Life settlement is a longevity-contingent, insurance contract-based type of an asset class.
According to Stone and Zissu 2006 in a life settlement transaction, the original policyholder sells both the liability of future premium payments and the claim of the death benefit of a life insurance contract to a life settlement company for a lump-sum payment. The life settlement company may further securitize a package of settled contracts in the capital market to sophisticated investors.
The goal of life settlements is to realize the potential value which is normally lost when a life insurance policy is lapsed or directly surrendered to an insurer. For investors, life settlement can be a lucrative investment opportunity as it offers a low market correlation. Nonetheless, it is important to note that life settlement portfolios are dependent upon life expectancy estimates and can be affected by longevity risk. In this article, we will go into detail about the meaning and process of an insured’s life expectancy (LE) assessment, what is longevity risk, and how the industry has evolved.
Life Expectancy: Definition and Process
By definition, life expectancy (“LE”) is a statistical & actuarial measure of the estimated time an individual is expected to live. That assessment is based on several factors that include but not limited to birthdate, gender, current age, family genes, health condition, and other demographic factors. In the life settlement industry, medical underwriting is known as a process to perform life expectancy assessment Professional third-party medical underwriters- review and analyze an insured’s recent and historical medical records and evaluate mortality risk based on characteristics such as age, gender, socio-economic factors, and lifestyle habits, etc. Based on the analyzed data points, the underwriter estimates an insured LE by selecting the suitable mortality table of “cohorts” — recording and analyzing people in distinct demographic sections of a population born in a particular year — corresponding to their demographic and health characteristics.
The most common method is known as the debit-credit underwriting approach. Using mortality tables a significant number of medical underwriters start with a base mortality multiplier of 100%. From there, an insured’s individual mortality is either “debited” i.e increased in the case of a negative health record for instance smoking habits, diabetes, blood pressure, need of assistance to function daily, etc. At the same time, an insured’s individual mortality can be “credited” which means it will be decreased in the case of a positive health record i.e absence of any medical disease in the insured’s family history, having an active lifestyle, etc.
This method is regarded as the crucial of the insured’s mortality curve, from which an LE assessment is obtained. To further validate the accuracy of the LE estimation underwriters use so-called an ex-post comparison of the actual number of deaths to the predicted or expected number of deaths, known as the A/E ratio (A to E ratio)- If the actual number is close to the expected number, then the ratio of actual to expected deaths will be close to 100% Actuarial Standards Board 2013.
After the completion of such assessments, a medical underwriter supplies LE estimates to licensed life settlement companies. As part of the standard, due diligence process and pricing determination similar type of reports are obtained from several life expectancy providers.
Longevity Risk: What is it and How to Effectively Minimize It
The insured’s life expectancy cannot be determined with 100% accuracy. However, it is almost certain that all life settlement contract insureds will mature earlier, some at assessed life expectancy and others later. One of the determining factors is the longevity risk.
What is it? longevity risk is the risk of mortality assessments made are not borne out in practice and the insureds live longer than estimated. As a result, an investor may have to pay additional premium payments in order to sustain the policy. The aggregate return for a portfolio of life settlement assets depends on the overall accuracy of the LE estimates.
The main source of longevity risk is the discrepancy found between the estimated and actual life span transpired for the insured. However, this risk may be minimized through diversification. This means, a mix of life settlement assets that have a diverse range of LE estimates so that if more than one insured’s LE are living longer or shorter than anticipated the portfolio can withstand the effect of these fluctuations. Longevity risk is apparent for all mortality-based investment products, yet with proper mechanisms in place and with help from certified professionals this risk can also be mitigated by taking the right steps. The advent of medical records technologies and the service providers having access to up-to-date mortality tables have made life expectancy estimations more accurate.
Historically, most LE estimates were generally too short, which hurt investors in the long run as they had to pay additional premiums affecting their aggregate return. During the early-to-mid-2000s, a large number of policies (mostly stranger-originated life insurance or STOLI) with underestimated LEs were traded in the life insurance secondary market. Many of those policies were arguably not supposed to enter the market in the first place as evidenced by poor subsequent performance. With the passage of time, underwriters changed their estimating methodologies and started to provide personalized assessment for each individual transaction. Now, most credible LE providers employ top of the tier physicians and medical experts who methodically arrive at the more reliable LE estimate by not only looking at the insured’s current medical profile but also predicting how the concerned insured can be impacted by potential medical diagnosis which are disease-specific.
Furthermore, experts are conducting robust experiments and research into more advanced ways to predict life expectancy. For instance, DNA-based testing, biomedical research, and facial analysis are a few of the methods experts are studying to improve the process and produce relatively accurate estimations.
To surmise, the primary driver of a valuation of a life settlement asset is in relation to an insured anticipated life expectancy. Which is an associated risk as the concrete lifespan of an insured cannot be made with absolute certainty.
Potential investors should not be wary of investing into life settlements. As due to its market immune characteristic, investors can achieve an additional level of diversification, stabilization, and overall performance enhancement by introducing this asset to their investment portfolio.
Furthermore, to reduce exposure to longevity risk significant inroads are being made in the industry to implement risk-hedging solutions. Moreover, continuous research is being conducted by experts to understand and practically implement the very best methodologies — DNA testing, biomedical research, updated mortality tables, facial analysis- that can produce very close estimates to an insured’s actual life expectancy.
To learn more about adding this product to your or your client’s portfolio, contact one of our specialist at VIP@life-xcel.com or 213–533–9002