FW speaks with Corwin Zass, the founder and principal of Actuarial Risk Management, Ltd, about the future of the life settlement market.
FW: How is the life settlement space shaping up in 2014 so far? What trends and developments are dominating the space?
Zass: Coming out of 2013 there was this cautious optimism for investors. The fact that the equity markets had a fabulous year in 2013 seemed to have investors focused on what was in front of them: attractive yields. However the little market hiccups in February 2014 had restored investors’ concerns about a market correction, not if but when. On the bond side, the fact that the US Federal Reserve has given indications that interest rates will remain low in spite of some sentiment for rising rates means that the likely outcome will be a rise in the short end of the curve thus creating a flattened yield curve. This simply means that long term risk adjusted returns of 7-9 percent from a prudently managed life settlement investment remains attractive for those investors looking for less equity volatility and longer term fixed income stability. This investment space requires large capital investments to harbour the results of the law of large numbers simply critical to any chance of success.
FW: What challenges has the life insurance market posed to life settlements in recent years? What has been the impact of the recent decline of the insurance market?
Zass: The life insurance marketplace has come to realise that the life settlement phenomena are more than a coming fad. In our opinion, the life insurance industry is slowing starting to follow the old adage that “keep your friends close but your enemies closer”. The two markets, the direct to the insured (that is, insurer) and the secondary (and tertiary) markets must work together into the future as there is an obvious role for both parties. The advancing tsunami of the US baby boomers which holds a large supply of in-force life insurance policies will continue for at least a decade to transition into the life settlement ‘sweet spot’ of the risk characteristics – meaning ages above the mid-70s – in which the economics can work for settlement. The only major concern we have on the direct insurer side is an even longer prolonged depressed low interest rate environment. Since insurers hold large allocations in fixed income assets, these lower yields may produce an erosion of capital resulting in pressure on the current credit rating. While we do not see this as a huge peril for the life settlement market over the short period, the long run could see counterparty risk going up through downgrades in A.M. Best ratings and the like. Furthermore, the life insurance industry, and more specifically the actuarial profession, will need to incorporate the life insurance settlement risk into the pricing paradigm to account for this quasi anti-selection risk.
“The life insurance marketplace has come to realise that the life settlement phenomena are more than a coming fad.”
FW: In your opinion, are holders of life insurance policies generally aware of the life settlement options available?
Zass: We do not believe a majority of life insurance policyholders know that they can sell their policy in the secondary market. If one was to survey US life insurance policyholders about their life insurance, a very large percentage of them would likely say they own life insurance and they bought it through their insurance agent. Since life insurance products are sold and not bought, most are ignorant about the underlying underwriting company let alone the type of product they own or what they can do with it. In the end, the greater ‘life insurance’ market must do a better job educating the masses about the value of life insurance and that it is an asset that can be sold, just like a house or a car.
FW: With the oldest ‘baby boomers’ now reaching their late 60s, and tens of millions more set to follow, what has been the effect of shifting demographics on life insurance policies and life settlements?
Zass: This large generational transfer from the shifting retiree demographics will create pressures on both incomes and responsibilities. The last 5-plus years have not been kind to many insureds as their nest eggs have materially reduced in size thus requiring additional working years. There are concerns that long term care needs are critical to mitigate some pressures placed on the kids of these baby boomers. All that said, some US states promote that life insurance policies can be settled with proceeds being used for LTC. The life insurance industry itself has started to create products, like longevity insurance, for this large population too. So the shifting demographics can benefit both the life insurance and life settlement markets.
FW: In recent years the life settlement market has been hit by regulatory developments. In light of this, in what ways are today’s investors approaching the market, uncovering value and unlocking new business opportunities?
Zass: Even though the life settlement market has experienced regulatory pressures, the reality is that no one wants to return to the chaos of the early life settlement years where certain participants created a bad impression of the space. Whether an investor is participating in the widget market or the life settlement market, the key to improving your success is to evaluate before starting. This means thorough due diligence – both financial/actuarial and legal – is a must to identify all the risks while also uncovering those arbitrage situations. In our opinion, those investors well prepared by solid advisers are able to accrete value. Proper and thorough due diligence costs money; if an investor is not willing to incorporate those costs into the overall investment then they need only look in the mirror when the investment underperforms, because it will.
“We do not believe a majority of life insurance policyholders know that they can sell their policy in the secondary market.”
FW: While there has been some controversy surrounding the issue, life settlement life expectancies are more credible than ever before. Are you seeing increasing confidence in the ability to make more accurate predictions? Is this bringing investor money back into the marketplace?
Zass: Let’s start with the eye-opening statement that there are no soothsayers, tea-leaf readers or oracles – both in life and in the life expectancy (LE) underwriting space. The life insurance industry has prospered for over a century as a result of learning from their mistakes, building in prudency and securing a large foundation of policies to spread the risk. Do we think the LE underwriters are all creating more credibility – the answer is a resounding yes; however, sophisticated investors recognise the need to supplement the work of these underwriters with their own independent evaluations of the insured’s impairments. The market is seeing new LE underwriters too which helps the overall market too. As we progress forward the LE underwriters will be measured against their own predictions, which is why the continued uncertainty in the projecting life expectancies contributes to a large pricing discount rate. Somewhat analogous is the hedge fund market, which demands 30 percent IRR since they may realise a minus 40 percent IRR in some years. Thus the key is to control volatility. Another point we harp on is the desperate need for an ‘industry life settlement mortality table’ that reflects the standard risk of an insured with a risk profile comparable to those transacting in the life settlement space. The best experience is that of the LE underwriters. In our opinion, this needs to happen sooner rather than later. Mortality predictions is the lifeline of this market and until the market demands this step, there will continue to be disconnects in the valuation of life settlements regardless of the ‘accuracy’ of the LEs. With 2014 VBT on the horizon, the cliff is in sight.
FW: The American Taxpayer Relief Act (ATRA) has eliminated federal estate taxes for a large proportion of the US population. How has this affected the life settlement market?
Zass: The US life insurance market has sold insurance products for various reasons including to use death benefits to pay the federal estate taxes. This law eliminates the need for certain insureds to continue holding their policies. We suspect this situation could very well increase the supply side assuming the insureds know a life settlement option exists.
FW: What considerations should be made when pricing a life settlement policy? What factors affect the discount rate?
Zass: The discount rate is a reflection of the risk premium over the risk free rate for an investment of similar length. In other words, the risk premium is the additive amount to account for any and all the risks of the investment. As an example, if there is a ‘guess’ used in setting the mortality assumption, then the explicit risk premium must be very large since the underlying mortality rates may be completely detached from the underlying mortality experience of the policy. If the underlying mortality table better reflects the perceived experience of the insured’s population underpinning the policy then the risk premium should, in theory, be lower vis-à-vis better knowledge. Again this evaluation is part of a comprehensive due diligence process. Further, this risk premium covers risks relating to future premiums, legal risks, origination risks, credit risk and liquidity risk to name a few ‘policy’ risks, while also reflecting the cost of capital to the investor too. Part of the problem in the life settlement space is that people equate the discount rate as a certainty of a return which occurs from three possible manners – transferring out all the risks to someone grossly ignorant with the risks or have luck on your side or incorporating a sound risk mitigating strategy for diversifying the risks.
“The long term returns of life settlement investments should not deviate too much from long term returns of life insurers.”
FW: With interest rates at record lows, the overriding view is that they can only go up, making bonds and similar fixed income investments a risky place to put money. As they are not pegged to interest rates, does this make life settlements a more attractive investment?
Zass: As implied earlier, life settlement investments, in our opinion, operate well as quasi-fixed income investments. With comparable long-term investments continuing to show compressed yields, the life settlement space can be attractive. Unfortunately, many of the LS investments continue to over-promise, which will produce under-delivery. The long term returns of life settlement investments should not deviate too much from long term returns of life insurers. Those looking for continual double digit plus returns should go elsewhere since the long term investment horizon inherently produces a rational long term return. Even the equity market has a perception of returning only 8 percent per annum over the long term, so why does the life settlement market foolishly think 20 percent returns are possible?
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: There will continue to be an increasing trend of interest in the life settlement space from factors like the advancing of the baby boomers, the political instability in the global arena, which puts pressure on economic policy creating undesired market variability, and some continuation of the new norm long term interest rate levels. Our best advice depends on the investment approach. If a $500m bond is being raised and an investor can take a small position, say $25m, then that can work. If an investor wants to play in the space like an equity investor with less $50m then they should just consider blackjack in Vegas. The investor must look at the overall size of the investment – in general, the more invested capital the better subject to the investment having parties, like ARM, who are very dependable and extremely knowledgeable in an advisory role. Otherwise, they too might as well head to Vegas.
Corwin Zass is the founder and principal of Actuarial Risk Management, Ltd. (ARM), an independent member of the BDO (USA) Alliance since 2006. For more than 20 years various sized US life insurers have sought Mr Zass and his team’s collective advice on M&A, product management, capital strategy, and financial reporting paradigms. His life actuarial training rests on a foundation blending common-sense, business views and actuarial technical aptitude enhanced by his direct experience in roles of appointed actuary, auditing actuary and consulting actuary. He can be contacted on +1 (512) 345 5200 or by email: czass@actrisk.com.
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