Aside from the “ick factor” discussed above, there are a few risks that must be carefully managed:
1. Extension Risk There is no way to be sure when the investment will pay off, because there is no way to predict when the insured will pass away. Investors are guaranteed a certain payoff, but as the term is extended, the return on investment is decreased. This is the main risk, and investors manage this risk by spreading their investments among several different deals (as discussed in detail below).
2. Credit Risk Stability of the insurance company is critical, but easily managed. This is a very low risk because life insurance companies are heavily regulated. Most investors will only invest in a life settlement where the policy is issued by an “A”-rated life insurance company that is licensed and regulated in the US No fly-by-night insurance companies based in a foreign island beyond the reach of US regulators.
3. Interest Rate Risk As with any investment in debt, timing of repayment is important because market conditions change. As interest rates increase, new investments yield higher returns, so older investments generally become less desirable. Will you miss out on higher interest rates while you are waiting for the life insurance policy to be paid off?
4. Fraud This is the risk that is hardest to manage, and which drives many would-be investors away. There have been many reported scams and Ponzi schemes orchestrated by fraudulent life settlement companies. The typical scenario is for the life settlement company to sell shares in life insurance policies that do not really exist. The life settlement companies are not large, well-known firms, so it is very difficult to reach a level of comfort with them. This is my personal reason why I have not invested in life settlements.
Credit Risk?
One of the attractive aspects of investing in life settlements is the low credit risk, which is the risk of a debt not being repaid. Most of the other chapters in this book include large sections addressing how the debt can be collected through lawsuits, foreclosures, sheriff’s sales, evictions, etc. Investors who buy life settlements face extremely low credit risk because the debt is owed by life insurance companies that are considered to be about as financially stable as any private company can be.
Life insurance companies are regulated by each state and are required to maintain reserves to cover all liabilities. They are inspected by state regulators, and if reserves fall too low, they are placed into receivership and sold to larger life insurance companies. Several life insurance companies have existed for over a hundred years through the World Wars, the Great Depression, the dot com stock market crash, etc. Warren Buffet’s “Berkshire Hathaway” company invests in life insurance companies, and the largest US banks hold billions of dollars in life insurance policies. Nothing is absolutely certain in life, but “A”-rated domestic life insurance companies are about as close as you will see. Of course, investors should stick with policies issued by “A”-rated life insurance companies with recognizable brand names and licensed in the US—nothing based in some tropical island.
How is This Done?
There are several life settlement companies that advertise to find sellers and package the investment for buyers. The life settlement agent will collect information about the life insurance policy and the policy holder so investors can evaluate the deal. The key factors include:
- Age of the (seller) policy holder
- Medical records of the policy holder
- Lifestyle of the policyholder
- Life insurance policy
Life Settlement vs Viaticals
Life settlement is the term for the sale of any life insurance policy. States regulate the transactions, so the rules and limitations vary a bit state by state. States generally impose the following rules:
• The “insured” (person who is selling the insurance policy) must be over 62;
• The insurance policy must be matured—typically at least two years since the creation of the policy;
• The insured must sign a medical record release so an accurate health and actuarial assessment can be prepared;
• A neutral third party must provide an actuarial report to estimate the average life expectancy for a typical person with similar health and lifestyle attributes of the insured.
A viatical is a type of life settlement where the insured is terminally ill with a limited life expectancy of two years or less. Viaticals are priced higher—closer to the amount of the death benefit due to the relatively short expected payment term, but advances in medical treatments may extend the payment term.
Viaticals gained popularity in the 1980s due to the HIV epidemic. Effective treatments had not been established, and many young people sought to cash out of their life insurance policies.
Managing against Extension Risk
The main risk is that the insured will outlive the expected life term, thereby delaying the investor’s payoff—Extension Risk.
This risk hurts investors in two ways:
- Delayed payment reduces the investor’s annualized return on investment. If a $100 investment generates a $50 profit in one year, it is a 50 percent annual profit. If it takes two years, it is a 25 percent annualized return, and if it drags on for 10 years, then the annualized return is reduced to just 5 percent. The investor still generates a $50 profit on a $100 investment, but the timing changes the results drastically.
- Premium payments also eat into profits. Some life insurance policies are sold with premiums that have been “paid up,” so the investor will not have to make any annual premium payments to maintain the policy. Most policies, however, are not “paid up,” so the investor must be prepared to pay the annual premium each year until the policy pays off. This obviously cuts into profits and must be priced into the deal.
Some life settlement companies arrange for insurance to address the risk of the investment not maturing in the time expected. For an additional cost, of course, an insurance bond can be obtained to pay the investor if the life settlement does not conclude in the time frame anticipated in the life expectancy report. Of course, the terms vary based on each insurance bond, but typically the investor will receive his investment back along with a market rate interest if the life settlement does not pay off by a set date. This is an interesting option, as it manages the main risk, but it can be costly. Also, the insurance bond is purchased by the life settlement agent, so there is an added risk that the agent may default on its obligation to obtain the bond and to pay the proceeds to the investors. Investors should insist on getting a copy of the insurance bond and only deal with reputable life settlement companies. A list of the larger life settlement companies is included below.
Fractioning
Another way to address extension risk is through “fractioning,” where a life insurance policy is sold to a group of investors rather than to a single investor. This allows for greater diversification by spreading an investor’s funds among many life settlements rather than just one or two. Similar to investing in a mutual fund of stocks rather than a single stock, the investor spreads risk, so the investment is more likely to perform as expected. By investing in many smaller deals, each investor is more likely to experience a more even and anticipated result because the outlying, unexpected results from quick payoffs and slow payoffs are spread out and shared among many investors.Another advantage is that the annual premiums are shared among the pool of investors. Some life settlement agents will arrange for the investors to escrow sufficient funds to pay the annual premium payments for the anticipated term of the deal, so that the investors will not have to contribute any further funds as long as the life settlement deal matures as expected. If the payoff is extended beyond the term anticipated, then the investors will have to contribute more funds each year to pay the premium. What happens if one or more of the investors fails to contribute his or her share of the annual premium? Be sure that if you invest in a fractioned or “pooled” deal, this contingency is addressed in writing.
Of course, “fractioning” or “pooling” adds some expense for the trustee’s fees, and it minimizes the chance of favorable outlying results from quick payouts. Fractioning also adds a level of risk in the trust that holds the policy for the investors. In a typical life settlement, the life insurance policy is assigned directly to the investor. In fractioned arrangements, the policy is held in trust for all of the investors, so investors must be comfortable with the trustee. I find this risk hard to get past because the trustees are typically small, local companies run by an attorney or former insurance agent. I’ve watched too many episodes of “American Greed” to trust the “trustee” unless the trustee is a federal agency or a large “household name” bank or insurance company.
This excerpt is taken from “How to Invest in Debt: a Complete Guide to Alternative Opportunities” by Michael Pellegrino. To read other articles of this book, click here. To buy this book, click here.
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