In a world of over-synthesized, derivative-based investment products concocted by Wall Street, it sometimes takes a reflection on the thoughtful genius of a Da Vinci to eliminate the confusion of boxes and arrows in pitch books.
As the insurance-linked asset class of life settlement investments has evolved over the past two decades, the genius of Wall Street has attempted to manufacture mind-bending investment products derived from life settlements. These have included highly speculative and risky longevity derivatives; synthetic mortality indices structured around derived pools of lives; project finance and commercial real estate linked structures .. and the list goes on and on.
Life settlements are simple. The underlying instrument is a life insurance policy that was issued by a major U.S. life insurance company based on the underwritten insurability of a U.S. citizen. The original purchaser of the policy has sold it in a secondary market for needed liquidity or due to a lessened need for the insurance. The purchasing investor paid the owner a sum that is a discount to the policy face value and is typically a meaningful multiple above the value that the issuing insurance company would give the owner, if redeemed. The life settlement policy purchaser will pay premiums on the policy for a projected period of time until the death of the insured, thereby relieving the original owner of the burden of these payments. The investor’s rate of return is based on the policy purchase price, premiums paid up to the policy maturity (the death of the insured party), and other related expenses as compared to receiving the policy maturity amount (the policy face value).
The basic investment premise is that the life settlement investor is taking the opposite side of the investment decision made by one of America’s top life insurance companies when the policy was issued. Though this was likely unintended by the large life insurance company when the policy was issued, the original policy owner has the protected right to sell the policy, much like other personal financial assets may be purchased and sold. The U.S. life insurance industry now finds life settlements challenging to their business model, even though providing value and liquidity to senior and terminally-ill citizens is an important benefit to Americans who have invested substantial annual premiums over multiple years with their life insurance company.
For investors, a life settlement is simply a discounted purchase of a payment contract (a policy) from a life insurance company (typically investment grade). The investor's rate of return is determined by the payment date of the contract (the insured's death) which can be variable, but predicted through actuarial methods. Sophistication in this asset class begins with the qualitative aspects of a thorough understanding of the anatomy of the underlying life insurance policy; sound underwriting of regulatory compliance in the policy’s original issuance; and forensic-quality due diligence related to the insured party’s mortality. Prudent portfolio management methods of minimizing premium payments through premium optimization techniques are also key. Life settlement investing is further refined through quantitative methods utilizing the benefits of The Law of Numbers by investing in a diversified pool of policies, not from exotic structures created by Wall Street. While the structure of life settlement investments is not overly complex, this asset class is best suited for sophisticated investors with ample liquidity and the ability to understand the underlying actuarial characteristics of the investment.