Life Settlement Funds: Current Valuation Practices and Areas for Improvement

• Author: Hato Schmeiser,Sarah Affolter,Alexander Braun
• Published date: 01 September 2016
• DOI: http://doi.org/10.1111/rmir.12042
• Date: 01 September 2016

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2015, Vol.19, No. 2, 173-195

DOI: 10.1111/rmir.12042

PERSPECTIVE

LIFE SETTLEMENT FUNDS:CURRENT VALUATION PRACTICES

AND AREAS FOR IMPROVEMENT

Alexander Braun

Sarah Affolter

Hato Schmeiser

ABSTRACT

We analyze the prevailing valuation practices in the life settlement industry

based on a sample of 11 funds that cover a large portion of the current market.

The most striking result is that a majority of asset managersseem to substantially

overvalue their portfolios relative to the prices of comparable transactions that

have recently been closed. Drawing on market-consistent estimates with regard

to medical underwriting, it is possible to trace back the observed discrepancies

to inadequately low model inputs for life expectancies and discount rates. The

main consequences are a dissimilar treatment of investor groups in open-end

funds structures as well as an unduly high compensation for managers and

third parties. Toaddress this predicament, we suggest defining life settlements

as level 2 assets in the fair value hierarchy of IFRS 13, improving transparency

and disclosure requirements, and developing new incentive-compatible fee

schedules.

INTRODUCTION

Life insurance protects a policyholder’s dependents against possible financial hardship

in case of his or her death. In 2011, the coverage in the United States was USD 19.2

trillion, an increase of 4 percent from 2010 (see American Council of Life Insurers[ACLI],

2012). Due to its classical risk management function, life insurance has long not been

considered as a financial asset. However, actuarial values are frequently substantial

while the policyholder is still alive (see, e.g., Doherty et al., 2004).1The shorter the life

expectancy (LE) of a person, the more valuable the insurance policy, since its actuarial

value converges to its face value (death benefit). Thus, a life insurance asset appreciates

when the policyholder grows older.

Alexander Braun works at the Institute of Insurance Economics, University of St. Gallen;

e-mail: alexander.braun@unisg.ch. Sarah Affolter works at KPMG AG; e-mail: saffolter@

kpmg.com. Hato Schmeiser is managing director of the Institute of Insurance Economics, Uni-

versity of St. Gallen; e-mail: hato.schmeiser@unisg.ch

1The actuarial value of a policy is the discounted expected face value of its death benefit (see,

e.g., Doherty et al., 2004). Since the death benefit payment is a contingent cash flow that may

occur at different points in time with different probabilities, a set of mortality assumptions (i.e.,

a mortality table) is needed to estimate its expected value.

173

174 RISK MANAGEMENT AND INSURANCE REVIEW

Historically,life insurance policies have been classified as illiquid assets, since, in contrast

to tradable securities such as common stocks, there was no active secondary market.

Policyholders who were no longer in need of coverage therefore had only two options:

lapsing the contract or selling it back to the insurance company for its predetermined

surrender value. In the latter case, insurance carriers were able to dictate prices within

legal boundaries as they held monopsony power for the repurchase of their products

(see, e.g., Kohli, 2006). Nowadays, however, it is also possible to sell to third parties

in transactions called life settlements. Regardless of their comparatively short history,

the life settlement asset class has managed to attract a lot of investor interest. The main

reason for this success is the independence of the underlying biometric risks from the

broader financial markets that leads to low return correlations with traditional asset

classes (see, e.g., Keating, 2009; Braun et al., 2012).

Considering the rapid evolution of the market for life settlements, it is not surprising

that a number of investment funds focusing on this asset class have emerged over the

last decade (see, e.g., Braun et al., 2012). In recent years, however, many funds have

either struggled or failed altogether. Industry experts regularly attribute this circum-

stance to the difficulties involved in adequately valuing the funds’ portfolios. Owing to

the unique character of each underlying life settlement asset, a mark-to-market approach

cannot be applied and one needs to resort to mark-to-model techniques. Consequently,

whenever the corresponding input parameters are not derived in a market-consistent

way, the funds’ portfolio valuations may significantly differ from the observed price

levels of current transactions. This implies that fund managers enjoy considerable lee-

way that they may exploit to the detriment of their investors. Although the valua-

tion practices of the life settlement industry have already been discussed in earlier

work (see Braun, 2012), an empirical analysis in this context is lacking in the literature

to date.

Instead, previous studies cover a broad range of other aspects concerning life settle-

ments. Doherty and Singer (2002) as well as Doherty et al. (2004), for example, discuss

the benefits and risks of a secondary market for life insurance policies. Gatzert (2010)

provides an industry overview for the United Kingdom, Germany,and the United States.

More recent studies of market size and development are undertaken by Conning (2011,

2012). While the impact of the secondary market on life insurers’ surrender profits is

explored by Gatzert et al. (2009), Fang and Kung (2010) discuss the corresponding im-

plications for consumer welfare. Moreover, Doherty and Singer (2003), Kohli (2006),

Evans et al. (2009), and Casey and Lowe (2011) review regulatory and tax issues. Further

topics that have been considered in the extant literature are the ethical aspects of life

settlement investing (see, e.g., Quinn, 2008; Nurnberg and Lackey, 2010), the purchas-

ing and due diligence process (see, e.g., Ingraham and Salani, 2004; Freeman, 2007),

the challenges and opportunities from a life settlement provider’s viewpoint (see, e.g.,

Seitel, 2007), and the issues involved in securitization (see, e.g., Stone and Zissu, 2006;

Ortiz et al., 2008). Apart from that, some authors have examined the risk, return, and

correlation characteristics of this asset class. Smith and Washington (2006), for example,

consider the diversification process for life settlement portfolios, Dorr (2008) illustrates

how they can be employed to extend the efficient frontier, and Bajo Dav´

o et al. (2013)

derive the optimal portfolio weight in a classical Markowitz framework. Finally,Rosen-

feld (2009) explores benefits and risks for institutions, Braun et al. (2012) measure the

performance of open-end life settlement funds and comprehensively discuss associated