Life Settlement Instrument
An insurance policy, besides having the benefit of protecting loved ones from, is actual a tax-free means of transferring wealth from the insured to the beneficiaries. At the inception of the deal, an insurance company and the insured agree on a payment schedule of future insurance premiums as well as the death benefit paid out to beneficiaries. As long as the insured lives, he or she pays the death benefits, which actually will increase each year. Therefore, the contract is generally not so attractive to the insured.
Actuarial Science and Modeling Insurance Policies
Valuation can be based on an actuarial table, where the rows are patient ages, and the columns provide the probability of death within the next year. One other point is the use of a mortality multiplier. One could first model the relative mortality of an individual m(t) = a * m’(t), where m’(t) is the standard mortality function and a is the mortality multiplier. The lower the a, the healthier the person. Generally, a ranges from 60% to 250%.
Investment Strategies
There are many ways of strategies when investing in life settlements. Viatical Settlement refers to investing in very short-term policies. The return of these short-term policies are less, but the instruments are more liquid. On the other hand, one could extend the maturities of life settlement instruments, thus creating “longevity funds”; these funds are more volatile but have the largest potential for return. Afterwards, there are some strategies which straddle grey areas. For example, it is illegal to buy insurance on someone whom the investor does not have an interest in keeping alive; one can buy insurance on their parents, because generally people want their parents to be alive, but one cannot buy insurance on another person. Another strategy life settlement funds might pursue is to pay people to open life settlement policies with the aim of buying these policies.
To structure such a fund, all the money must be collected in the beginning. Part of the cash will be used to invest in policies, but part of the cash will be used to pay investors a steady dividend as well as paying the premiums.
Most arbitrages or market opportunities exist due to a forced seller. Here the forced seller is the insured; the rationale for the trade is that if the insured wants to cancel his policy, he or she could try to cancel with the original insurance company who underwrote the policy. However, the insurance companies would pay very little or give a very poor price to buy back the policy. As a result, the market developed as there was a need for liquidity and efficient pricing in a “secondary market” for insurance policies. The analogous illustration would be plane tickets: if people try to cancel their plane tickets, the airlines themselves would give very little refund. However, investors might want to buy plane tickets from people who would otherwise receive very little from the airlines if the investors felt there was a pay-off that provided a good return on the plane tickets.
Historically, investors and insurance companies had mispriced due to the fact that most people who take out huge insurance policies are wealthy and that wealthy people are in better health than normal people. Another example of a mispricing is when investors purchased insurance policies on AIDs victims. At inception of the trades, investors estimated that AIDs victims only had very little time to live and thus purchased policies on these patients. However, over time, new drugs were developed which prolonged the life of these AIDs victims, thus hurting the returns of investors.
Just as with other types of fund management, life settlement fund management requires ability to be liquid. One problem with life settlements is that the maturity is unknown, no one knows when the insured will pass away. Some funds actually suffered because they were short on cash, but still had to pay premiums; in that case, the investors might need to sell some of their investments. As with a lot of other derivative instruments, the short end (shorter maturities) is more liquid than the long end; we see this in equity option markets or in interest rate swap markets. Therefore, investors must balance return with liquidity constraints. It would be attractive to buy only long-term policies because they would provide the most potential, but if the investor needs cash, he or she will not be able to sell the long term life settlement instruments at a reasonable price if at all.
One nuance that some life settlement Portfolio Managers allude to is the existence of an implied government support of insurance underwriters and companies, a la “have you ever seen a government let an insurance company go bankrupt?” Market participants closely evaluate counterparty risk, and insurance companies are not considered risk-free counterparties, especially since the insurance company owes a large death benefit payment to insured people. So people should also take the potentially small probability of default by insurance underwriters into consideration. However, since insurance companies serve a purpose to society, governments may do their best to save failing insurance companies so that insured people still are able to get their death benefit. We saw this case with AIG especially: AIG Financial products was a division of AIG which underwrote insurance on risky mortgage securities and derivatives. When the 2008 financial crisis occurred, AIG Financial products suffered heavy losses and almost caused the parent company to go into bankruptcy, but the U.S. government bought a large stake in the company. This year, the government has exited completely out of its stake in AIG at a profit, allowing the company to increase its weight in equity indices like S&P500 and opening the path to a re-initiation of the dividend (famous hedge fund managers like Dan Loeb and Bruce Berkowitz predicted these developments). However, we should still assume that the government will classify AIG as “systemically important” (similar to banks which are too large to fail), and that insurance companies such as AIG, Prudential, and Metlife might be subject to increased regulation. With further regulation, we might even conclude that the business will become boring, rates of return and net income will become stable but lack growth, and equity volatility on these companies might be dampened.
Helpful Links (More Bedtime Reading)
http://insurancestudies.org/wp-content/uploads/2008/05/Brad.pdf
http://en.wikipedia.org/wiki/Life_settlement
http://www.quatloos.com/uconn_deloitte_life_settlements.pdf
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