The Life Settlement Market Passed the Test
What You Need to Know
- The Great Storm of 2008 raised questions.
- When the COVID-19 pandemic hit, some investors cashed out.
- In the end, life settlement funds took a punch and kept on going.
Roughly 13 years ago, the life settlements market suffered a massive dislocation. Changes to actuarial assumptions used by industry medical underwriters combined with the global financial crisis to create a confluence of events that left many portfolios in shambles and many investors wary of the asset class.
However, today, with stock market valuations near record levels and real bond yields below zero, the central premise of life settlements — an asset class capable of delivering high single to low double-digit annual returns with low correlation to traditional financial investments — is more relevant and appealing than ever.
With that perspective as context, it’s instructive to recall exactly what happened to life settlements late in the first decade of the new millennium and to ask whether today’s market is in a better position to withstand the next major financial shock. To the extent last year’s pandemic-related market swoon served as a stress test for life settlements, the early indications are reassuring.
The Great Storm of 2008
Thirteen years ago, a perfect storm impacted life settlements, and the industry was not prepared. “Hot money” was pouring into a comparatively small market. Banks were loosening their purse strings to provide leverage and financing for policy premiums. At the same time, new buy-side players were entering the space, often with more capital than experience in the highly specialized asset class.
Two distinct events combined in short order to cause market conditions to deteriorate rapidly.
The first domino to fall was in late 2007, when two leading underwriters to the life settlements industry made changes to their data tables. This was followed in February 2008 by an update to the Valuation Basic Tables (VBTs), a key mortality input used throughout the life insurance industry to calculate life expectancies. These changes affected asset valuation levels for many portfolios more negatively than expected. In some cases the writedowns triggered by revised life expectancies meant financed assets were underwater, resulting in forced selling.
On their own, the valuation markdowns would have been a big development for the life settlements market. However, they were followed the very next month by an event that shook the entire global financial system — the March 2008 collapse of Bear Stearns (and, just six months later, by the even bigger collapse of Lehman Brothers). The ensuing financial crisis had major impacts on life settlements: the leverage that was financing premiums in many portfolios became much more expensive or dried up altogether and discount rates climbed sharply, creating losses on portfolios being marked-to-market. The natural desire to cash in “good assets” to pay for “bad assets” in difficult times also had a negative effect on life settlement funds, as redemption requests forced the liquidation of policies at distressed levels.
What a difference a decade (or so) can make.
Thus, returns in the asset class broadly declined, which led some to question whether life settlements truly are less correlated to the financial markets. After all, stocks and bonds traded down sharply, and to a lesser extent, so did life settlement assets — at least on a mark-to-market basis.
A Key Distinction
Correlation, however, comes in different flavors. One is the “direct correlation” of returns between certain asset classes. For example, the returns of equities are often correlated to the returns of corporate bonds since both are linked to companies’ operating performance and the financial condition of company balance sheets. Similarly, international stock values frequently correlate to the strength of the dollar due to currency translation.
The other major form of correlation is what has come to be known as “embedded beta.” This is where assets with no obvious relationship nonetheless trade lower together in times of distress due to liquidity concerns and the very structure of financial markets. Notably, most of the life settlements markdowns 13 years ago had little to do with a direct, fundamental relationship to other financial assets and everything to do with embedded beta.
If the dislocations of 2008 were largely the result of macro-economic forces, it is worth considering whether those factors are still operative. In other words, have life settlements reduced their vulnerability to embedded beta? If so, an investment in an asset class capable of generating above-market returns with low correlation to traditional financial assets may be worth a fresh look.