The morbid niche of life settlement funds | Funds

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Life settlements are the sale of a life insurance policy to a third party. The purchaser, who is now the owner of the policy, assumes the payment of the premiums in exchange for the death benefit on the death of the insured.

Most life insurance policies are considered assets under federal law, which gives the owner the right to sell them, says Los Angeles-based Jeffrey Post, managing director of Trident Risk Strategies, an insurer. general practitioner specializing in longevity risk. An insured may choose to sell their policy instead of ceding it to the insurance company, as an investor will typically pay more for the policy, typically 10-25% of the death benefit.

In return, the buyer gets an asset unrelated to the stock or bond market that earns 8-10% after fees, although this is a somewhat morbid investment.

As a result, a niche category of private mutual funds that invest in life settlements was born, giving investors a better path to an entirely different type of asset. “A life settlement is not just an asset; it’s an asset and a liability, ”says Emmanuel Modu, general manager of insurance-related securities at AM Best in Oldwick, New Jersey.

Lifetime settlements look like fixed income investments, but unlike bonds, which pay you interest to lock in your money, a lifetime settlement requires you to cover the premiums to maintain the death benefit, a cost that is passed on to investors. .

Funds are the smartest way for individual investors to access life insurance settlements because risk can be diversified with hundreds of policies, says Jay Jackson, vice president of capital markets at Abacus Settlements at Orlando, Florida.

The risks and costs can add up. And there is considerable risk in life settlements, whether you buy them individually or through a fund. For example, investors risk lawsuits that challenge their right to the death benefit. Insurers, in particular, carefully review life insurance regulations to determine if any insurance laws have been violated.

Therefore, there is a risk that the insurance company will refuse to pay the death benefit or go bankrupt, and you will never get your money back, although Modu says the risk of bankruptcy is low, as most of these insurance companies are well rated and unlikely to default. The biggest risk with life insurance settlements is that the insured lives longer than expected and that investors end up paying more in premiums than they receive from the death benefit.

Premiums aren’t the only costs to consider. Investment costs can be substantial and can include a broker’s commission of up to 30 percent of the settlement price plus a life insurance settlement provider’s fee. Investors may also face a management fee of 0.5% to 2% if they invest through a settlement-life fund.

Taxes are another consideration. When you buy a life settlement as an investment, “you lose the tax-free benefit of insurance, which is one of the best benefits of life insurance,” says Scott Witt, insurance advisor at fees at Witt Actuarial. Services in New Berlin, Wisconsin. For investors, distributions from a life settlement fund and the death benefit are taxed as ordinary income.

One solution is to hold lifetime settlements in an IRA, but this can be difficult to do if you are investing through a mutual fund. Under federal law, most funds with more than 25% of assets held in IRAs are required to adhere to more stringent rules governing pension plans, including restrictions on how the fund manager invests and is paid, says Jackson. To avoid this, most fund managers do not allow investors to hold the fund in an IRA once the fund has reached the 25% threshold.

And even holding life settlement funds in an IRA cannot protect you from all taxes. If the fund uses leverage or debt to cover future premium payments, then “your IRA money may be subject to alternative minimum tax,” he says.

Funds must be structured with care. When life insurance settlements are pooled into a fund, money must be available to pay the premiums for those policies. This money can come from maturing policies, that is, policies that have paid their death benefits because the insured died.

Typically, when fund policies expire, the proceeds are returned to investors as quarterly or monthly cash flows, but “sometimes a percentage is withheld to pay future premiums,” says Jackson.

In order for the death benefit to cover future premiums, the funds must be structured so that the policies mature permanently. To do this, “you have to be able to predict how long people will live, and in this industry, that prediction has been notoriously bad,” Modu said. This is one of the reasons AM Best has refrained from reviewing many life insurance settlements. Other reasons include pools that are too small to generate cash, or too many parties involved in the securitization process.

Most funds use third party underwriters to value policies. The insurer reviews the insured’s medical records and estimates the person’s life expectancy to determine the current value of the policy, Witt says. Beyond that, insurers “largely fly blind,” he says, although they have the right to call every few months to check if the insured is still alive.

There is no market price for life insurance settlements because they are not publicly traded, so underwriters use models to determine the value of policies. “But these models depend on absolutely uncertain inputs”, explains Modu, namely the life expectancy of the insured. “If your subscription is wrong, it doesn’t matter what kind of financial chemistry you put around this deal; someone is going to lose money.”

An inaccurate model creates a systemic bias affecting the entire portfolio, as all values ​​in the policy will be based on the same imprecision. This could leave investors with their money stuck in a fund that cannot pay them back. The fund’s net asset value is determined monthly or quarterly and shared with investors, Jackson says.

Verification of funds. In short, life insurance investors need to “come in with their eyes wide open,” Modu says. Post suggests carefully reviewing the backgrounders to get a sense of the portfolio’s best and worst-case scenarios.

Jackson says to verify that the fund is registered with the Securities and Exchange Commission under Regulation D for private placements, and that third-party underwriters are registered in the state. Use the Financial Industry Regulatory Authority’s Online Broker Check Tool to see if any complaints have been made against the provider or fund manager. And ask questions: what are the liquidity conditions? Are policy maturity amounts reinvested or distributed? Does the fund use debt leverage?

“You have to seek advice and make sure it’s an asset to you,” Jackson says. He suggests Vida Capital and GWG Holdings as credible funds for investors. Witt adds, “Don’t invest anything that you can’t afford to lose completely, and good luck.”

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