The Life Insurance Industry Has a Flawless Track Record
The life insurance industry has been around for over a hundred and fifty (150) years. Since the life insurance industry began, there has never been a single instance where a life insurance company was unable to pay a death benefit to an individual that owned a policy where all the premiums had been paid on time and his/her policy was in good standing at the time the policyholder passed away.
The reason why life insurance companies are so reliable is that there is a system in place to assure adequate reserves are available to pay death claims. The system is overseen and administered by the state insurance commissioners to ensure there is always enough money to pay a claim when a policyholder passes away. The system is called the US Legal Reserve System (USLR).
The USLR system segregates a portion of the policyholder’s premiums for death benefit reserves. The reserves are separate and held away from the operational side of the insurance company’s business. The insurance company is not allowed to dip into death benefit reserves if the company suffers from operational insolvency. The USLR manages the transition if a carrier fails so that policyholders maintain the continuity of their coverage. The USLR works.
“During the Great Depression, over nine-thousand banks failed. Not one insurance company went out of business.”
In simplest terms, insurers benefit from a very large number of premium payors and a relatively small number of claimants. As a matter of fact, only about ten percent (10%) of all life insurance originated ever pays a claim to a beneficiary.
A large percentage of all life insurance is term insurance. Term insurance is just what it sounds like. The people that buy term insurance are insuring their lives for a set term, like ten (10) or twenty (20) years and if the policyholder does not die during that term, the life insurance policy expires and the insurance company is relieved of its obligation to pay a death claim.
The remainder of life insurance coverage in place is called permanent insurance. Permanent insurance means that if you keep paying the premiums and don’t fall behind, no matter how long you live, the insurance company will pay the death claim when the insured passes away. Only a small portion of those insureds are able or willing to continue to pay the premiums.
As time passes, the reasons for which a policy was originally purchased change:
- Coverage becomes unaffordable or undesirable
- Policyholders no longer have any living or needful beneficiaries
- The risk for which a policy was originally purchased no longer exists
So, long story short, the life insurance companies take in a lot more money than they pay out. But, as stated above, every time a legitimate death claim has been filed on a policy in good standing, the insurance company has kept its end of the bargain without failure.
The Legal Basis for the Senior Life Settlement Industry
The legal basis for the establishment of a traded secondary market for life insurance was established by the United States Supreme Court over one hundred and twenty years (120) ago. In 1911, Chief Justice Oliver Wendell Holmes ruled that permanent life insurance had all the characteristics of any other privately-held asset just like a car or home and the owner of a life insurance policy could sell it to a third party if they so decided.
…life insurance has become in our days one of the best recognized forms of investment and self-compelled saving. So far as reasonable safety permits, it is desirable to give to life policies the ordinary characteristics of property.
Supreme Court Justice Oliver Wendell Holmes
Grigsby v. Russell, 222 U.S. 149 (1911)
Relatively few people are aware that this law exists and the life insurance companies would like it to stay that way.
The insurance companies have only ever offered two ways for an insured to get out of paying premiums if they no longer wanted, needed, or could afford their coverage:
- Stop paying premiums, let the policy lapse and lose everything, or
- Surrender their policy back to the insurance company at a price that the insurance company determines.
The insurance companies did not design this arrangement to benefit the policyholder. The life insurance company only offers pennies on the dollar if the insured wants to sell their contract back to the life insurance company. This arrangement is called a Surrender.
Look at it this way. Say for instance you buy a house from someone for one-hundred thousand ($100,000) dollars. Over time, you decide that you do not want to live there any longer. Maybe it’s too small now because your family has grown. Or perhaps you lose your job and it gets to be too expensive. It could be you do not like it anymore or any other reason you can imagine.
Now, you only have two options. Walk away from it and lose your house and all the payments you made or you can sell it back to the person from whom you bought it and that person has total pricing control. The buyer could say I will give you ten thousand ($10,000) dollars…take it or leave it. If that was the case, would you ever buy a house?
Even though the laws have been around for a long time that says you have the right to sell your policy to anyone you want for however much you can get them to pay, the insurance companies do not want you to know you have that legal right because it is to their benefit to pay as little as possible, preferably nothing at all, keep the premiums you paid over the years and walk away from their obligation to pay the death benefit.
The Supreme court created a third option. It is called a Life Settlement. A Life Settlement is a transaction where an insured sells his/her life insurance to a third party. The buyer/investor becomes the new owner and the beneficiary of the seller’s policy and they continue to pay the premiums until the insured passes away. The policy buyer is then entitled to receive the contract’s death benefit.
Life settlements work best if the life insurance policy is on the life of an older person and the insured is in diminished health and only expected to live for a relatively short period of time. Since the new owner has to pay the premiums to keep a policy in force, it will not work to buy a policy on a much younger person because you would have to pay the premiums for so long, that you would end up paying more than you would eventually receive.
So, more specifically, the investment being described here is called a Senior Life Settlement. A Senior Life Settlement is a life insurance policy that an elderly person, typically sixty-five (65) years of age or older, sells in a secondary market transaction. This idea works because the purchaser will have to pay the premiums for a much shorter period of time.
Traditional exchange-traded assets like company stocks, real estate, and commodities exhibit price volatility due to all kinds of different reasons, economic and otherwise. And of course, the risk of a company going out of business at a total loss to the equity investor exists as was seen during the Technology Bubble of 2000, the Credit Crisis of 2007-2008, and most recently during the COVID Pandemic. Albeit, the probability of a public company failing outright tends to be remote given the reporting requirements and access to information, it still happens from time to time.
Bonds can lose their value when interest rates rise. In order to sell a bond with a lower coupon rate than a newly issued bond with a higher coupon, the bond has to be sold at a discount in order for the buyer to have an equivalent yield. The seller discounts the bond on the transaction by taking a principal loss. Bonds of course can suffer from credit default as well due to the borrower’s inability to make interest and principal payments to bondholders.
When life insurance stands behind the investment, the only trigger that causes the investor to receive his or her payout is the mortality (death) of the insured. No external stimulus is directly interconnected to human life. It does not matter what happens in the stock market, it does not matter what happens to interest rates, it does not matter who is in the White House…nothing else matters. Because there are no other influences that can change the legal rights conferred in the contract, life insurance is resistant to outside catalysts, and therefore this investment has a very low correlation coefficient.
In Q1 & Q2 of 2022, it has been abundantly evident that interest rates have a high negative correlation to equity prices. As the Federal Reserve has begun a rather hawkish tightening cycle to rein in inflation, rising rates have had a pronounced negative effect on stock prices.
So why is understanding correlation important? Because Senior Life Settlements are largely non-correlated to almost everything. It really does not matter what happens in the economic and business cycle because a life insurance contract is the engine that creates the yield in a life settlement investment. Because of this fact, having a portion of your investments in Senior Life Settlements will act as an insurance policy against volatility with other riskier investments in your overall portfolio.
The Risks of Owning Life Settlements
You might be saying to yourself, “This sounds too good to be true.” Nothing is ever totally risk-free. That is true. There are two primary risks of owning Senior Life Settlements. The biggest risk is time. It takes time for policies to mature because there are no payments made before the insured person passes away. So, once you have made the decision to invest in Senior Life Settlements, you have to wait for an indeterminate amount of time that is difficult to predict with precision.
The second major risk is that you have to make sure that you can maintain your lifestyle from other sources of income or savings you have in reserve. Because Senior Life Settlements are a “Buy and Hold” investment, they are considered illiquid. Once you own them, you own them and there will be no cash flow until the insured passes away. The good news is that if you own Senior Life Settlements, they pay you an attractive Illiquidity Premium in exchange for the value of time. In other words, if I have to wait, then it better pay me well for my lost opportunity cost. Senior Life Settlements do that.
Diversification & Differentiation
We have all heard the phrase, “Don’t put all your eggs in one basket,” right? That cliché refers to spreading out risk across several different investments in various industries and market segments so that if one asset class falls, you don’t lose everything. That is why correlation is important. If you buy different kinds of investments where some go up and some go down when say interest rates go up or real estate prices fall, you are better off than trying to guess what is going to happen next that makes all your investments go up. That is called market timing and it just does not work. That is why Senior Life Settlements are a good idea because there are only three possible outcomes: Win early, win on time or win late…but you always win. With all other investments you can make, you have to take some risk that they might go down in price.
If you want to make a lot of money, you have to take a lot of risk. Nothing ventured…nothing gained. If you are ok with making just a little bit of money, you do not have to take as much risk. This is called Risk Tolerance. Whether your risk tolerance is high or relatively low, losing your principal investment is the risk that this alternative asset class helps to avoid.
“It’s better to have it and not need than need it and not have it!”
Everybody has their own burdens to bear. In my own life, many of the career paths that I have chosen where I thought I would be set for life just did not turn out like I thought they would and always for some reason that I never saw coming. My Dad was a big wig car dealer and always thought that my Plan B was to go back and run the family business if my pro tight end career got derailed…which it did.
Well, the Chevy dealer down the street had a lot more money than sense and offered my Pops twice what the dealership was worth and he sold it out from under me. My family joke is that I became “the heir apparently not.” So, I had to go reinvent myself.
I got hired by Morgan Stanley Dean Witter in late 1999. My first day on the job was March 1st, 2000. What could possibly go wrong with this? Well, what I did not see coming was by June of 2000, the Technology Bubble imploded and I helped bring my Dad back down to Earth because we invested almost all his big payday from selling the store in technology stocks and I lost half of it.
That is when I learned about correlation and balancing your investments across many different asset classes. It was a painful lesson (that I was reminded of often) but there is no growth without pain, right? I would not believe so deeply in the lessons I am attempting to convey here if I had not lived through them myself.
At Soteria Capital, we build diversification into every portfolio to reduce the risk that anyone insured lives too long and your investment is illiquid longer than you would like. Rather than just owning one senior’s life insurance policy, we position multiple policies with different characteristics in a portfolio.
Soteria diversifies risk in several different ways:
- More males than females (statistically, women live longer than men)
- Different Life Expectancies (a medically and actuarially projected estimation of how long someone is expected to live)
- Contracts from many different insurance companies with good credit ratings (credit ratings are an indication of how well a company is run by management in terms of being able to meet their obligations and pay their bills)
When you make an investment in a life settlement portfolio, you are buying a portion or a fractional share in a portfolio of policies. Then, as the portfolio matures, the investor is paid his or her proportional share of the portfolio that he or she owns on a policy by policy basis.
You do not have to wait until the entire portfolio matures. The investor receives multiple, variably timed death benefit payments. It is important that the investor has other sources of liquidity, income, or savings to maintain their lifestyle. Life settlements are a true “Buy and Hold” and are illiquid until maturity.
Long-Term Capital Growth & Principal Preservation
Life settlements are a good strategy for investors with a longer time horizon for the need for their capital. Over time, if you keep reinvesting and continue to gain exposure to more Life Settlement portfolios, then you gradually start to increase your contract count. Each contract is a separate payment receivable in the future. It is a good idea to acquire assets that provide residual income.
If you look at an example of a portfolio of Senior Life Settlements, there is one price that you pay to buy the investment and each policy in the portfolio pays out its face amount when it matures. Generally, the weighted average amount of profit or Yield-to-Maturity (YTM) in a portfolio that an investor will receive is pegged to sixty-five percent (65%) or more. The portfolio YTM is Dollar Weighted. In other words, for every one dollar ($1) that you invest, you will receive at least one dollar ($1 Cost basis in your investment) and sixty-five cents ($.65 YTM) back when the entire portfolio has matured.
Although, the portfolio’s Total YTM is pegged to a weighted average minimum of sixty-five percent (65%), not every life insurance policy in the portfolio pays out the same percentage. That is because each policy in the portfolio has a different LE assessment, face amount, and premium load. That is to say that no two life settlement contracts are the same.
As mentioned previously, the risk of any one policy in a portfolio taking longer than expected to pay out is called Extended Longevity (an individual insured lives longer than the assessed LE projected). When you diversify a portfolio with short, medium, and long LEs, the expectation is that the policies will perform in line with the projections. It is very important to understand that LE is an estimation and is not guaranteed. Human mortality is random. Some lives will mature prior to LE, some at LE, and some beyond LE. In some cases, much longer than LE. We do not want to set an overly aggressive expectation that life settlements are a suitable investment for someone with a short (Less than 5 – 10 years) time horizon for the need for their investments to mature.
There is just as much weight attached to the possibility of early maturity (Upside Surprise) as there is an extended maturity. There are, of course, outlier results where sometimes terminally ill people outlive their longevity prognostications and exceptionally healthy people die prematurely. Life and death are completely random so the more exposure an investor has to a larger number of policies increases the likelihood that your Upside Surprises offset your extended longevity outcomes and the rest of the policies mature at or near the average LE. In other words, diversification is a function of the law of large numbers.
The key difference here to recognize is that the risk you are trying to quantify is not based on every risk under the sun that could affect other asset classes like stocks, bonds, or real estate. A life settlement is triggered only by the death of the insured. The mortality tables tell us that we as people have a reasonably reliable and finite shelf life. In the simplest way it can be described, in general, men live to be about eighty-five (85) and women tend to live to be about eighty-seven (87). Soteria Capital relies on Capstone Alternative Strategies to underwrite the risk associated with the Senior Life Settlement policies we choose. It is important to understand the actuarial and medical science behind longevity assessment and that is why the LE is so important to the analytics driving policy pricing strategy.
In the life settlement secondary market, LE is the only common metric utilized by all participants in their pricing methodologies. The logic is that you would expect to pay a higher price for a contract that has a shorter LE than you would for a contract with a longer LE. The assumption is that an asset with a shorter holding period to constructive receipt of the YTM would price at a premium to one with a longer LE and vice versa.
- A 78-year-old man with an 87-month Life Expectancy passed away in 24 months. The holding period return (Total Projected Yield to Maturity divided by the number of months he actually lived) was around 35%.
- A 92-year-old woman with a 24-month Life Expectancy lived for 47 months. The holding return on her policy was a little under 17%.
- A 74-year-old man with an 84-month Life Expectancy passed away in 13 months. The annual return on his policy was 59%.
This illustration demonstrates the randomness of human mortality. No one knows what or when anything will happen. However, since life expectancy is the only critical component in quantifying the investment risk, this asset class ignores nearly all the other risks that affect other asset classes.
Mitigating Extended Longevity Risk
Let’s look a little deeper into the Life Expectancy Assessment process. Specialist medical underwriting companies review all of the medical records of an insured and assign a Life Expectancy estimation to each Senior Life Settlement policy. To mitigate the risk that any one assessment is materially flawed, the Capstone risk pricing methodology utilizes three (3) different, independent companies that provide Life Expectancy Assessments to remediate the concentration risk of only using a single LE. If one of the three Life Expectancy estimates comes back and is considerably longer or shorter than the others, that policy will undergo a deeper review.
Because we know that the LE assessment process is an inexact science, we take added measures to manage the risk of extended longevity. The investor’s acquisition cost includes an additional two years (twenty-four months) of optimized annual premiums to the average policy/portfolio LE assessment to further mitigate the risk of extended longevity.
While policies are active and premium-paying prior to maturity, the premium pool is cash managed by professional money managers to earn additional yield and elongate the pool’s utility in mitigating extended longevity risk.
In the event a contract matures earlier than the assessed LE, there are surplus premium dollars still in reserve that were never paid to the insurance companies. This surplus premium is held in reserve as an additional umbrella of protection to be used to pay premiums on any policy managed in any portfolio.
The extended longevity risk mitigation strategy above is at the core of the Capstone Premium Reserve Management (PRM) System. This proprietary extended longevity risk management system was created and managed by Capstone Capital Management, the Grantor of the Capstone Capital Trust. The chain of custody is a tested structure with experienced counterparties in place to assure safe keeping and accountability of investor funds. Over a decade of experience and dedicated human capital has gone into the PRM System to assure the business model is safe from the possibility of fraud, theft, or misappropriation.
The Soteria Capital Absolute Return Portfolio Series is the accumulated wisdom and the collective strength of specialists in the life settlement space. With the benefits of non-correlation, diversification, and execution, an investment in Soteria Capital can help preserve long-term capital and achieve desirable, risk-adjusted returns in this uncertain economic landscape.
Subscribe to the Soteria Blog
The Soteria Blog is a short weekly editorial commentary about how life settlements can affect investing and risk management in the current economic and geopolitical environment.