“It's very easy for trusted companies to mislead naive customers, and life insurance companies are trusted.” - Daniel Kahneman
In case you have totally tuned out financial news, (if so, good for you!), the US and China are in a good ol’ fashioned trade war as David wrote about in our last post entitled A Chaos Moment. The on-again/off-again nature of the trade war has brought a good amount of volatility to the US and global stock markets as investors try to weigh the odds and impact of the various threats being lobbed back and forth. Over the past 12 months, the S&P 500 is up around 2% on a total return basis (inclusive of dividends), while at one point in time it was down close to 20% off its high. In other words, all the uncertainty has put a lid on returns while increasing the daily price volatility. It’s times like these where we are happy to have a number of diversifiers in our client’s portfolios which generate returns independent of what is happening in the stock market. One of such diversifiers is a strategy known as life settlement investing.
Before we get into what life settlement investing is and why we like it, a little background on the life insurance industry. It is no secret that life insurance salesmen (now rebranded as “financial advisors”) are fairly low on the list of professionals that people want to “get to know better” and “learn about their business” because of the dialing for dollars and hard-sell stigma this industry has perpetuated for decades. But that hasn’t stopped many a salesperson (sorry…”financial advisor”) to sell a wide range of commission heavy insurance products which may or may not be in the client’s best long-term interests.
Now we are not going to go as far to say that all life insurance is a scam or unnecessary, but we definitely believe that the saying, “if all you have is a hammer, everything looks like a nail” holds true for this industry. The dirty little secret that the life insurance industry doesn’t want people to know is that according to the 2011 Milliman Industry Mortality Study and Analysis, close to 9 out of every 10 permanent life insurance policies either lapse or are surrendered back to the insurance company. Let that sink in for a minute...only 1 out of every 10 whole or universal life policies actually “mature” and pay out a death benefit. What that means is that the insurance companies are banking on the overall naivety of their own clients to make bad financial decisions and reverse course at some point in their lives on their decision to buy permanent life insurance. Talk about a contentious relationship! This is why when we wrote about permanent life insurance several years back, we likened it to a marriage and not a dating relationship. So what happens to the 9 out of 10 people who don’t hold their policies to the grave? Historically, they have either walked away with nothing (e.g. allowing the policy to lapse) or they have surrendered their policy back to the insurance company for pennies (cash/surrender value) on the dime (death benefit).
This is where life settlement investing comes in. About 15 years ago, savvy institutional investors created a new market when they started buying permanent life insurance policies from individuals who were looking to sell their policies. There are a variety of reasons why an individual might want to sell an insurance policy but the most common are for financial planning purposes (e.g. they can no longer afford the premium payments) or medical reasons (e.g. they need to pay for expensive medical procedures). Life settlement investors are simply providing these individuals with a “second opinion” on what their policy is worth rather than surrendering the policy back to the insurance company as the “only game in town.”
In most cases, a life settlement investor is able to pay multiples more than the surrender value of a particular policy while still earning adequate returns on their investor capital (industry average is around 15% annually today). This relatively new market is creating a win-win for both the seller and the buyer of the insurance contract. The only loser is the insurance company because their clients are becoming more sophisticated and less naïve, but they can’t really do anything about it thanks to a 1911 Supreme Court case which ruled that life insurance is considered transferable property.
There is a lot to consider when it comes to buying life insurance policies including the insured’s health and life expectancy as well as the amount of cash that needs to be held in reserve to make all the anticipated premium payments until the policy matures. At the end of the day, it is a math intensive industry with a lot of actuarial science behind it, but for those that have the knowledge base and infrastructure in place to execute on the opportunity the returns have been fantastic. The chart below shows the returns of the AAP Investable Life Settlement Index compared to a variety of different financial indexes including the S&P 500 and the Credit Suisse Hedge Fund Index from December 2012 through the middle of last year. Not only has the life settlement index produced the best absolute returns over this time period, it also has created far and away the best risk adjusted returns as it has done so with very little month to month volatility in the return stream.
On the surface, the idea of investing in someone else’s life insurance contract seems morbid, but in actuality it is empowering individuals with a better financial option than the insurance company who is trying to capitalize on their naïve client base. In summary, life settlement investments are a perfect example of some of the diversifier opportunities we actively source, vet, and recommend to our clients for the purpose of creating a more all-weather portfolio that isn’t betting the farm any one single asset class or risk factor. As is the case with most investments, the devil is always in the details. You have to consider things like fee structure, management experience, size/diversification, cash reserves, and any use of leverage when looking at different opportunities in this space, but for those that can find a life settlement fund which “checks all the boxes” the benefits can be significant.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.