After a 10-year bull run, many insurance professionals are now wondering if the life settlement market has flat-lined.
Agents assisting their clients in the sale of their unneeded life insurance policies have no doubt been frustrated by the lack of bids in the current life settlement market. It doesn't help much either when the few bids that are made are often 50% or less from what they would have been in years past.
So will the life settlement market return this year? And if it does return, the more important question may actually be: Will it last?
The life settlement market has seen double-digit annual growth for a decade with the only significant slowdown occurring in the last 24 months. In 2008 when the financial crisis hit global markets and credit evaporated, life settlement markets came to a standstill. How did this happen to a market that was supposedly not correlated to other markets? The life settlement market has long been touted as a non-corollary asset class. Even today many promoters looking to raise funds from investors still highlight this investment benefit. The problem, of course, is that it's not quite true.
This misconception surrounding non-correlation originated with an often-cited research report by Deloitte which showed that longevity is not correlated with interest rates, oil prices, stocks, etc. The key here is that "longevity" is not correlated. Many people misinterpreted the report to believe that longevity and life insurance were one and the same. Life insurance policies which have longevity as just one of many components, as it turns out, are highly correlated to other markets.
Upon further examination this should come as no surprise. Interest rates and stock market prices impact the portfolios of life insurance carriers. And the solvency of a carrier directly impacts their ability to meet death claims. Why would life settlements be immune? If carriers like AIG teeter on the edge of financial ruin, then credit risk becomes a primary concern for life settlement investors.
"An 'A'-rated carrier has never failed to pay a death claim."
This is a favorite quote from the life insurance market and is terribly misleading. As we like to say around our office, "the carrier is usually no longer rated 'A' by the time they fail to pay."
Additionally, if the cost of borrowing goes up or worse simply goes away, then the ability of life settlement funds to borrow money to make premium payments or meet investor redemptions becomes significantly impaired.
The reality is that the majority of today's life settlement investors are extremely sophisticated. They are aware of the various risks involved with investing in this asset class and it is for these reasons they demand to be compensated.
Running the numbers
Life settlements have historically traded about 1,000 bps above investment grade corporate bonds of similar maturity. So for example if a 15-year corporate bond is trading at a yield of 7%, then life settlement investors will be looking for yields of 17%.
If yields in Treasury bonds and corporate bonds rise, they will also rise in life settlements. The biggest challenge to life settlements, though, is that once yields rise to 20% or higher virtually nothing prices. To understand why this happens, it is helpful to return to the example of a 15-year corporate bond yielding 7%. Let's say that bond is a zero coupon bond, meaning that it has no coupon and is issued at a discount to its face value so that at maturity, the investor receives the equivalent of having been paid a 7% coupon. A 15-year zero coupon bond with a face value of $1,000 would have to be issued today at $356 for an investor to realize a 7% return annually over 15 years.
Life settlements work in a similar fashion. The secondary market value is a function of calculating investors' desired yield backwards until they get to a net present value for today. So imagine if investors are looking for 17-, 18-, 20%-plus yields. The net present value turns negative in most scenarios and thus there are no bids.
We estimate that a healthy life settlement market requires yields of 14% or less to keep liquidity moving. That means that in order for the life settlement market to rebound, corporate interest rates would need to either fall dramatically or the 1,000 bps spread between corporate interest rates and life settlements would need to be halved. We do not believe either is a realistic scenario.
A quick glance at the aggregate duration of U.S. corporate debt reveals that over 70% of U.S. corporations will need to refinance their debt within the next 48 months. That will be a lot of money that will need to be rolled over, and as corporations compete to get investors' capital, they will have to offer higher interest rates. Corporations, of course, are not the only borrowers competing for capital. Governments worldwide are doing the same.
There has been substantial media coverage lately following the deficits of various countries and how those deficits impact their cost of borrowing. Recent disasters include Iceland and Greece. Other developed countries such as Spain, Portugal, Ireland, and perhaps even the United States loom on the horizon as the next potential crisis areas.
Risk of sovereign default is real and historically defaults are more common than most people realize. Additionally, the leverage of many corporates are at historic highs while rates are at historic lows.
It is for these reasons as well as other challenging issues such as burdensome regulation and changes in carrier COI rates that indeed the life settlement market may be entering a prolonged period of contraction and perhaps even extinction.
We believe that there may be some spurts of capital to come into the life settlement market this year, but within 24 months, the entire market will dry up.
Who will get the last laugh?
Many have long forecast that carriers would get the last laugh on the life settlement industry. Their vast experience in underwriting has already proven victorious as table changes in 2008 damaged the NAV of all life settlement funds. Their lobbying against life settlements has also been successful. Overly burdensome and poorly written life settlement regulation in various states has simultaneously increased the operating expenses for life settlement firms and decreased the opportunity for the consumer. Additionally, carriers such as Phoenix are adjusting their COI rates higher and blaming life settlements for the change. While we disagree with Phoenix's rationale, the fact remains that other carriers will likely follow.
The last laugh, however, may not be had by anyone. Carriers sell products to preserve and protect wealth, yet the very products they sell are backed by investments in mountains of debt, equities with high P/E ratios and issued in a currency that is deeply flawed. Even though many carriers survived the Great Depression, our financial markets are considerably more complex today than they were then. This may cause many carriers to soon find themselves uncomfortably correlated.
What should policy sellers do?
The best thing financial advisors can tell their clients interested in life settlements is to sell their policies now and not to gamble on getting a higher settlement price in the future. Policy sellers should also give serious consideration to taking their settlement proceeds and purchasing gold and silver -- stores of value that were preserving wealth long before life insurance was invented.
David Dorr is the founder and president of Life-Exchange, Inc., Miami, a pioneer in the development of auction and trading solutions for the life settlement marketplace. Life-Exchange is a leading source of life settlement news and data and is the industry's only online community dedicated to the study and advancement of longevity risk markets.
More on life settlements from our June issue: "Policy servicing taking more prominent role in life settlement industry"
