April | May 2016
Life Settlements and Longevity Swaps
Opportunities for investors, individuals, insurers and pension funds
HAMLIN LOVELL
T
rillions of dollars of unfunded (and
under-funded) social security and
pension liabilities, combined with the
demographic time-bomb of aging populations,
creates a daunting challenge in terms of
covering the costs of retirees’ costs of living,
care and healthcare – before even considering
their desire to bequeath wealth (and lifetime
gifts can be more tax efficient than bequests).
But once initial transfers of ownership have
taken place, the tertiary market – which
involves investors selling to other investors –
is very active, and highly heterogeneous. “It
might involve one, five or hundreds of policies.
Face values of policies are mainly within a
$500,000 to $10 million range, with the average
between $1 million and $5 million,” Weinberger
observes.
Many older people may not realise that
they do have assets, besides their home,
that can be monetised – and life assurance
policies can be amongst the most valuable
financial instruments they may own. While it
is commonplace for people to release equity
from their homes, far fewer take advantage of
the opportunity to sell a life assurance policy.
“There are always some people negative on life
settlements but the industry provides a vital
source of revenues for our senior population,”
says Schulte Roth & Zabel (SRZ) partner Thomas
R. Weinberger.
Additionally, the leverage, or premium finance,
market is active and SRZ represents a number
of lenders who make loans to investors to pay
premiums on policies.
“It can be cheaper to
borrow to pay premiums than to use equity
capital to do so,” argues Weinberger, but
leverage is not present in all vehicles. According
to Ziser, “Investment vehicles can be funds or
other aggregation structures and will vary for
tax and other reasons.”
The United States is among those countries
that do permit transfers of ownership for life
insurance policies, which can change hands
more than once.
Vibrant tertiary market
In fact “the tertiary market is more active than
the secondary market,” explains Boris Ziser, SRZ
partner and co-head of the firm’s Structured
Finance & Derivatives Group, who, along
with Weinberger, serves as outside general
counsel to the Institutional Longevity Markets
Association (ILMA).
He explains how the initial sale from the policy
holder is ‘secondary’ and all subsequent transfers
are ‘tertiary’. The secondary market is not that
active, because “consumers may not be aware
of the value of their life policies or the existence
of the life settlement market; and the investors
may not have the ability to deploy capital over
the lengthy time period that might be required to
aggregate a large portfolio,” surmises Ziser.
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Investors into longevity risk include some of the
world’s largest pension funds, endowments and
foundations; smaller allocators can also access
the asset class, sometimes through funds.
Investors are targeting high yields in the mid-tohigh teens that are seen as compensation for a
number of risk factors.
The most obvious risk is
when longevity exceeds estimates, which may
also increase premium costs. Rising longevity is
one reason why cash inflows from mortalities
could fall short of the outflows needed to
pay premiums; increases in premiums, where
permitted, are another. Foreclosure risk can
apply where any lenders have recourse.
There
are also legal risks around contestability of
policies.
Assessing risks
Weinberger, who lectures on longevity and
mortality, acknowledges that in the early
2000s, some funds made what turned out to
be aggressive assumptions that have left some
allocators ‘once bitten, twice shy’. In particular,
longevity estimates (which naturally require
confidential access to medical records to protect
individual privacy) were far too low. Explains
Weinberger: “Assessing life expectancy reports
is all part of the process, and investors have
developed proprietary evaluation mechanisms
to arrive at a value for policies that takes
longevity risks into account.”
This is where the diversification benefits of a
portfolio of policies come into play, he goes on.
“If you buy a portfolio that has enough diversity,
then if some people live longer and others
shorter, the portfolio can withstand the impact
of fluctuations.”
There are several ways to address the
unpredictability of cash-flows, which has
historically resulted in some funds falling prey
to unintended debt-for-equity swaps.
Some
structures may involve a private equity structure
whereby committed capital is drawn down as,
and when, required. “Other models can use
already invested equity capital. If a fund is setup and not all of the capital raised is spent on
acquiring policies, a reserve can be set aside,”
Ziser adds.
The reserve is sized based on assumptions about
premiums for the pool of policies.
Or there may
be a leverage facility that is paid down as, and
when, mortalities occur. Nonetheless, the risk
of asynchronous cash flows resulting in policies
lapsing, or leverage being required, is disclosed
and can be seen as a type of contingent liability.
Contestability risk diminishing
Investors are cognisant of the legal risks, too.
The secondary market for life insurance policies
only exists after policies have passed the twoyear threshold for contestability. However,
there is also some risk of insurance companies
challenging policies after this two-year period.
Here, it seems the ‘devil is in the details’ and
thorough legal due diligence is recommended.
Notes Weinberger “the insurers have not
generally been successful at challenging
policies but have had success in certain states.
The risk of litigation and loss must be analysed
state by state.”
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April | May 2016
March 2016
Each US state has its own insurance regulator,
and insurance companies’ legal challenges are
usually brought in the state where policies are
issued, and vary in nature. Ziser enumerates
insurers’ typical arguments as being “that the
insured never paid premiums; did not disclose
everyone else’s afford so policy; does not
financing; could notprofits, theBreslowor a third
expect to see a tail of insurable interest,
party funder did not have more than 5-10%.
andValuation is rarely anor voidable.”
so the policy is void explicit requirement
for typical transfers of ownership around
succession. “These transactions are not
Precedents set are again state-specific. “Some
structured in case law way others and
states have more the same than as selling
minority or controlling interests to seed
some have none at all, partly because they or
strategic rather than proceed to trial,”
usually settleinvestors,” Breslow reveals.
Rather,
“a sunset provision lets the key person
Ziser observes. The good news for investors is
continue to share in profits on declining
that “insurers have lost more oftenathan they
basis, so in have seen a very ‘sunsetted’
have won,andwe this way they get marked
out of the business,” explains
decrease in litigation,” he says. Breslow.
This
may imply some probabilistic value on what
is a kind of declining
Aligning interests variable annuity, but
there is no need to carry out a valuation
Sophistication in assessing all of these risks,
andexercise.
in particular, longevity and mortality risk,
has grown greatly, and investment vehicle
One reason become more appropriately
structures havefor this deal structure is
optimising risk factors. Structures are
tailored to the tax efficiency for the continuing
alsoemployees. Explains Nissenbaum, “Though
aligning interests between investors and
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managers more effectively.
Some investors may
have memories of pre-crisis fund structures that
allowed managers to receive (or sometimes
accrue as a liability) carry based on unrealised
theoretical valuations that turned out to be too
high, because longevity estimates were too low.
a one-off sale will typically involve realisationNow structures of retirees’ ownership could
be advantageous for investor expectations
driven carry, reflectingtheir estate, because for
profits would incur capital gains
less liquid investment strategies. tax at lower
rates than income tax, if the new owners
made an outright purchase of interests in
Longevity swaps, pension funds and
the business, the consideration would not
insurance companies
be tax deductible an would be viewed as
Life settlements areas itexample of ‘micro’
like an investment in public swaps are
longevity risk while longevity equity.” SRZ also
has specialist teams longevity risk. “Life
an example of ‘macro’of industry-leading tax
lawyers who will advise on these pools of
settlements tend to involve smallermatters
parallel to the fund formation team.
lives whereas longevity swaps can involve
tens of thousands of lives or be based on a
Centenarian index depending on how they
population-wide managers?
Though both emergency and longer-term
are structured,” explains Weinberger.
succession plans should be in place, in
some also they may macro longevity swaps,
SRZ hascases worked onnot be actioned for
many years or even decades.
The absence
which can include insurers buying or selling
of a of annuities, pension funds performing
pools mandatory retirement age in the
United and other transfers of risk between
buyouts, States – combined with the energy,
stamina and good health of some people
various players. These deals have generally
been bilateral, bypassing capital markets,
though “there are potential opportunities for
intermediaries to bridge investors with sellers
of longevity risk,” foresees Ziser.
So far, SRZ has mainly dealt with European
working in finance – means that a number
insurers the space as the market for
of septuagenarian and even octogenarian
European longevity swaps has been stronger
hedge fund managers are still going strong.
for two key reasons. Weinberger explains that
The number in the UK and theand centenarian
“regulators of nonagenarian Netherlands are
money managers longevity risk; grow.
focused more on seems sure to and pension
Studies including some from the Brookings
funds in Europe often offer escalating payments
Institute show higher income groups in the
that exacerbate the longevity risk.”
US are extending their lifespans every year.
At the other US pensionage spectrum, many
In contrast, end of the funds have emphasised
successful hedge fund managersand cash-flow
LDI (Liability Driven Investment) could afford
to retire almost any time thinks the United to
matching.
However, SRZ and some choose
do so in their 40s, making itwith Europe in
States is poised to catch up a more urgent
matter.longevity: “We have seen deals done and
macro THFJ
expect to see more,” says Weinberger. THFJ
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