Life settlement has become an increasingly popular alternative investment in recent years. It involves the sale of an existing life insurance policy to a third party for more than its cash surrender value, but less than its net death benefit. As an investor, life settlement can provide stable returns uncorrelated to the broader financial markets. However, there are also risks associated with this investment strategy that need to be considered. This article will provide an overview of life settlement, analyze its pros and cons as an investment, and discuss key factors to evaluate when incorporating life settlement into an investment portfolio.
Life Settlement Provides Access to an Alternative Asset Class
Life settlement gives investors access to an alternative asset class that historically has low correlation with traditional stocks and bonds. The returns from life settlement are not tied to market fluctuations but rather to actuarial projections of life expectancy. This unique risk-return profile makes life settlement a potential diversifier and stabilizer within a broader portfolio allocation strategy. However, this alternative investment also comes with its own set of risks, such as mortality projections being longer than expected and premium costs cutting into gains.
Life Settlement Returns Have Historically Been Attractive
Academic studies have shown that life settlement investments generated high single-digit to low double-digit returns from 2002 to 2009. The study by Deloitte Consulting found that life settlement returns outperformed public equities. However, past performance does not guarantee future results. Since the 2008 financial crisis, returns have moderated but remain within high single digits based on industry data. There are several factors that affect life settlement returns, including premium financing costs, life expectancy projections, and portfolio diversification across medical conditions, underwriting companies, and demographics.
Evaluating Carrier and LE Projection Risks are Crucial
Two major risks exist when investing in life settlements – the financial strength of the insurance carrier providing coverage and the accuracy of life expectancy projections. If the carrier experiences financial distress, the policy benefits may not be paid out. Investors should evaluate the credit rating and financial standing of the insurance carrier. Life expectancy projections are provided by specialized LE firms, using big data and medical records. However, human longevity is ultimately unpredictable. Having a diversified pool of policies across LE firms helps mitigate this risk. Investors should examine the historical accuracy of a firm’s LE projections.
Liquidity is Lower than Traditional Investments
Liquidity is a downside of life settlement investing. The investment is tied up until the insured passes away and the death benefit is paid. Life settlement funds often have lock-up periods where investors cannot redeem their capital for 5-7 years. While the returns have historically compensated for the illiquidity, investors should evaluate their liquidity needs and constraints prior to investing. A life settlement portfolio itself should be diversified across demographics, medical conditions, and maturity dates to provide cash flows over time rather than a single lump sum payout.
In summary, life settlement as an alternative investment provides unique diversification benefits but also comes with risks such as illiquidity, carrier credit risk, and mortality projection risk. Evaluating the reputation of the life settlement provider, analyzing historical performance data, and ensuring appropriate portfolio diversification across policies can help mitigate the downside risks.