Running a life settlements fund
Like any fund manager a life settlements fund has a team of specialists and an asset to analyse and purchase to maximise return.
It must be understood that the market is tiny where only 3,200 life insurance policies came onto the market last year in the USA. Given the surrender rate of several hundred thousand each year, it is a small number. A lot of people don't often know what a valuable asset they have paid for over many years and simply let them close down.
People buy insurance to protect a family or a mortgage debt in the event of untimely death but once the family has grown up and left home and the house paid for, the need for insurance has gone. Typically the insured will contact the insurance company and just accept the contractual surrender value. Some will instead speak to their agent and learn that there is a chance of a far greater cash sum by selling the policy to an investor. In this instance the agent will contact a Licensed Broker whose job it is to represent the seller. He will prepare a file which will include all the policy details and arrange for the insured to have a medical examination the results of which will be provided to one (or more) of the actuarial firms that provide a Life Expectancy (LE) for the individual where the LE is a number usually given in months.
It is worth making the point that the LE is not the month in which the insured is expected to die but rather the midpoint on a probability distribution curve where of 1,000 people of the same age and gender and with the same health issues, 500 are expected to die before the LE and 500 after. The file is then sent to Licensed Providers in the U.S. who are the only people legally able to buy an insurance policy from an insured and who represent the investors who are typically managers; an auction process follows.
The managers have a great deal of certainty around many of the metrics of the asset; the death benefit is known; the premium costs are known and the credit risk is immaterial; the only thing that is not known is the maturity date. Managers do have the LE which has been provided by the actuarial firms that service the life settlement market and can have access to the medical records but most simply rely upon the LE.
It then remains for the manager to choose what discount rate to apply to the cashflows (given the assumed LE) and to make a bid for the policy on that basis. The market usually trades policies where the purchase price assumes a projected internal rate of return (IRR) of between 12% and 14% (though there is wide dispersion around this range) and on this basis the purchase price offered is usually around four times more than the contractual surrender value offered by the insurance company.
Most middle-class Americans do not have sufficient assets to fund a comfortable retirement, let alone pay for all the medical and care costs that might be anticipated. Selling their life insurance contract, rather than surrendering it to the insurance company, in many cases makes a very significant difference to the quality of their lives going forward.
If the LEs were right and were in fact the mid-point of the mortality curve then the manager could rely upon the law of large numbers, buy lots of policies and expect gross IRRs across the portfolio to be 12% to 14%. The asset is very expensive to track and fund costs are correspondingly high so management fees and fund costs will reduce this gross return by 4% or 5% leaving a net-to-investor return in this situation of 7% to 10%.
Most managers and investors do rely upon the accuracy of the LE and the law of large numbers. However, if instead of 500 dying before the LE and 500 after what happens is that only 450 die before and 550 die after, then the LEs from which the policies were purchased and the portfolio was valued are wrong and where the gross projected IRR was 12% to 14%, the gross actual IRR turns out to be 8% to 10%, with a corresponding net-toinvestor return of 3% to 6%.
It is obvious that you can test the accuracy of LEs historically, but how can you be sure if forward-looking LEs are accurate?
Consider this: With a probability distribution curve over a large population, for any given LE it is possible to predict how many deaths the portfolio would experience each year with a high level of statistical confidence. So, even though the LE has not yet been reached, deaths should already be occurring and the number can be compared with those expected. If the actual number of deaths is (statistically significantly) less than expected, the LE is too short and should be pushed out to fit the early years' experience.
History has shown that the LEs provided by the actuarial firms have been and continue to be too short and consequently investor expectations have not been met. If a manager is able to construct a portfolio where half the insureds die before the LE and half afterwards then the gross projected IRRs are preserved and this is the focus of the Laureola investment approach.
The six actuarial firms that provide LEs to the market have strengths and weakness across different illnesses and clusters of illnesses. This fact is known qualitatively by all the participants in the life settlement market, including the Licensed Brokers who first bring the policy to the market. It should be no surprise that the Brokers choose the shortest LE available because this pushes the price (and their commission) up.
Laureola's four-person investment team spent two years analysing the strengths and weaknesses of the LE providers and has a much better understanding quantitively of how short or long they are with respect to various health conditions. Additionally, Laureola has a medical and scientific advisory panel which reviews the LE in the light of current research. Areas of expertise of the panel include heart disease, circulatory disease and cancer - illnesses which account for the death of two thirds of American citizens. For example the heart specialist (who is working on the leading edge of new treatments for heart disease and has several patents for medical devices) might advise the investment team that there are treatments being developed which might prolong the life of a particular insured with heart or circulatory problems beyond current estimates, in other words that he/she is more likely on average to live beyond the given LE than die before; this would be a reason not to buy this policy.
Or in the case of a cancer patient, the Chief Scientific Officer might advise the investment team that a particular insured with a particular from of cancer with particular features and at a particular stage is more likely on average to die before the given LE which would be a reason to consider buying the policy.
It is not enough just to buy cheap policies (as measured by the discount rate) because the real value is extracted from this asset class by choosing policies which mature before the LE; all the value of a cheap policy is lost if the insured lives too long past his/her LE. The added value of the Laureola investment team is its focus on the mortality of every single policy in the portfolio.
Once a policy has been purchased and is held within the portfolio, it needs to be understood that the health of the insured might worsen or improve over time, affecting its value within the portfolio. Changes in the health of the insureds is critical information for an investment team focussed on the mortality of every policy. Most managers outsource what is loosely referred to as "tracking" to third parties where the information sought is when there has been a death.
Laureola carries out the tracking function internally with a team dedicated to forming relationships with the insureds. In the case where the health of an insured has improved, for example by surviving cancer, the team will quickly learn about it and although the improvement in health and life expectancy is to be celebrated, the mortality of the policy has worsened from Laureola's standpoint and the policy has become an underperforming asset. In these circumstances, the investment team is likely to consider selling the policy to another manager. Policies are valued very conservatively within the portfolio and Laureola's experience is that in those circumstances where they have sold policies they have done so at a price higher than the prices marked on the book, thus making cash profits on the sale.
Laureola Advisors is an established boutique manager in the life settlement space with a 9-year track record (and only 2 negative months). Over 80% of Laureola's published returns are realised gains, i.e. profits from death benefits or policy sales. Returns which are derived from mortality secure the non-correlation sought by many investors.
It takes a 12-person team to run Laureola's life settlements operation because the qualitative input requires time and expertise alongside the quantitative analysis to maximise returns.
Written By John Swallow, Director of Investor Relations
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