Insurance-Linked Investments: Doctor in the house?
Lynn Strongin Dodds outlines the importance of quality medical underwriting and ongoing assessment of life expectancies in the traded life policy world
Now may be the perfect time to invest in life settlements but cases of alleged mis-selling and mis-pricing have continued to dog the industry. Participants have worked hard to rectify the pricing errors and promote the benefits of strong – and uncorrelated – returns. Many institutional investors, though, remain wary and have turned their attention to more liquid assets.
The origins of the asset class are in the US with viatical settlements, made in response to the AIDS epidemic of the 1980s and 1990s. Terminally or chronically ill individuals – those with less than two years’ life expectancy – sold their insurance policies for a lump sum to a third party who paid the monthly premiums and received the full benefit when the individual died.
Unscrupulous brokers pressurised people into selling at a discount to pay for expensive medical care, but, even so, investors often subsequently lost money because medical breakthroughs meant that patients’ lives were extended.
The product did not disappear, however. It resurfaced as life settlements with the focus on senior citizens (typically wealthier, well-educated, over-65 Americans) who sell policies for a lump sum that exceeds its cash surrender value, but is less than the expected pay-out in the event of death.
The new version also ran into trouble because of inaccurate longevity forecasts. Medical underwriting at the beginning of this century was more of an art than a science, due to incomprehensive data and out-of-date actuarial tables. The fallout came in late 2008 and early 2009, when the major medical underwriting firms significantly changed their processes, resulting in an increase in projected life expectancies. The promised 10-11% returns were whittled down to 3-4%, according to industry experts.
Investors took flight and the industry has yet to recover. The latest report from US-based Conning Research & Consulting shows that life settlement sales dropped for the fourth straight year in 2011, partly due to investor nervousness about the asset class but also stronger preference for distressed portfolios rather than new policies. The face value of transactions reached their acme of about $12bn (€9bn) in 2007 and 2008, but sales then plummeted to $3.8bn, with $36bn outstanding, in 2010. It fell further to just $1.2bn the year after, with a cumulative market size of $35bn. Conning expects activity to stabilise over the next 10 years at $2-3bn a year.
US investors continue to be the dominant players, with Dow Chemical Pension Fund making the news last year with its $250m investment into the asset class. Asian institutions have also shown interest. There are European pension funds allocated – Pensioenfonds Metalektro (PME) retains a small investment, although it declined to comment for this article – but, in general, European and especially UK pension funds remain reluctant to re-enter the fold. This is mainly tied to the UK’s Financial Service Authority’s consultation paper which was issued in 2011 as part of its review of unregulated collective investment schemes. Traded life policies (TLPs) were singled out as being “high risk, toxic products that were generally unsuitable for the majority of UK retail investors and should therefore not be promoted to them”. The strongly-worded warning caused an exodus that hit all funds, including the largest, Guernsey-based EEA’s £600m Life Settlements fund, which had to be suspended.
The FSA has since admitted that the use of the word “toxic” might have led to some confusion for some customers. It also clarified that its guidance on investing in these products does not apply to professional and institutional investors. Market participants also argue that the medical underwriting industry has made great strides in improving its forecasts – it increased its estimates for life expectancy by 30-40% – although pricing longevity is never easy.
According to industry experts, there are three components that affect the policy purchase price – the life expectancy of the insured, the future cash flows (premiums, expenses and death benefits), and the discount rate. The first requires an analysis of the current health status of the insured to define a mortality curve for estimating longevity, while the second entails a detailed analysis of the premium requirements specified by the insurance policy form. The third is determined by the investor to account for the risks perceived in the particular case.
Although institutional investors might seem like naturals to crunch the numbers, they have had difficulty predicting the future. “Many have had similar problems with the pricing of longevity,” says Jonas Martenson, managing director and founder of life settlements manager Ress Capital. “They miscalculated and underestimated the cost of their liabilities.”
This is perhaps why they still look towards their fund managers – but attention to detail is also required.
“Pricing today is significantly better than it was but that does not eliminate the need for investors to undertake in-depth due diligence,” says Patrick McAdams, investment director of life settlements specialist SL Investment Management and chairman of the European Life Settlement Association, the industry trade body. “For example, investors should assess the strengths and weaknesses of the medical underwriters employed and look carefully at their track records of the life expectancy estimates they have produced for insured persons across various age ranges and levels of medical impairment. SL’s team undertakes careful analysis to determine what to acquire and we typically do not participate in distressed sales because the quality of the policies tends to be poor.”
Jeremy Leach, group managing director of Managing Partners, another life settlements manager, also argues that the valuation of a TLP fund needs to be dynamic.
“Whilst life expectancy underwriters provide TLP managers with indicative mortality expectations, which are a very useful start point for identifying a market price for a policy, the on-going valuation needs to be much more sophisticated,” he says. “For example, in our fund we value the traded life policies on a monthly basis with an actuarial valuation model that makes adjustments for claims experience, future premium liabilities and continues to extend the life expectancy every month so that all of the value is never released before a maturity occurs. The aim is to equitably unwind the growth of the TLPs and to have smooth and consistent returns.”
It is also crucial to have an external independent review to validate the accuracy, according to Martenson. “In the past, investors relied on the sellers providing life expectancies which were not always correct,” he says. “I sometimes compare it to selling a car. You would not believe what I as a seller told you, but would of course want someone independent verifying it.”
EEA, which will soon re-open its fund, only buys impaired life policies and employs a team of nurses that re-evaluates and monitor policies on up to a monthly basis. “Ultimately this feeds into our valuation process,” says Peter Winders, the group’s marketing director. “We can sell a policy if there is a significant increase in the life expectancy forecast. For the sake of prudence we also add 12 months to the life expectancy of every policy we buy for the purpose of valuation.”
Winders believes that many of the capital losses that have occurred were with aggregator type of funds that used mortality tables and bought policies en masse based on probability of deaths. “Provided you can get your life expectancy forecasts broadly correct, the asset class is particularly well suited to pension funds because you match their liabilities with expected fund performance. High single digit returns are achievable with the right fund managers.”