Investing in Life Settlements: Greater Returns and Diversification
Rajiv Rebello
Author
February 21, 2022
Summary: Investing in life settlements in place of low-yielding bonds can provide uncorrelated cashflows to help offset equity risk and create better portfolio diversification.
In previous articles we discussed how to use life insurance as a tax-efficient vehicle by which to invest in long-term bonds—with some equity participation via dividends (whole life) or options (indexed universal life)—as well as tax-inefficient investments (private placement life insurance). In this article we discuss why investing in the mortality element of life insurance policies through life settlements can be more attractive than using life insurance merely as a tax-efficient vehicle to invest in long-term bonds. Life settlements offer clients access to cashflows that are uncorrelated to market or interest rate risk with net expected returns in the 8%-11% range. In the wake of low bond yields and rising interest rates, life settlements can help portfolio managers create better risk-adjusted returns for their clients by taking a portion of the assets they would have allocated to bonds in a rising interest rate environment and allocating it to life settlements instead.
Life Settlements Offer Greater Opportunity for Higher Returns Than High Yield or High Quality Debt
In the current low yield and rising interest rate environment, life settlements can provide higher risk adjusted returns than either high yield or high quality debt.
Improving Risk-Adjusted Portfolio Returns by Allocating Portion of Bond Portfolio to Life Settlements
By taking a portion of a client’s portfolio that would otherwise be allocated to bonds and allocating it to life settlements instead, RIAs can achieve higher risk-adjusted returns and better portfolio diversification.
What is a life settlement?
For those unfamiliar with life settlements, a life settlement is the sale of an in-force life insurance policy to a third party for an amount greater than what the insured could receive from simply canceling the policy. In return for providing the seller with a cash payment, the third-party purchaser (investor) owns the life policy, pays all premium payments going forward and eventually receives the entire death benefit at the time of the insured’s death.
A life settlement allows the current policy owner (seller) to exit his investment in an asset that he or she no longer needs or can no longer afford. For the buyer, the investment offers great risk-adjusted returns and cashflows that are not correlated to market or interest rate risk.
Why is a Life Settlement Transaction Valuable for the Seller?
Life insurance is a necessary protection vehicle for individuals who have significant liabilities, but limited assets to pay for them. For example, young parents typically have mortgages and debt obligations but limited assets to pay for them in the event that a primary income earner were to pass away unexpectedly. A life insurance policy helps protect the family against this unforeseen event.
As these parents get older, however, their assets increase as they earn more at their jobs and save for retirement. Their liabilities also decrease as the mortgage gets paid down and children grow into adults and become financially independent. Older policy owners no longer need life insurance at that point, but have other life expenses that need to be paid while they’re still alive: healthcare, assisted living, etc.
As insureds get older, the cost of insurance on these policies also gets more expensive and often times seniors on fixed incomes can no longer afford to pay the premiums on these policies. Many life insurance policy owners simply cancel their policy if they no longer need or no longer can afford to pay premiums on the policy. In fact, Society of Actuary lapse studies show that almost 50% of permanent life insurance policies are canceled within the first 10 years. Since permanent life insurance policies often have surrender penalties for canceling that last as long as 20 years, policy owners who cancel their policy early will end up leaving with very little—if anything—of the original investment they made into the policy. Therefore, the ability to treat their insurance policy as an asset and sell it for more than what the policy owner could receive from merely canceling the policy is an incredible benefit for an aging population with increasing costs of living.
Why is a Life Settlement Valuable for the Buyer (Investor)?
An investor in life settlements knows that aging insureds on life insurance policies are more likely to be less healthy now than when the policy was originally purchased. Professional investors and asset managers in life settlements confirm this decrease in health through independent third-party consultants that provide life expectancy reports. Furthermore, life settlement investors know that if they can find specialized actuarial and insurance expertise they can calculate the mortality arbitrage on the policy and determine how to pay significantly less in premiums than the previous policy owner was paying to keep the policy in force. These two factors make the purchase of an individual policy attractive as the life settlement investor typically pays a cash price for the policy at a discount rate (IRR) of 13%-16%.
An investor can expect to achieve two outcomes. The insured could pass away before the life expectancy (in which case the return would be higher than the 13%-16% the policy was priced at) or the insured could pass away after the life expectancy (in which case the return would be lower than the 13%-16% the policy was priced at).
However, the life settlement investor also knows that just buying one policy is extremely risky as the investor doesn’t know exactly when the return on investment will be realized. In order for these priced IRRs to materialize, and for the investment to be less volatile, investors have to acquire a decent number of policies at attractive prices using a combination of sourcing channels and insurance expertise that properly finds policies, evaluates the risk and then manages the risk post-acquisition. Hence, while the underlying return on the asset may be uncorrelated to traditional capital markets, this return is very much correlated to the expertise of the asset manager. Therefore, in order for investors to realize stable, high yielding returns in the space that exceed those of traditional equity/bond portfolios they must find highly specialized asset managers that truly understand the space and work on behalf of the investor.
Given the large benefit that life settlements can add in a low-yield/rising interest rate environment it’s no surprise that investment in this asset class has significantly increased over the last few years with large and respected institutional investors like Apollo and BlackRock leading the way.
Over the last several years, large amounts of capital have surged in the secondary life settlement space as institutional investors seek the uncorrelated cashflows that these investments can provide. Even more capital has been deployed in the tertiary life settlement space where existing life settlement investors purchase policies from one another.
*2021 volume is estimated
What to look for in a life settlement fund?
While life settlements can provide greater risk-adjusted returns, that doesn’t mean that all life settlement funds are equal. As such, investors in life settlements should evaluate funds for the following attributes:
1. Actuarial and insurance expertise
The core determinant of returns in the life settlement space are tied to the actuarial and insurance expertise of the fund manager. Just as you wouldn’t want to invest in a real estate fund with managers that have no direct experience in real estate, you wouldn’t want to invest in a life settlement fund that doesn’t have deep life insurance and actuarial expertise. This type of expertise allows funds to identify undervalued policies in the marketplace, and properly manage mortality, insurance, and tail risk.
2. Open versus closed end structure
Open-ended life settlement funds offer investors a greater ability to exit the investment early and typically come with lower investment minimums. However, in exchange for this liquidity, open-ended funds typically have higher fees, lower returns, and are largely dependent on subjective valuation practices.
Closed-end funds in comparison have significantly higher investment minimums and limited ability to exit the investment early. However, in exchange for this limited liquidity, investors in closed-end life settlement funds receive more investor friendly fee structures and transparency in the return profile.
Life Settlement funds are inherently tax-inefficient. That’s because the majority of the gains are taxed at ordinary income rates for investors—similar to how coupon rates from bonds are taxed. Due to the inherent tax-inefficiency of the asset class, it’s important that funds consider this in both the structuring of the fund as well as in the purchasing of policies within the fund in order to make the investment as tax-efficient as possible.
4. Sourcing
Only about 8% of the policies that would qualify for a life settlement transaction are actually sold in the life settlement market place. The main reason the other 92% are not sold is simply because those policy owners do not know that selling their policy on the life settlement is an option. Furthermore, the 8% of policies that are sold in the life settlement market are often sold through broker channels which can eat up 15% to 30% of the total offer for the policy.
By focusing on developing proper education and sourcing channels, life settlement fund managers can develop their own proprietary channels that will both increase supply and reduce transaction costs which will result in higher returns for their life settlement funds.
Rajiv Rebello
Author
Rajiv Rebello, FSA, CERA is the Principal and Chief Actuary of Colva Insurance Services. Colva helps family offices, RIAs, and high net worth individuals create better after-tax and risk-adjusted portfolio solutions through the use of life insurance vehicles and low-correlation alternative assets. He can be reached at [email protected].
Determining the right death benefit level for your Private Placement Life Insurance (PPLI) policy is one of the most critical decisions that will impact your policy’s performance, costs, and overall effectiveness. This comprehensive guide explores how to balance regulatory requirements, estate planning needs, family protection goals, and investment capacity optimization to find the optimal death benefit level for your unique circumstances.
Hedge Fund Investments in PPLI: Benefits, Risks, and Due Diligence for Private Placement Life Insurance Strategies
Private placement life insurance (PPLI) has become an increasingly popular vehicle for high-net-worth individuals seeking to combine life insurance benefits with alternative investment strategies. Among the various investment options available within PPLI structures, hedge fund investments offer unique opportunities for portfolio diversification and enhanced returns. Understanding the benefits, risks, and due diligence requirements of hedge fund investments in private placement life insurance is essential for making informed decisions about this wealth management strategy.
## Understanding Hedge Fund Integration in PPLI Structures
Hedge fund investments within PPLI policies operate through carefully structured arrangements that maintain the insurance wrapper’s tax advantages while providing access to alternative investment strategies. These investments typically occur through dedicated funds or separately managed accounts designed specifically for insurance company separate accounts, ensuring compliance with regulatory requirements governing private placement life insurance.
The structure allows policyholders to access hedge fund strategies that might otherwise be unavailable or less tax-efficient in direct investment formats. Insurance companies work with established hedge fund managers to create insurance-dedicated versions of their strategies, often with modified fee structures and enhanced liquidity provisions tailored to the insurance environment.
PPLI hedge fund investments can encompass various strategies including long-short equity, event-driven approaches, relative value strategies, and macro trading. The insurance wrapper provides a tax-deferred growth environment where hedge fund returns can compound without immediate tax consequences, potentially enhancing long-term wealth accumulation compared to direct hedge fund investments.
## Tax Advantages and Wealth Preservation Benefits
The primary benefit of hedge fund investments within PPLI lies in the tax treatment of returns generated by these strategies. Traditional hedge fund investments typically generate significant taxable income through short-term capital gains, dividend income, and interest income, all of which are taxed at ordinary income rates. Within the PPLI structure, these returns accumulate tax-deferred, allowing for more efficient compound growth over time.
Estate planning benefits represent another significant advantage of hedge fund PPLI investments. The death benefit proceeds pass to beneficiaries income tax-free, effectively transferring hedge fund returns without the tax burden that would apply to direct hedge fund investments. This feature proves particularly valuable for families seeking to transfer wealth generated by alternative investment strategies to future generations.
The ability to access policy values through loans without triggering taxable events provides additional flexibility compared to direct hedge fund investments. Policyholders can access liquidity based on their hedge fund investment performance without the immediate tax consequences associated with hedge fund withdrawals or redemptions.
## Enhanced Diversification and Return Potential
Hedge fund strategies within PPLI offer portfolio diversification benefits that extend beyond traditional stock and bond investments. Market-neutral strategies, for example, can provide returns with low correlation to equity markets, helping to reduce overall portfolio volatility while maintaining growth potential.
Alternative risk premia strategies accessible through PPLI hedge fund investments can capture returns from various market inefficiencies and behavioral biases. These strategies often provide steady returns with different risk characteristics than traditional investments, contributing to more balanced portfolio performance across various market conditions.
The ability to combine multiple hedge fund strategies within a single PPLI policy creates opportunities for further diversification. Policyholders can allocate among different hedge fund managers and strategies, creating a fund-of-funds approach within the insurance wrapper while maintaining the tax benefits of the PPLI structure.
## Liquidity Considerations and Management
Hedge fund investments traditionally involve lock-up periods and limited redemption windows that can restrict investor access to capital. PPLI structures often negotiate enhanced liquidity provisions with hedge fund managers, including shorter lock-up periods, more frequent redemption opportunities, or side-pocket arrangements for illiquid investments.
Policy loan features provide additional liquidity options that bypass traditional hedge fund redemption restrictions. Policyholders can borrow against their policy values, including those supported by hedge fund investments, without triggering hedge fund redemptions or violating lock-up provisions.
The insurance company’s role in managing hedge fund redemptions within PPLI policies helps coordinate liquidity needs across multiple policyholders. This pooling effect can sometimes provide better redemption terms than individual investors might achieve in direct hedge fund investments.
## Risk Assessment and Management Strategies
Hedge fund investments within PPLI carry specific risks that require careful evaluation and ongoing monitoring. Manager risk represents a primary concern, as hedge fund strategies often depend heavily on the skill and discipline of individual portfolio managers. Due diligence must focus on manager track records, investment processes, and risk management capabilities.
Operational risk assessment becomes critical when evaluating hedge fund managers for PPLI investments. The insurance wrapper adds additional operational complexity, requiring hedge fund managers to maintain proper reporting, compliance, and administrative capabilities to support insurance company requirements.
Concentration risk can emerge when PPLI policies become heavily weighted toward hedge fund investments or specific hedge fund strategies. Diversification across multiple managers, strategies, and asset classes helps mitigate this risk while maintaining the benefits of alternative investment exposure.
## Due Diligence Framework for Hedge Fund Selection
Effective due diligence for hedge fund investments in PPLI requires analysis of both investment merits and insurance-specific considerations. Investment due diligence should evaluate the hedge fund manager’s investment philosophy, process consistency, and historical performance across different market cycles.
Operational due diligence must assess the hedge fund manager’s ability to operate within the insurance environment, including reporting capabilities, compliance infrastructure, and experience with insurance company separate accounts. The manager’s willingness to modify fee structures or provide enhanced liquidity for insurance applications represents important considerations.
Third-party due diligence resources, including hedge fund research platforms and specialized consultants, can provide valuable insights into manager capabilities and operational strengths. Insurance companies often maintain preferred manager lists based on their own due diligence processes, providing additional filtering for PPLI hedge fund investments.
## Fee Structure Analysis and Cost Management
Hedge fund investments within PPLI typically involve multiple fee layers that require careful analysis to understand total investment costs. Management fees and performance fees charged by hedge fund managers represent the primary investment costs, often following traditional “2 and 20” structures or variations thereof.
Insurance company charges add additional costs to hedge fund PPLI investments, including mortality and expense charges, administrative fees, and surrender charges. Understanding the interaction between hedge fund fees and insurance charges helps evaluate the total cost of accessing hedge fund strategies through PPLI.
Fee negotiations for hedge fund investments in PPLI sometimes result in reduced costs compared to direct hedge fund investments. The pooled nature of insurance company separate accounts and long-term investment horizons can provide leverage for better fee arrangements with hedge fund managers.
## Performance Monitoring and Reporting
Hedge fund investments within PPLI require specialized monitoring and reporting capabilities to track performance and ensure alignment with investment objectives. Monthly performance reporting should include both gross and net returns, attribution analysis, and risk metrics specific to the hedge fund strategy employed.
Benchmark comparisons become important for evaluating hedge fund performance within PPLI, though appropriate benchmarks vary by strategy type. Hedge fund indices, peer group comparisons, and risk-adjusted performance measures help assess whether hedge fund investments are delivering expected value within the insurance wrapper.
Regular portfolio reviews should evaluate the ongoing suitability of hedge fund investments within the broader PPLI policy structure. Changes in market conditions, investment objectives, or hedge fund manager capabilities may necessitate adjustments to hedge fund allocations or manager selections.
## Regulatory Compliance and Reporting Requirements
Hedge fund investments within PPLI must comply with various regulatory requirements governing both insurance products and alternative investments. Investor control restrictions ensure that policyholders maintain appropriate distance from investment decisions to preserve favorable tax treatment under private placement life insurance regulations.
Anti-money laundering and know-your-customer requirements apply to hedge fund investments within PPLI, requiring proper documentation and ongoing monitoring of beneficial ownership and source of funds. These requirements may be more stringent than direct hedge fund investments due to the insurance wrapper.
Tax reporting for hedge fund investments within PPLI occurs at the insurance company level, simplifying tax compliance for policyholders while maintaining transparency regarding underlying investment performance and tax characteristics.
## Integration with Overall Wealth Management Strategy
Hedge fund investments within PPLI should align with broader wealth management and estate planning objectives rather than serving as isolated investment decisions. The insurance death benefit, tax deferral features, and liquidity options must work together to support overall financial goals.
Coordination with other investment accounts helps optimize asset location and tax efficiency across the entire investment portfolio. Hedge fund strategies within PPLI may complement traditional investments held in taxable accounts or retirement plans, providing diversification benefits while maximizing tax efficiency.
Regular strategy reviews ensure that hedge fund investments within PPLI continue to serve their intended purpose as circumstances change. Market conditions, tax law modifications, or personal financial situations may affect the optimal allocation to hedge fund strategies within the insurance wrapper.
## Future Considerations and Market Developments
The hedge fund industry continues to develop new strategies and approaches that may become available within PPLI structures. Emerging areas such as digital assets, ESG-focused strategies, and quantitative approaches may offer additional opportunities for PPLI hedge fund investments.
Regulatory developments affecting either hedge funds or private placement life insurance may impact the attractiveness or structure of these investments. Staying informed about regulatory changes helps ensure continued compliance and optimal strategy implementation.
Technology improvements in hedge fund operations and insurance administration may enhance the efficiency and cost-effectiveness of hedge fund investments within PPLI. These developments could expand access to hedge fund strategies or improve the overall economics of combining hedge funds with insurance wrappers.
Hedge fund investments within private placement life insurance represent a powerful tool for wealth accumulation and estate planning when properly implemented and managed. The combination of tax advantages, diversification benefits, and professional management creates opportunities for enhanced long-term wealth creation. However, success requires careful due diligence, ongoing monitoring, and integration with broader wealth management strategies. By understanding the benefits, risks, and requirements of hedge fund PPLI investments, high-net-worth individuals can make informed decisions about incorporating these strategies into their overall financial plans.
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