Life settlements are the sale of a life insurance policy to a third party. The buyer, who is now the policy’s owner, takes over the premium payments in exchange for the death benefit when the insured dies.
Most life insurance policies are considered assets under federal law, giving the owner the right to sell them, says Los Angeles-based Jeffrey Post, managing director of Trident Risk Strategies, a managing general underwriter specializing in longevity risk. An insured may choose to sell his policy instead of surrendering it to the insurance company because an investor will typically pay more for the policy, usually 10 to 25 percent of the death benefit.
In exchange, the buyer gets an asset not tied to the stock or bond market that returns 8 to 10 percent after fees, though it’s a somewhat morbid investment.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
As a result, a niche category of private mutual funds that invest in life settlements was born, giving investors a better avenue to an entirely different kind of asset. “A life settlement isn’t just an asset; it’s an asset and a liability,” says Emmanuel Modu, managing director of insurance-linked securities at A.M. Best in Oldwick, New Jersey.
Life settlements sound like fixed-income investments, but unlike bonds, which pay you interest for tying up your money, a life settlement requires that you cover the premiums to sustain the death benefit, a cost that gets passed on to fund investors.
The funds are the smartest way for individual investors to access life settlements because the risks can be diversified with hundreds of policies, says Jay Jackson, vice president of Capital Markets at Abacus Settlements in Orlando, Florida.
The risks and costs can add up. And there is considerable risk in life settlements, whether you buy them individually or through a fund. For instance, investors risk lawsuits that challenge their right to the death benefit. Insurers, especially, are scrutinizing life settlements to determine if any insurance laws were violated.
Consequently, there is the risk that the insurance company refuses to pay the death benefit or goes bankrupt, and you never get your money back, although Modu says the risk of bankruptcy is small, as most of these insurance companies are highly rated and unlikely to default. The greatest risk with life settlements is that the insured lives longer than expected and investors end up paying more in premiums than they receive from the death benefit.
Premiums aren’t the only costs to consider. Investing fees can be substantial and may include a broker’s commission of up to 30 percent of the settlement price plus a life settlement provider’s fee. Investors may also face a management fee of 0.5 percent to 2 percent if they invest through a life settlement fund.
Taxes are another consideration. When you purchase a life settlement as an investment, “you forfeit the tax-free benefit of insurance, which is one of the best things that life insurance has going for it,” says Scott Witt, a fee-only insurance advisor at Witt Actuarial Services in New Berlin, Wisconsin. For investors, distributions from a life settlement fund and the death benefit are taxed as ordinary income.
One way around this is to hold life settlements in an IRA, but that can be hard to do if you invest through a mutual fund. Under federal law, most funds with more than 25 percent of assets held in IRAs are required to abide by the more stringent rules governing retirement plans, including restrictions on how the fund manager invests and is compensated, Jackson says. To avoid this, most fund managers won’t allow investors to hold the fund inside an IRA once the fund has reached the 25 percent threshold.
And even holding life settlement funds in an IRA can’t protect you from all taxes. If the fund uses leverage or debt to help cover future premium payments, then “your IRA money may be subject to alternative minimum tax,” he says.
[See: 7 Reasons to Invest in an IRA.]
Funds must be structured carefully. When life settlements are pooled into a fund, the money must be available to pay the premiums on those policies. This money can come from policies that have matured — in other words, policies that have paid out their death benefits because the insured died.
Typically, when fund policies mature, the proceeds are returned to investors as cash flow either quarterly or monthly, but “sometimes a percentage is kept back to potentially pay future premiums,” Jackson says.
For death benefit payouts to cover future premiums, funds must be structured so that policies are continually maturing. To do that, “you need to be able to predict how long people will live, and in this industry, that prediction has been notoriously bad,” Modu says. This is one reason AM Best has abstained from rating many life settlements. Other reasons include pools that are too small to generate predictable cash flow, or too many parties involved in the securitization process.
Most funds use third-party underwriters to value the policies. The underwriter reviews medical records of the insured and estimates the person’s life expectancy to determine the policy’s present value, Witt says. Beyond that, underwriters are “largely flying blind,” he says, although they have the right to call every few months to check if the insured is still alive.
There is no market price for life settlements because they aren’t publicly traded, so underwriters use models to determine what the policies are worth. “But those models depend on inputs that are absolutely uncertain,” Modu says, namely the insured individual’s life expectancy. “If your underwriting is wrong, it doesn’t matter what kind of financial alchemy you’re putting around that transaction; somebody is going to lose money.”
An inaccurate model creates a systemic bias affecting the entire portfolio, as all of the policy values will be based on the same inaccuracy. This could leave investors with their money locked into a fund that can’t pay them back. The fund’s net asset value is determined monthly or quarterly and shared with investors, Jackson says.
Checking the funds out. In short, life settlement investors need to “go in with their eyes wide open,” Modu says. Post suggests reviewing the disclosure documents closely to get an idea of the portfolio’s best and worst case scenarios.
Jackson says to verify that the fund is registered with the Securities and Exchange Commission under Regulation D for private placements, and that third-party underwriters are registered in the state. Use the online broker-check tool from the Financial Industry Regulatory Authority to see if any complaints were filed against the fund’s provider or manager. And ask questions: What are the liquidity terms? Are the policy maturity amounts reinvested or distributed? Does the fund use debt leverage?
[See: 10 Skills the Best Investors Have.]
“You need to seek advice and make sure it’s an asset for you,” Jackson says. He suggests Vida Capital and GWG Holdings as credible funds for investors. Witt adds, “Don’t invest anything you can’t afford to lose completely, and good luck.”
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The Morbid Niche of Life Settlement Funds originally appeared on usnews.com
