Valuing Life Settlements: Growth of Securitization and Sophisticated Metrics
Life settlements have recently generated a lot of interest in the capital markets due to the current demographic environment and the market growth expected from this asset class at present and in the future. Since the emergence of this industry, many financial institutions have been accumulating multiple life settlement portfolios that they expect to securitize.
In this article, we investigate why evaluating life settlement policies is essential for investors, how this process can be more effective using the Life Extension Duration and Convexity metric, and discuss the factors contributing to the industry’s growth securitization.
Importance of Valuing Life Settlements for Investors
There are several determining factors that life settlement administrators or asset managers must consider when picking policies from credible life insurance providers. These factors include examining the insured’s health condition, medical history, age, sex, fitness levels, and lifestyle by independent medical professionals, measuring the actual face value of the policy, and determining the insured life expectancy “LE” estimate.
After the “LE” estimate is obtained, the insured is classified into a separate group and given a mortality rating. This rating is based on a few risk factors — health status, age, sex, and medical history — to which they possess similarity/ resemblance. This kind of actuarial approach to pricing a life settlement policy relies on data and is contingent/dependent upon matching the insureds risk factors to corresponding mortality tables.
Investors interested in investing in life settlements should conveniently access them through hedge funds which offer professional expertise for structuring and managing a diversified portfolio. Depending on the fund type: close-end, open-end, fractional ownership, fund managers may use a few or combination of factors above to determine the value of a life settlement or mortality-linked contract.
For investors, longevity risk is one of their primary concerns when investing in life settlement contracts. When selecting life settlement funds, having a specific criterion defined by specialists should help to mitigate possible portfolio risks.
Life Extension- Duration and Life Extension-Convexity Method
Life expectancy underwriters have now developed an advanced metric widely used to evaluate life settlement contracts and portfolios. This metric is called Life Extension-Duration and Life Extension-Convexity. This methodology was developed by Stone and Zissu (2006) to address the sensitivity of these contracts to deviations of life expectancy.
The Life Extension-Duration measures the percentage change in the value of life settlement contracts given an unexpected change, rather than a percentage change in the insured’s life from its life expectancy. The rate of return will depend on the weighted average life expectancy of the insured.
Life Extension-Convexity measures the rate at which duration changes of the life settlement contract occur concerning fluctuations in interest rates. If the convexity of the asset increases, the range in the life expectancy duration is accurate and relative to unexpected changes in return. If the convexity is positive, this implies that the insured lives longer than the estimate, and the value of the life settlement contract will decrease in the future.
Life settlement providers and financial institutions are now utilizing such innovative methodologies and other estimating techniques to handpick and select policies to assemble a portfolio that can withstand portfolio risks and market fluctuations.
To summarize, accurately valuing a life settlement contract is crucial to mitigate risks and assess the potential return on investment. For investors, longevity and liquidity risk are major concerns to investing in life settlement contracts. Life settlement companies have standardized procedures to select policies that fit their defined criterion to reduce such risks. For instance, LifeXcel vets and picks policies on an individual level that have diverse LE estimates and meet their pre-defined buy-box criteria.
The benefits of investing in life settlements outweigh the risks as this asset has no direct correlation to traditional financial markets and, at the same time, produces attractive returns due to their independent behavior.
Evaluating life expectancies should only improve with advancements in estimating methodologies such as the actuarial approach and Stone and Zissu LE-duration and LE-Convexity Parameters to better value, price, and hedge a hedge portfolio of life settlement contracts.