In 1911, The U.S. Supreme Court ruled that life insurance is an asset and that individuals have the right to sell their life insurance policies. Since then, Life Insurance has been considered an asset class that can be bought and sold.
In 1911, United States Supreme Court ruled in Grigsby vs. Russell that insurance policies are legally viewed as financial assets which may be sold to a third party at the owner’s discretion. This court case is the foundation for the large and growing secondary market for life insurance in which policy owners can receive fair market value for their policies rather than accepting the usually lower cash surrender value offered by the issuing insurance company.
A life settlement is the sale of an existing life insurance policy for more than its cash surrender value to a third party purchaser for a lump sum payment. The purchaser buys the policy at a discount to its face value and typically holds it until maturity (death of insured) at which time the investor receives the death benefit payable under the policy from the issuing insurance company.
The amount paid in a life settlement is based primarily on the life expectancy of the person insured, the face amount of the insurance policy and its ongoing premium requirements. From the original owner’s standpoint, a life settlement typically is a more lucrative alternative to letting the life insurance policy laps or surrendering it to the issuing insurance company, essentially turning a non-productive asset into a productive asset.
Low Market Correlation
An investment in a life settlement offers an excellent way to diversify any portfolio and also serves as a great defensive strategy since the return is not dependent on or affected by a soft economy, stock market volatilities, interest rate fluctuations, unexpected global events, or other traditional economic factors.
Strong Risk Adjusted Returns
Investing in Life settlements provides for the opportunity to earn attractive yields, particularly in today’s low interest rate environment. Projected returns for life settlement investments are targeted in the high single digits in a fully managed fund scenario.
These returns are certainly better than any of the equity markets and major market indices over the past 15 years. The Dow Jones Industrial Average has returned an average of just 3.7% from 2000 to 2014. Given the current economic, political and global landscapes, it is reasonable to assume life settlement returns will be higher than market indices for the foreseeable future.
Underlying Asset is a Highly Rated Insurance Company
Portfolios and policies structured are issued by highly rated insurance companies such as Met Life, Prudential, John Hancock, Mass Mutual and New York Life. Many of these institutions have been in existence for over 100 years and represent some of the strongest companies in the world. The claims paying ability of these entities is independently reviewed by rating agencies such as A.M. Best Company and Standard’s and Poor’s (S&P).
Targeted Performance through Forecasting and Selective Criteria
The return on a life settlement is contingent upon the maturity of each life insurance policy (i.e.- death of the insured). The return is a function of the death benefit collected minus the cost to acquire the policy, the premiums paid to maintain the policy, and other policy servicing fees.
With the exception of “when” the policy will mature, all other costs can be reasonably estimated such that projections can be done in advance to illustrate the projected returns at various points in time. This sensitivity analysis provides a range of likely outcomes that can help investors quantify their decision making process.
The use of independent third parties to provide life expectancy underwriting provides the estimate of “when the policy will mature. Independent underwriting firms utilize specific actuarial tables and in depth medical analysis to estimate life expectancies.Sage Life Equity Advisory employs stringent policy standards and utilizes highly recognized industry service providers to meet these challenges.
People buy life insurance to protect their dependents against financial hardship when the insured person dies. A business may purchase a life insurance to protect against the economic loss that would result from the death of the owner or key employee.
There are numerous reasons to consider selling a life policy:
- The premiums are no longer affordable
- The need to replace lost income in case of death of the insured no longer exists
- The need for funds to pay estate taxes no longer applies
- There is a need for resources to pay for health expenses and long term care
- Funds are wanted to improve a retirement lifestyle
Life insurance is an important investment in many seniors’ portfolios and business strategies. There are 38 million insurance policies owned by American seniors over the age of 65, which have a collective face value of more than $3 trillion.
- An astounding $100 billion+ in face value of life insurance is lapsed or voluntarily surrendered each year by seniors over the age of 65.
- A 2010 survey prepared for the Insurance Studies Institute indicated that 90 percent of seniors who have let a policy lapse would have considered selling it if they had known a life settlement was an option.
- A 2013 study prepared for The Lifeline Program (conducted by ICR) indicated that 55 percent of seniors allowed their life insurance policies to lapse, viewing it as a liability instead of an asset.
Insurance companies are required by statute to comply with the legal reserve requirements established by the state insurance laws. Life companies that comply with the legal reserve requirements established by the state insurance laws are known as Legal Reserve Life Insurance Companies
Generally speaking, life insurance companies must keep reserves in stable investments, for example in cash, or in government bonds. This ensures that the reserves are sufficiently protected from loss. While there are usually no specific investment recommendations, insurance companies are generally encouraged to invest in very conservative investments for their cash reserves.
It is a little known fact that it was not the U.S. government that bailed out the banking industry in the Great Depression but instead, it was Legal Reserve Life Insurance Companies. From 1928 through 1938 over 9,000 banks suspended operations while 99% of all life insurance in force continued unaffected.
Insurance companies must have by law at least dollar for dollar match to their liabilities in legal reserve. Most have much more and many have been in existence for over 100 years.
The State Insurance Department
Most state insurance departments mandate a conservative “statutory” accounting system that will insure company solvency. This “statutory” system has been successful for decades in minimizing insurance company failures and preventing policyholder losses. The state insurance department does review and measure the insurance companies’ cash flow and liabilities to ensure that they have the cash to meet policyholder obligations. They are audited by state insurance departments at least every 3 years. Life insurance companies also file quarterly and annual statements.
Required Reserves Ensure Payment of Policyholder Benefits
A large percentage of each premium dollar calculated by actuaries for each company goes into the policy owner’s reserve fund. This policy reserve (Legal Reserve) fund is a liability to the life insurance company. The fund is established as a way of determining or measuring the assets the company must maintain in order to be able to meet its future commitments under the policies it has issued.
If an insurance company’s reserve levels fall short, and it goes into what is called receivership, the remaining insurance companies in the state legal reserve pool must assume the liabilities and obligations of the insurer. The amount they are required to accept are based on the amount of insurance and annuities they have issued in that state. If one company has issued 10% of all insurance and annuities in that state, then they must accept 10% of any bankrupt insurer’s obligations for that state.
The reserve liabilities are established as financial safeguards to ensure the company will have sufficient assets to pay its claims and other commitments when they fall due. These assets are kept intact for payment of living and death benefits to the insured’s. The reserve pool protects annuity investors as well as those who purchase other life insurance products or policies.
Additional Security Safeguards
Nearly every legal reserve life insurance company further protects its policyholders by reinsuring part of the coverage with a life reinsurance company. This is done when the company will not or cannot undertake a risk alone. Reinsurance prevents relatively sizable claims from depleting a company’s policy holder reserves. The amount reinsured depends on many factors such as the size of the individual claim and the number of claims a company can expect.
The surplus is the amount by which a company’s assets exceed its liabilities. The surplus protects the policyholders and third parties against any deficiency in the insurer’s provisions for meeting its obligations. The determination of the optimum amount of surplus that a company will retain must be based on experience, current conditions, and an awareness of the primary goal of maintaining a strong company that is always able to pay claims as they arise.
In the unlikely event that a company’s annual statement or its own examination reveals possible financial weakness, one of several avenues is open to the company:
1) Produce additional operating capital
2) Sell its business to another life company
3) Merge into another financially stable life company
A legal reserve life insurance company simply does not close its doors and go out of business. Legal reserve life policyholders enjoy personal security safeguards unknown by other types of business. Legal reserve life insurance companies have established a public responsibility to respect both the letter and the spirit of laws and regulation so the interests of their policyholders are always protected.
The payout of a Life Settlement transaction is not impacted by stock market volatility, interest rate fluctuations, variations in the economy, or foreign instability. The factors that do affect life settlement pay outs are few, and they are considered very carefully for each policy before it is offered to a participant.
An insurance company can contest the payment for death benefits. This time period is usually up to 2 years after the policy is originally purchased. Therefore, Sage Life Equity Advisory does not consider policies that are not at least 2 years old.
The purchaser of a life settlement is obligated to make future premium payments to keep the policy in force until maturity. A Premium Reserve Methodology provides safeguards to reduce premium call risks to investors.
- Policy Specific Reserve: (used only to offset individual policy premiums)
Premiums to Life Expectancy plus 20%of Life Expectancy
Example: Life Expectancy = 60 months, individual reserves = 72 months
- General Reserves: (used to offset premium calls for all policies in fund)
5% of all death benefits upon maturity of policies; plus
Any unused policy specific reserves upon maturity of that policy
No one can predict exactly when an insured will pass away and the policy will mature. Because the exact date is the single factor that determines the effective annual rate of return, the shorter the longevity of the insured, the higher the effective annual return. In contrast, the longer the longevity of the insured, the lower the effective annual rate of return. This risk is mitigated through the utilizing multiple life expectancy actuaries, selecting policies in an older insured age range with health issues basing payout on a known factor which is the face amount of the policy. Sage Life Equity Advisory takes additional steps to mitigate tail end risk.
- Investment Banks
- Hedge Funds
- Life Insurance Companies
Warren Buffett is a major purchaser of life settlements through Berkshire Hathaway Inc.