Life Settlements – A Fixed Income Alternative for Superior Alpha
As Covid-19 continues to cause uncertainty across global markets, fixed income investors have been particularly hard hit amid the turmoil. Markets rebounded from the coronavirus induced crash in March of this year, with an apparent strength which in fact took many investors by surprise. But six months on, uncertainty remains at levels which prove problematic for investors who rely on their capital producing a steady flow of income. The traditional 60/40 portfolio model having proven ineffective for preserving capital during the market rout earlier this year, investors are seeking to make allocations in alternative asset classes on an unprecedented scale. The next challenge to overcome however, is the limited availability of viable options when it comes to alternatives for a fixed income portfolio.
Investors seeking to diversify require truly uncorrelated alternatives which are not linked to the economic cycle. However, there is a very limited choice of assets in areas such as forestry or social care homes and, to make matters worse, the potential for such assets to generate alpha tends to be minimal. There is however one asset class which offers an excellent opportunity for diversifying portfolio risk yet receives surprisingly little attention – life insurance. Longevity in developed economies is in no meaningful way correlated with the economic cycle, unlike almost all other asset classes.
The primary market for life insurance in the US is very large by any standard, where around 60 million households have a life insurance policy, resulting in a combined $20tn worth of life insurance policies. Less well-known however is the secondary market for such policies, also known as ‘life settlements’, in which Ress Capital is active. Investing in this market means purchasing life insurance policies at a discount to face value – an opportunity which exists because sellers of life insurance policies can thereby obtain a higher cash value than the surrender value offered by insurance companies. The investor buying the policy then continues to pay the premiums until the policy pays out, wherein the insurance company pays out the face value to the investor.
The asset class stands out among the very limited number of such uncorrelated assets, for its potential to generate significantly superior alpha compared to alternatives such as trees or care homes. The low volatility of a well-diversified life insurance portfolio means the asset class also offers a highly attractive, asymmetric risk profile, for investors prioritising capital preservation. In combination with these characteristics, the predictable cash flows of life settlements offer a fixed income investment opportunity, but with superior alpha – especially when compared with the established alternatives outside the US.
Another highly attractive aspect of the asset class is the heavily regulated status of the US secondary market for life insurance policies. Life settlement transactions are regulated by State Insurance Commissioners in 45 states and over 90% of the US population are covered by regulations and protections. Legislation which favours the right of policy holders to sell their policies on the secondary market means standardised contract terms and protections for all parties to the transaction. Regulation is also promoted by the Life Insurance Settlement Association (LISA) and the Institutional Life Markets Association (ILMA). This well-established regulatory environment strongly mitigates the risk of default on the part of the insurance companies.
Additionally, life insurance is an asset class suitable for ESG focused portfolios, as policyholders are provided an option otherwise denied to them by the insurance companies. Without active buyers in the secondary market for life insurance, policy holders no longer wishing to pay their premiums would have to simply cancel their policy, or in the best case accept the comparatively small ‘surrender value’ offered by the insurance company. Selling an unwanted life insurance policy on the other hand allows one to recoup a significantly higher portion of premiums paid.
It is worth noting however, that taking advantage of this asset class requires experience and technical expertise. As longevity represents the single greatest risk in this market, a highly selective portfolio construction is an absolute necessity. A host of factors including life expectancy, age, medical impairments, gender, premiums, mortality rating, and the insurance company which issued the policy, all need to be taken into account. As such, customised portfolio management systems need to be designed, built, and tested from scratch, in order to review vast numbers of policies. Ress Capital for instance only purchases 3-4% of the policies reviewed, and even then, only after an expert medical opinion is obtained. Legal reviews are also required prior to closing any transactions involving life settlements.
Longevity risk should also be further mitigated, and diversification further increased, by purchasing policies with low premiums. As longer life expectancies are more accurate, the average life expectancy in a reliable portfolio of policies should be around 12 years at purchase. Building and maintaining a strong network of contacts with institutional sellers and brokers is also essential to long-term success in this market, as policies are mainly sourced through brokers, which are regulated and authorised in the various states. Indeed, the complexity of building a portfolio in this space, combined with the long lead times involved, can present a significant barrier to entry for new funds seeking to establish themselves. Additionally, the asset class is not suitable for short-term investors, but rather those seeking a fixed income investment opportunity with an investment horizon of five years or more.
When done correctly, life settlements as an asset class offers a fixed income alternative with yields comparable to those of an equity portfolio, but with volatility below that of investment grade bonds. In times of high equity valuations and low expected returns for fixed income investments, life settlements present a unique, truly uncorrelated asset class.
Jonas Martenson is Founder and Sales Director at Ress Capital
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