Guidelines for Qualitative and Quantitative factors for considerations in a life settlement fund

Life Settlement Funds

guidelines for qualitative and quantitative factors for considerations in a life settlement fund

What are the risks of life settlement funds?

Investors longevity risk. Investors targeting high yields in the mid-to-high teens expect compensation for a number of risk factors. The most obvious risk is when longevity exceeds estimates, which may also increase premium costs. Rising longevity is one reason why cash inflows from mortalities could fall short of the outflows needed to pay premiums. Foreclosure risk can apply where any lenders have recourse. There are also legal risks around contestability of policies.

What is the influence of longevity risks?

Funds that make aggressive assumptions particular in longevity estimates can create negative yield if premiums increase. The insurance specialist assessing life expectancy reports is all part of the process, and investors have developed proprietary evaluation mechanisms to arrive at a value for policies that takes longevity risks into account. This is where the diversification benefits of a portfolio of policies come into play.

How to address longevity risks?

There are several ways to address the unpredictability of cash-flows, which has historically resulted in some funds falling prey to unintended debt-for-equity swaps. Some structures may involve a private equity structure whereby committed capital is drawn down as, and when, required. Other models can use already invested equity capital. If a fund is set-up and not all of the capital raised is spent on acquiring policies, a reserve can be set aside.

The reserve size is based on assumptions about premiums for the pool of policies. Or there may be a leverage facility that is paid down when mortalities occur. Longevity risk is usually addressed by combining with mortality risk in a portfolio, namely investors holding a portfolio of annuity and life insurance contracts.

What are the mechanics of an open-end life settlement fund?

To interpret empirical results for open-end life settlement funds and analyze their risk profile, it is of critical relevance that one first understands their mechanics.

Life settlement funds are a collective investment that depend on trustees, made up of certain institutions which hold their property and facilitate their transactions. Before entering business, the fund management company needs to appoint a custodian (depositary) in its country of domicile. The primary function of the custodian is to hold the fund’s assets. In general, the custodian administers any liquid assets, such as government bonds or cash and assigns the safekeeping of life settlements to a sub-custodian in the United States. Furthermore, the custodian is responsible for the administration of the fund shares (units), for receiving and holding application money, and for redistributing funds to investors in the course of redemptions.

Whenever life insurance policies are acquired, the custodian transfers the necessary amount of money to the sub-custodian, which, in turn, uses it to settle transactions. With regard to policy purchases, the sub-custodian also serves as an escrow agent, facilitating the acquisition by retaining the payment for the respective life settlement in an escrow account while the transfer documents are sent to the insurance company in order to change ownership rights and beneficiaries. Once the amended documents have been returned by the insurance company, the money is released to the seller. The original life insurance contracts as well as the transfer and assignment documents are subsequently held by the sub-custodian on behalf of the fund. Whenever due, regular premiums are paid by the sub-custodian.

What do medical underwriters do?

Medical underwriters review the medical records of the insureds and, based on the information contained therein, prepare mortality profiles that comprise a summary of the medical conditions, a mortality schedule, and an estimation of the life expectancy for each insured. For this purpose, they assess how certain characteristics and medical conditions affect the insureds mortality. The outcome is a specific multiplier (also called mortality rating) which modifies the reference mortality. Methodologies for the derivation of the multiplier as well as standard mortality tables depend on the medical underwriters. However, within the last few years, many medical underwriters have opted for the Valuation Basic Tables (VBT), which are prepared by a task force of the Society of Actuaries (SOA). These tables include mortality rates for ages up to ninety years over time horizons from one to twenty-five years, which have been derived from historical data and are differentiated according to simple characteristics such as smoking status and gender. Consequently, some funds seek to mitigate the impact of misestimation by demanding at least two life expectancy estimates and then applying the longer one or a (weighted) average of the two.

What do servicers do?

The servicer (tracking agent) performs a wide variety of supporting services in the context of premium and claims administration for the pool of lives in the portfolio. Its goal is to ensure a smooth and on-time transfer of legal paperwork, notifications, and cash flows. The servicer notifies the trustees and provides them with disbursement instructions for the regular premium payments and maintains close contact with the insurance company to obtain the latest information on developments of each policy. Moreover, it is responsible for ordering the policyholder’s medical records and life expectancy estimations from the medical examiners and then archiving them. Another key duty is the tracking of the insured. For this purpose, the servicer relies on routines which resemble those employed in consumer loan servicing such as subscribed database services, mailings, and telephone calls. In addition, it matches social security numbers to death indices on a regular basis. Whenever the servicer becomes aware of the death of a policyholder, it immediately informs the fund manager and the trustees and obtains the death certificate. After the signed insurance claim package has been provided by the trustee, the servicer forwards it to the insurance company and follows up until the claim is paid so as to facilitate the prompt collection of death benefits.

What do life settlement providers do?

Life settlement providers source life insurance contracts from policyholders or licensed brokers in order to pass them on to the funds. For this purpose, the funds usually set certain investment criteria, which reflect the cornerstones of their portfolio diversification approach. Life settlement providers can also act as investment advisors, pitching life settlements to the manager and participating in the policy-picking and portfolio structuring process. Whereas some funds rely on a so-called single-source approach, thus exclusively collaborating with just one life settlement company, others deliberately maintain business relationships with several. An important aspect to be considered with regard to life settlement providers are their incentives to act in the interest of investors. Since their fees are paid upfront and generally depend on number and volume of the policies rather than their long-term investment performance, the degree of diligence that can be expected from life settlement providers during the acquisition process is questionable. Once acquired, the policy is then resold by the life settlement provider to the fund whose investors ultimately have to bear the risk of a misestimated life expectancy.

What are the third-party services of life settlement fund?

The general mechanics of open-end life settlement funds are usually complemented by third-party service providers. Auditors advise on accounting and tax implications, inspect the funds’ balance sheets and income statements, and issue annual reports with their opinion of the funds’ financial situation. Moreover, actuarial advisors assist with the pricing of transactions as well as the valuation of life settlements in the portfolio and review actuarial models used by the funds. Similarly, legal advisors offer counseling with regard to the legal form, draft all the contracts, and ensure the completeness of documentation packages in addition to compliance with the applicable legislation and regulation. Banks are involved either by providing medium- to longer-term debt financing, which some funds use to leverage their investments, or through a liquidity facility, which is commonly employed to bridge life settlement purchases or premium payments in the absence of other cash inflows. Finally, life insurance companies originally issued the policies and must be notified about the transfer of ownership. They continue to receive the premiums after the sale has been completed and pay out the death benefits to the fund’s sub-custodian after the insured has passed away.