A. Overview of Life Settlement Market
A life settlement is the purchase of an insurance policy from the policy owner at a discount to the policy’s face value. Unlike viatical transactions, which involve the purchase of a life insurance policy where the insured suffers from a life-threatening, terminal or chronic illness or condition, life settlements relate to the purchase of a policy where the insured is usually sixty-five years or older and has medical impairments that allow a professional medical underwriter to project the insured’s life expectancy.
The past decade has seen an explosion in the growth of investment in life settlements. Due to the fact that virtually all participants in the life settlement market are privately owned and are generally unwilling to share their purchase experience data, definitive numbers are difficult to obtain. However, it is believed that the size of the market has grown from approximately $1 billion in face value transacted in 1999 to over $25 billion in face value transacted in 2007. This rapid growth was fueled in large measure by institutional investors, such as German closed-end funds, hedge funds and Wall Street investment banks. Even Warren Buffet’s Berkshire Hathaway has invested in life settlements. Bernstein C. Sanford & Co., LLC, in its March 4, 2005 “Research Call”, predicted that the secondary market for life insurance policies could grow to as large as $160 billion in the next decade.
B. Economics of Life Settlements
The economics of a life settlement transaction are straightforward. The policy owner is able to realize the present value of an insurance policy that is no longer wanted or needed, rather than surrender the policy for its cash value (often a fraction of its current market value). The policy owner is also freed from the burden of having to pay on-going premiums.
The purchase price life settlement investors are willing to pay for a policy is typically the policy’s net present value. Net present value is equal to projected future cash flows over the insured’s estimated life expectancy discounted at the investor’s desired yield. Projected cash flows include the death benefit less administrative costs and future premiums to maturity. From the investor’s perspective, they are investing in an asset that has little or no market correlation (that is, if the Dow Jones average drops 1000 points in one day, it will not impact the value of the underlying asset) and should return steady cash flows over time. The investor is, in essence, assuming the insured’s longevity risk with the potential of greater yield if the policy experiences an earlier than projected maturity.
C. The “Cash” Market Versus the “Synthetic” Market for Longevity Risk
The purchase of a life settlement is an investment in longevity. The investor bets that the insured will live for a certain period of time and that the policy will mature as predicted, giving the investor the predicted yield. If the insured outlives his or her life expectancy, the investor will not realize the desired yield. Longevity risk is distinct from the mortality risk borne by issuers of life insurance policies. The longer that premiums are paid for a life insurance policy, the more profit a carrier realizes. If an insured dies earlier than predicted, or before the owner decides to lapse the policy, the carrier will not realize the anticipated profit; thus, carriers are exposed to mortality rather than longevity risk.
Historically, the only way to invest in longevity was to directly purchase life insurance policies in life settlements transactions. The direct purchase of life insurance policies is referred to as the “cash” market. In the past two years a new class of “synthetic” longevity products have arisen that allow investors exposure to longevity risk without the risks associated with owning the underlying asset.
1. The Cash Market
The cash market is the traditional life settlement market in which an investor, utilizing intermediaries such as life settlements brokers and providers, invests directly in life insurance policies. In the cash market, the investor becomes the record owner and beneficiary of the policy. The cash market presents certain advantages and disadvantages. The advantages include: control of risk by direct underwriting; legal transfer of title to the asset; full visibility to the maintenance of the underlying asset; and, because the underlying asset is directly owned, there is no basis risk. The risks associated with the cash market include: legal and reputational risk; ramp-up risk; insurable interest risk; on-going servicing and maintenance requirements; a finite supply of policies that fit target parameters for purchase; and, high costs associated with the intermediaries typically involved in settlement transactions.
2. The Synthetic Market
Unlike the cash market, the synthetic market for longevity is not predicated on direct ownership of an underlying asset. Instead, synthetic transactions “reference” either life insurance policies or indices that can be based on targeted lives or broad populations. The synthetic market allows an investor to deploy capital into a longevity-linked asset without many of the risks associated with the cash market. For instance, because the investor does not own an underlying asset, legal and reputational risk, ramp-up risk, insurable interest risk, servicing and maintenance risks and finite supply risks are virtually eliminated.
D. Synthetic Longevity Investment Structures
The structures utilized for synthetic longevity investments take different forms, but the two main instruments currently utilized are swaps and notes.
1. Swaps
Private parties, one owning a portfolio of previously purchased policies, and the other interested in investing in longevity without the risk exposure of owning the underlying asset, will come together and structure a longevity “swap”. In a typical transaction, the owner of the pool of policies will, in essence, “sell” the economics of the portfolio to the new investor for a defined period of time by issuing a swap, the value of which can either be derived from the value of the underlying portfolio, or agreed upon between the counterparties without reference to the portfolio.
In one structure, an investor can purchase a synthetic portfolio that duplicates an existing portfolio. The investor will pay a sum to the portfolio owner that is equivalent to a purchase price for the portfolio. Thereafter, the investor will make scheduled payments to the portfolio owner that are similar to the premium amounts paid to a carrier to keep the policies in force. As maturities occur in the underlying pool, the investor receives the equivalent face value of the underlying policies. Thus, the investor is able to invest in longevity via a synthetic portfolio without having to assume the origination and direct ownership risks associated with the underlying asset
In an alternative structure, the reference individuals in the pool are assigned notional amounts that do not relate to the actual amount of coverage in force on their lives. In fact, it is not necessary for any coverage to be in force on the individual reference lives if they have agreed to allow their mortality to be tracked. In essence, the notional amount is the same as a life insurance policy’s face value, but the parties can set the notional amount at whatever level they see fit to achieve their risk/return goals. As with the structure described above, scheduled payments are made and when a maturity occurs the investor is paid the notional amount, just as an investor in the cash market receives a policy’s death benefit upon a maturity.
The overall return on investment experienced by an investor in a synthetic portfolio can be higher or lower than the expected return depending on the mortality experience of the underlying reference pool.
2. Notes
Similar to the structure used for synthetic longevity swaps, a pool of reference lives is used as the basis for tracking payments. Each reference life is assigned the same fixed notional amount or face value, and a stream of scheduled payments is assigned to each reference individual. Unlike synthetic swaps, in which the investor receives the notional amount as maturities occur, an index is used to track the value of the notes. Scheduled payments are debited to the index for the individuals alive at the end of each quarter, and notional amounts are credited to the index as reference lives pass away. Thus, the value of the notes at redemption are linked to the performance of the index, subject to a cap and a floor. The overall return on investment in the notes will depend on the mortality experience of the reference pool.
E. Conclusion
Although synthetic trading in longevity risk is still in its nascency, its growth has been rapid as the number of investors interested in participating in this alternative asset class has increased. Both Goldman Sachs and J.P. Morgan have created indices used to track longevity/mortality of targeted groups of individuals. Goldman Sachs has created the QxX index, which tracks a pool of U.S. insured individuals age 65 and older, underwritten by AVS, LLC. Goldman Sachs makes daily two-way markets in 5 year and 10 year swaps referencing the QxX index. J.P. Morgan, through its Life Metrics division, has created indices that track longevity/mortality in the Netherlands, Germany, England and the United States.
Given that synthetic longevity products have only existed for a brief period of time, their potential to revolutionize both longevity and mortality risk is extraordinary. Any investor in the life settlement space, as well as anyone who deals with longevity or mortality risk as part of their daily business, should consider whether utilizing synthetic longevity structures is an appropriate tool to manage their overall risk portfolio.
James W. Maxson is Of Counsel in the firm’s Insurance Practice and co-chair’s the firm’s Life Settlement Practice. Mr. Maxson concentrates his practice in corporate and regulatory matters for the life settlement industry, as well as focusing on mergers and acquisitions and securities transactions. Jim received his bachelor’s degree from Denison University and law degree from the Ohio State University School of Law.