produce an uncompetitive bid. Finding an efficient balance between over-diligencing and incurring that respective cost will take a few tries, yet honing toward a form of best practice will pay off in the end. As an actuary, I believe there is a need for more scrutiny into the health of the insured during the diligence stage, whereas legal advisers, for example, typically look to see the chance that the carrier would balk at paying a death benefit. Unless the policy was questionably originated in the first place – which does introduce a significant amount of risk – the insurance policy, meaning the legal contract between the insured, the carrier and the policyowner, has some commonness between policies, yet the health of an insured can take on many combinations that require an evaluation of the morbidity and co-morbidity risks that underpin the development of a statistical average survival curve that supports the discounted cashflow math.
FW: What essential advice would you give to life settlements players on maximising returns in today’s continued lower interest rate and highly volatile equity markets? What about life settlement return volatility?
Zass: My first point of advice is setting real expectations in the first place. Do I believe that an investor can produce above average returns in this asset class? The answer is yes, but compared to what? Look at the other asset classes and ask yourself: where do life settlements fit? It has features like debt and equity investing, some predictability – but on the other hand a pure form of gambling too, since you are betting the over-under on a specific person’s date of death. A rule of thumb we have is to divide the discount rate by two. If that resulting rate is an acceptable ‘floor’ for your investors, then you have set rational expectations. Obviously, the investors want more than this outcome, which is where the investment manager shows their stripes. With respect to the volatility, we have unexpected movement in cash flows, primarily from insureds dying earlier or later than your expectation. Those dying sooner result in life insurance premiums stopping early and the anticipated receipt of the death benefit paid by the carrier. On the other end, if the insured survives longer, then you have further cash drag to fund the premium payments with no death benefit in sight. On a cash basis, volatility is purely from mortality events not occurring as expected. However, on a reporting basis, the balance sheet is based off market price perception under a fair value mark-to-model framework – due to the lack of any real observable prices – which would not explicitly show the same volatility given the assumptions in the model are longer tenor views not short-term movements. This is akin to seeing equity market daily volatility, yet market values are moving average prices. In the end, the investor in this asset class must accept meaningful cash flow volatility with at least some reasonable predictability in their profit reporting results.
FW: How would you describe insurer’s efforts to change cost of insurance (COI) rates? Do you expect such efforts to escalate or taper off?
Zass: To start, universal life (UL) insurance is an unbundled, flexible, hybrid product combining a term life insurance feature with a savings component. Flexible UL premiums come in various flavours, with the annual premium implicitly covering at least one year’s policy costs required to keep the policy in force, and with the balance of the annual premium covering the level of savings trying to attain. Here, those one year’s policy costs include the charges for mortality, policy administration, and other expenses associated with keeping it in force. Premiums paid to the insurer in excess of the policy costs simply accumulate, and are credited with interest, in the policy’s cash value. In general, most UL policy types approved by state regulators had two scales of policy costs: a lower set that is used in the accumulation and a higher set that is the maximum allowable by a regulator. There were also two credited interest rates: a current and a floor. The insurer makes money through a spread mechanism built into the three core profit levers – earn more on the investments than the rate being used to credit interest to the policyholder, charge more in mortality charges than you need to pay-out on death, and charge more in expense charge than the cost to acquire and service the policy. The cost of insurance (COI) rates, in this context, are the rates per $1000 of risk amount used to develop the mortality charges, where those rates generally rise as a person ages, and vary by gender, tobacco and implied levels of mortality. The policy form contracts have legal language that provides some leeway as to what conditions must be met to change the ‘lower scale’ of costs, or the credited interest rate. It is this legal language that is being challenged in the courts by both the life settlement market and the UL insureds who have not yet settled their policies. At stake is whether the carriers can prove they have adverse development, meaning a compression in the spread mechanism – both in terms of how much and for how long – to support the scale change. Any increase in the ‘lower scale’ of costs flows directly into the amounts needing to be paid to keep the policy in force. For those policies already held as a life settlement policy, they were acquired with an assumption as to future policy costs, which include the mortality charges based on the appropriate scale. Those carriers making scale changes generally fall into one of three arguments: their interest spread has eroded because interest rates have been going down for the last 30-plus years, they experienced worse than expected levels of mortality thus paying out more than collected in the mortality spread mechanism, or both. The legal disputes have been contentious; a battle between lawyers and actuaries on both sides of the cases. There have been at least 20 insurers which have attempted to alter their COI scales over the last few decades, some with no disputes and others making the media front page. As you might expect, the impact of the changes to the scales are a driver in seeing the cases making it to the courts. As we understand, there are a couple of big cases, some at a class action level, in the current pipeline. Ultimately, whether more carriers follow this path does come down to the success of the cases on the docket.
FW: What developments are you seeing in life expectancy assessments, and what is the impact they are having on the market?
Zass: This is a fascinating area that in my opinion consists of some art and a lot of science; yet it is still the foundation of betting on longevity. Not unlike the underwriting of a borrower’s credit risk when they attempt to take out a loan, the lender has a process to identify and measure the risk characteristics with the outcome being a score of the creditworthiness which impacts the terms of the loan. Here for longevity, the process looks – underwrites – primarily at the insured’s medical history, with some assessments looking to other areas: the insured’s lifestyle habits and other health influencers. The assessments consist of two stages: the underwriting, meaning the assessment as to the current health profile, and then the translation of that profile into some metrics. While the underwriting provides a profile, the development of a metric – life expectancy (LE) – simply varies for several reasons so there is no standard underwriting measure equivalent to the FICO-score. With the advancements in technology impacting all industries, including the life settlement space, there are expectations of new ways to conduct and collect the information beyond a review of medical records and the completion of a questionnaire or telephone interview. We are aware of a couple of start-ups that are looking to leverage Big Data and other forms of predictive analysis to more accurately profile an insured’s health. In the end, the market will reward those risk assessors evaluating alternatives to the historical underwriting methods.
FW: What are your predictions for where the life settlement space is headed in the next 12-18 months? What is your advice to investors interested in this market?
Zass: In the past, I have been overly optimistic on a few fronts, and frankly hoped for more material changes, including speed to perform the review in the underwriting area, albeit the recent announcements by some of the underwriters may indeed be that change catalyst. My expectation for the forthcoming 12-18 months does not deviate too much, since the market is desperate for change in a few key areas. First, there is a desire for increased consumer awareness, to continue increasing the supply of life insurance policies. Second, we hope for a new wave of life expectancy assessors, with an increase in those using the smaller assessors. Finally, there needs to be acceptance of gold standard reporting of A-E percent, both at the LE assessors but, more importantly, by the investor funds for transparency to show that returns have volatility when measured on a cash basis.
Corwin (Cory) Zass is the founder and principal of Actuarial Risk Management, Ltd, a 12-plus year old consultancy. For over 25 years, Mr Zass, a trained life actuary, and his teams’ collective advice have been sought on topics such as M&A, product & risk management, capital strategy and financial reporting paradigms. His actuarial training rests on a foundation blending common sense, business views and actuarial technical aptitude. Over the last 10 years he and his firm have regularly advised clients on mortality, morbidity and other risk matters important to those participating (or investing) in the insurance space either directly or indirectly, including life and structured settlements. He can be contacted on +1 (512) 345 5200 or by email: czass@actrisk.com.
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