The thriving US life settlements market is attracting a growing
number of investors eager to cash in on what they perceive to be
easy profits. However, a life settlements expert has cautioned that
even minor miscalculations of life expectancy could prove
financially disastrous. Charles Davis
reports.
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Life expectancy, already a wild card in the US life industry, is
now introducing uncertainty in the life settlements market as well.
The story of life expectancy in the US is overwhelmingly
positive when it comes to life customers – the US enjoys one of the
world’s highest life expectancy rates in the world; it’s the
unavoidable variance in that rate that plagues life
settlements.
Darwin Bayston, MD of broking and advisory firm Life Settlement
Consulting and Management, raised eyebrows at the Life Insurance
Settlement Association’s autumn conference by likening risks in
life settlements to the subprime mortgage market. He didn’t equate
the two; he merely said that lessons from turmoil in the subprime
mortgage market provide important clues about risk.
“Misjudgements were made about the maturity characteristics of
subprime mortgages and investors lost billions of dollars,” Bayston
said. “Investors who fail to analyse the maturity characteristics
of life settlements could lose hundreds of millions of
dollars.”
Given the recent headlines generated by the subprime mortgage
market, such an introduction was bound to gain the attention of
attendees, but Bayston’s presentation was measured, statistically
driven and unmistakably nerve-wracking to the industry.
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By GlobalDataPrimed to implode
Why did the subprime market implode? Bayston said that the
fundamental assumption was that subprime borrowers would pay their
mortgages on time and default rates would occur as expected. In
reality, default rates were greater and not appropriately adjusted
for in the analytical models of institutional investors and rating
agencies. The resultant debacle has everyone looking for analogous
risk scenarios and Bayston’s presentation drew some eerie
parallels.
The question for the life settlement industry, he said, is whether
life policies will mature as expected. In other words, are life
expectancies valid and could future variance plague the sector? If
life expectancy rates are found to be flawed, investors may
likewise withdraw from the market, leaving a void of new capital
available for the market.
Life settlement companies, Bayston said, have become overly reliant
on life expectancy models and need to reassess how they factor into
pricing. If they don’t, he argued, the life settlement market may
end up learning the same lessons that are currently being
experienced by subprime mortgage lenders.
While acknowledging that few industry experts share his opinion,
Bayston said there are strong similarities between the secondary
life market and the subprime mortgage market. Both were developed
in a world “awash with liquidity” that has fuelled their growth and
much of that growth is based on reliance on “complex valuation
models”.
‘Marking to model’
Like subprime lenders, who relied too heavily on models that proved
to be incorrect, many life settlement companies are putting too
much stock in models in their pricing, a phenomenon that he called
“marking to model”. This marking to model, Bayston said, is where
the going gets truly risky, because life expectancies are at the
root of investing in life settlements. As life expectancy is the
most important factor in determining value and pricing in a life
settlement transaction, even relatively minor misses in the model
can cause real instability.
To illustrate this point, Bayston calculated a life expectancy
report using the same policy and the same mortality table. Two
different models, he said, produced a variance of some 23 months in
life expectancy. That may not seem like a huge difference, but he
found that the 23-month gap could yield a pricing difference of 74
percent and a difference in expected returns of as much as 3
percent per annum. Multiply that difference across a life
settlement portfolio and the revenue loss could be truly
disruptive.
The explosive growth in life settlement players means more of a
short-term focus, Bayston said. He noted the tension inherent in
the life settlement equation was an added variable. Selling agents
want the shortest life expectancy report possible, while investors
seek the longest life expectancy reports they can obtain for a
lower price tag. Self-interest clouds the entire process and life
settlement providers find themselves in the middle trying to obtain
policies while keeping investors satisfied. The answer, he said,
lies in the creation of an independent rating agency that could,
based on life expectancy, assess and verify a company’s expected
results versus its actual results.
Ultimately, the availability of long-term capital is at stake, he
said. And if inaccurate life expectancy reports begin to shake the
market, the effects could be widespread. While insurers are
improving life expectancy data and maximising technology to hone
their reports, a degree of variance is unavoid-able. To make
matters even more confusing, life expectancy continues to
increase.
The latest data published annually by the government’s National
Center for Health Statistics shows that a newborn baby boy can
expect to live to age 74 years and six months, while a newborn baby
girl can expect to live to 79 years and nine months on
average.
Sweet spot for market
Life expectancy at birth is not particularly relevant for retirees
– the life settlement market’s sweet spot. They have already
survived to retirement age, by definition, and are very likely to
survive to considerably higher ages.
However, basing life settlement price calculations on life
expectancy statistics alone ignores the distribution of deaths.
This indirectly assumes that the timing of deaths within the life
expectancy duration and beyond is unimportant – and, of course,
nothing could be further from the truth.
Bayston’s analysis certainly gives one pause, particularly when
considered against the backdrop of the rapid growth in life
settlements. Institutional money managers invested more in life
settlements last year – an estimated $10 to $15 billion in face
amounts – than in the previous seven years combined.
Already, a chorus of financial professionals has called for greater
transparency. Eventually, either the industry will provide
transparency voluntarily or regulation will require it to. With a
gold rush under way in life settlements, it’s worth examining the
wreckage of the subprime mortgage crisis for any clues it might
provide.
