EVALUATING THE RISKS OF THIS ATTRACTIVE YET MISUNDERSTOOD ASSET CLASS

As asset classes go, life settlements tend to go unnoticed by advisors. CNBC’s talking heads don’t wax rhapsodic about them as they do with stocks. Bloomberg reporters don’t genuflect before a life settlements portfolio manager the way they might when interviewing a multibillion-dollar bond portfolio manager. Face it, life settlement investing – purchasing life insurance policies, paying the premiums, and waiting to collect the benefit when the policyholders pass away – is niche, esoteric, even, dare I say, misunderstood.

But for advisors looking to add diversification and growth potential to client portfolios, they are compelling. With little to no correlation to the returns of traditional asset classes, as well as the potential for consistent double-digit annual returns, an allocation to life settlements protects portfolio value in a market downturn and builds wealth over the long haul (for more information, read Whether Volatility is High or Low, Life Settlements Perform).

While investing in life settlements provides distinct benefits, they also are an alternative asset class with risks uncommon to other investment types. That’s why I want to give advisors – especially those unfamiliar with the space – a guide to evaluate life settlement managers’ approaches to managing these risks so their clients can reap the rewards.

Quick summary of life settlement investing

Similar to a fixed income investment, life settlements are purchased at a price determined by a discount rate on future cash flows. Life settlements are effectively negative coupon bonds with an indeterminate maturity date. The negative coupon is the carrying cost which is predominately made up of the premium payments, and the maturity date occurs upon receipt of the death benefit proceeds. Returns for life settlement investments hinges on realizing this mortality income or selling the policy at a profit – similar to a bond held to maturity or traded in the open market.

Strong managers in the life settlement space have consistently had success, but as with any investment, there are risks involved. The primary risks in managing a portfolio of life settlements include longevity, liquidity, valuation, and carrier risk. Understanding these risks is critical for advisors reviewing the asset class. Here I address each of these risks and how to evaluate a prospective manager’s approach.

1. Longevity risk: Quantitative versus qualitative approaches

The biggest risk to the underlying assets in a life settlements portfolio is longevity risk, which refers to the probability that a policyholder will live longer than the actuarial estimate of their life expectancy. The amount of longevity risk in a portfolio is primarily a function of the portfolio construction process.

Though all life settlement investing is quantitative to a degree, one way of evaluating managers is considering whether they are purely quantitative or do they incorporate a significant qualitative aspect in their approach.

• Qualitative: Predict the short lives. Some managers purchase policies they consider attractive because of specific attributes. For example, they may seek – and bid up the price of – policies with shorter life expectancies, like cancer or diabetes, to yield greater returns. They are, in effect, trying to arbitrage the actuarial tables through policy selection, which could be problematic as it can create biases and concentrate risk. It also can be challenging to find new impairment patterns for which to exploit inefficiencies consistently. This is akin to a stock picker always having to develop a new idea for every selection. And this approach can increase longevity risk. Predicting which policies will be profitable is challenging for even the most experienced underwriter, as every individual is unique, and underwriting data is inherently backward-looking. That’s especially true in the long term as the release of a new drug or therapy can instantly impact previously successful impairment patterns.

• Quantitative: Scoop up the bargains. Quantitative buyers, on the other hand, build a portfolio by selecting a diversified mix of policies, looking to acquire them at a low price, much like a market maker would in a traditional asset class. Rather than taking big bets on certain impairment patterns, they spread longevity risk across a range of life expectancies. And by buying at a low price, they leave more cushion to capture returns even if longevity is higher than expected. Like value investors, they seek assets with solid fundamentals that are underappreciated by the larger market for various reasons – including a lack of attributes compelling to qualitatively oriented market participants or the ability to transact more efficiently with lower transaction costs.

When evaluating an approach to longevity risk, advisors need to weigh whether they prefer a manager whose edge is to pick winners through impairment patterns or generate value with a diversified mix of policies at low prices.

2. Liquidity risk: Cash (management) is king

Managers of open-end life settlement funds need to adroitly juggle multiple variables that affect cash flow to ensure they’ll be able to pay premiums on the underlying policies. That’s because open-end funds are subject to redemptions (typically after lockup periods that may be one or two years, and notice periods that may be up to 180 days). As a result, advisors considering an open-end structure for their clients should ensure the manager is properly equipped to manage premium reserves, any leverage, and the death benefit proceeds effectively. In addition, ask about other means the manager uses to generate portfolio liquidity, such as trading.

3. Valuation risk: How much is the policy worth?

Assigning value to a life insurance policy isn’t as straightforward as making an actuarial life expectancy calculation. A biased valuation process results in assets that do not accurately reflect a reasonable market price. These discrepancies can be exposed when compounded with liquidity pressures that can occur when a manager is forced to sell assets to address liquidity needs or as part of their regular portfolio management process.

Some managers have dedicated in-house teams – made up of actuaries, medical personnel, and others – that calculate life expectancies and policy values. But those who do their own underwriting may run a higher risk of biases that can lead to valuation errors as the market tends not to recognize proprietary valuation models and typically are traded off the third-party life expectancy reports that those managers are hypothetically trying to arbitrage. Managers can reduce that risk by drawing on one – or multiple – of these experienced third parties. For example, third-party underwriters, valuation agents, and auditors that regularly evaluate similar assets for multiple life settlements may better ensure investors that their results are in line with the broader market. Best practice may be a collaborative approach that allows for consensus valuations of policies and ongoing calibration of valuation models through portfolio trading and comparing values of policy sales across the market.

4. Carrier risk: When a non-issue is an arbitrage

Carrier risk is if a life insurance carrier fails to pay death benefits on valid policies, although no U.S. carrier has been unable to do so, regardless of its rating. Other facets of carrier risk include the risk of premium increases, which typically require regulatory approval and have been limited to only a small minority of carriers. Diversification across multiple insurance companies is an effective strategy to manage carrier risk. This can present an arbitrage opportunity for quantitative managers willing to add lower-rated carriers to a portfolio of numerous insurance carriers. Adept managers add mortality alpha by purchasing cheaper policies from lower carrier ratings since the death benefits have never defaulted due to carrier insolvency.

I hope that this framework will prove helpful for advisors evaluating this often-misunderstood investment option, even for those who didn’t know much about life settlements. With a better understanding of the compelling risk-reward profile, advisors can confidently provide an alternative investment that will help their clients reach their financial goals.I encourage advisors to examine how managers add value to a portfolio by successfully navigating these risks and how they take advantage of inefficiencies in the life settlement market to maximize returns, reduce risks, and diversify a portfolio from risks in traditional asset classes.

By Richard Beleutz, CEO of AIR Asset Management

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PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. No assurance can be given that any investment will achieve its objectives or avoid losses. Unless apparent from context, all statements herein represent AIR Asset Management’s opinion.

This article is provided for guidance and information purposes only. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy. This website and information are not intended to provide investment, tax, or legal advice.

AIR Asset Management (“AIRAM”) is an investment adviser registered with the SEC. The information contained in this email is for general informational purposes only and should not be construed by any prospective or existing client (or investor) of AIRAM as a solicitation to effect transactions in securities. In addition, the information herein should not be construed by any prospective or existing client (or investor) of AIRAM as personalized investment advice. AIRAM’s personalized investment advice is given only within the context of its contractual agreements with each client. AIRAM’s investment advice may only be rendered after the delivery of its Form ADV-Part 2A/2B and the execution of an agreement by the client and AIRAM.

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Risk Overview

Management of Operational Risk- In the normal course of business, AIRAM life-settlement funds may be exposed to a variety of operational risks, including position pricing and Net Asset Value calculation procedures, client reporting procedures, compliance controls, and policy acquisition sources. Our managers seek to manage these risks by employing experienced service providers and management who report and manage in accordance with the investment objectives of each fund as outlined in its prospectus. Our approach is to hire the most experienced professionals and firms to add value and protection to our investors.

Longevity Risk- When evaluating the value of life settlements, each policy must be reviewed for multiple quantitative aspects of the insured and their health to get a firm handle on the probability of death over a given timeframe. Understanding the broader implications of these small details within a life settlement transaction is important. One of the key pieces of data used during the underwriting process is the medical underwriting report, which is performed by an independent medical underwriter. Utilizing the latest mortality information, premium data, mortality tables, and verification of coverage, an asset profile is developed and a valuation is produced by an independent valuation agent. A thorough review should then be conducted by a number of parties to create redundancy, and a detailed checklist utilized to ensure uniformity such that all criteria and regulatory requirements correspond to accurate underwriting and quality standards.

Liquidity Risk- Liquidity risk is the risk that a fund may not be able to settle or meet its obligations on time. Investment vehicles are traditionally exposed to quarterly and annual cash redemptions of units at specified amounts. Liquidity risk is managed by investing the majority of the Fund’s assets in investments that can be readily disposed of through various life settlement firms and exchanges. AIRAM utilizes marked-to-market accounting practices within its assets that provide quotations to its fund managers on a regular basis ensuring proper valuations are maintained.

Longevity risk is the biggest quantitative risk factor in the valuing of life settlements. In general, investment managers focus on reducing the economic impact of unexpectedly increased policyholder longevity. In order to ensure this, a fund must review actual versus expected results and stress test different scenarios of mortality expectations in order to determine the impact that these stressed scenarios have on the value of the life settlement. This stress testing is typically performed on the current portfolio as well as on policies available in the market that are being evaluated for purchase. The primary driver of a policy’s sensitivity to longevity risk is the cost of insurance (“COI”). COI increases every year until a mortality event because premiums must be paid to maintain the policy. A policy’s sensitivity to longevity can be found by reviewing how probable it is that mortality will occur when the COI would produce an unacceptable return.

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Certain information contained in this material constitutes forward-looking statements, which can be identified by the use of forward-looking terminology, such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Such statements are not guarantees of future performance or activities. Due to various risks and uncertainties, actual events or results or the actual performance of the AIRAM funds may differ materially from those reflected or contemplated in such forward-looking statements.

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This website and information are provided for guidance and information purposes only.  Investments involve risk and unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy. This website and information are not intended to provide investment, tax, or legal advice.