Cheering at Funerals

Life settlements could become a staple of portfolio diversification because these investments can bring annual returns in the 9% to 13% range. But with the benefits come four major risks to understand.

Here’s a sneak peak at an investment that will likely become a staple of portfolio diversification. It is called a life settlement. The reason to pay attention to this type of investment is because annual returns can be in the 9% to 13% range.

A life settlement is when a seller chooses to sell his or her life insurance policy to a buyer other than the issuing insurance company. The seller receives cash, and the buyer is entitled to the proceeds of the life insurance policy when the seller passes away. The seller benefits by unlocking the market value of their policy and gains liquidity. The buyer benefits by purchasing a known payout at a discount.

In other words, an investor buys a policy at a discount to the face amount. When that policy matures, the investor receives the face amount of the policy. For instance, an investor may pay $300,000 for a policy whose face amount is $1 million.

Benefit and risk

As you evaluate this investment space, pay close attention to the main investment benefit as well as the key risk of the investment. The main benefit gained by investing in life insurance policies is diversification. A bad market or a sluggish economy has virtually no correlation to how a life settlement investment performs. The investment pays out when the insured dies. As long as the company that wrote the policy is still in business, that’s the extent of the correlation to the market.

You will also want to keep in mind that owning a piece of many policies is a much better approach than just owning one. This is a long-term investment, and the significant unknown is the timing of when a policy will mature. Medical experts will place life expectancy estimates on how long they believe the person will live based on their current health. Remember that these are merely guidelines, and individuals can live well past those estimations. The smart investors manage this risk by investing in pools of life settlement policies knowing some people will live longer than expected. On the flip side, some policies may mature early.

There are four main risks to understand when investing in life settlements.

1. Longevity risk

Policies that you buy may mature years later than expected. However, it is not a question of “if,” but “when.”

2. Operational risk

Someone is going to construct and manage the fund that owns the policies. You want operators who know how to source good policies, and are efficient in dealing with the insurance companies when a policy matures. Portfolios of policies should be diversified in face amount, age of the insured, health condition and insurance carrier.

3. Counterparty risk

Policies that are purchased and put into the pool should be underwritten by highly rated insurance companies that have been in business for many years. In addition, you don’t want all of the policies you own to be underwritten by the same company. You need diversity amongst insurance companies as well to reduce this risk.

4. Regulatory risk

The insurance world is highly regulated, and tax laws and regulations can change. Some insurance companies don’t like the life settlement business because it is a cost they have not put in their pricing model. Before the life settlement business, a seller of a policy had two choices if they no longer wanted, needed or could afford their policy: let their policy lapse and turn off the premium spigot, or sell it back to the issuing insurance company for a cash surrender value that often falls well below the market value for that policy.

Life settlements are not going away, but life insurance companies and the government can make the investment less attractive through tax treatment and burdensome regulations.

Bottom line

Take time to continue to learn more about the life settlement business. With a world that has become increasingly correlated, a life settlement investment offers a straight forward, easy to understand way to make money that is not correlated to your other investments.

Marshall H. Dean JD, MBA, is a registered representative at Alliance Affiliated Equities Corporation, a FINRA-registered broker/dealer specializing in the evaluation and acquisition of alternative and real asset investments. He invites questions and comments at (913) 428-8278 or marsh@aaeconline.com.