How to Evaluate the Risks of Life Settlements
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As asset classes go, life settlements tend to go unnoticed by advisors. CNBC’s talking heads don’t wax rhapsodic about them as they do with stocks. Bloomberg reporters don’t genuflect before a life settlements portfolio manager the way they might when interviewing a multibillion-dollar bond portfolio manager. Face it, life settlement investing – purchasing life insurance policies, paying the premiums, and waiting to collect the benefit when the policyholders pass away – is niche, esoteric, even, dare I say, misunderstood.
But for advisors looking to add diversification and growth potential to client portfolios, they are compelling. With little to no correlation to the returns of traditional asset classes, as well as the potential for consistent double-digit annual returns, an allocation to life settlements protects portfolio value in a market downturn and builds wealth over the long haul (for more information, read Whether Volatility is High or Low, Life Settlements Perform).
While investing in life settlements provides distinct benefits, they also are an alternative asset class with risks uncommon to other investment types. That’s why I want to give advisors – especially those unfamiliar with the space – a guide to evaluate life settlement managers’ approaches to managing these risks so their clients can reap the rewards.
Quick summary of life settlement investing
Similar to a fixed income investment, life settlements are purchased at a price determined by a discount rate on future cash flows. Life settlements are effectively negative coupon bonds with an indeterminate maturity date. The negative coupon is the carrying cost which is predominately made up of the premium payments, and the maturity date occurs upon receipt of the death benefit proceeds. Returns for life settlement investments hinges on realizing this mortality income or selling the policy at a profit – similar to a bond held to maturity or traded in the open market.