Everything you need to know about investing in a life settlement fund
In a low bond yield and rising interest rate environment, bond investments pose significant interest rate risk and limited portfolio diversification benefits. As such, investors need to utilize other assets besides bonds that provide greater risk-adjusted returns and portfolio diversification benefits. Ideally these assets would have limited to no correlation to interest rate or equity risk.
Replacing part of the bond portfolio, in particular the long-term bond portfolio, with uncorrelated alternative assets can create portfolio diversification and risk-adjusted returns.
By taking assets that would be otherwise allocated to the bond portion of the portfolio (particularly the long-term bond portion) and allocating the assets to life settlements, portfolio managers can achieve higher risk-adjusted returns, greater portfolio diversification, and greater protection against interest rate risk.
Investing in a life settlement fund, can be one way for investors and portfolio managers to provide the portfolio diversification that bonds used to provide in a higher yield environment.
With gross discount rates of 12%-15%, we believe the life settlement market offers significantly higher risk-adjusted returns than either high yield bonds or high quality bonds.
With discount rates well above both high quality and high yield debt, life settlement cash flows offer opportunity for higher risk-adjusted returns in a low yield environment and have increased in popularity the past few years amongst institutional investors but have yet to fully gain traction in the RIA community.
For those, that are not familiar with what a life settlement investment is, a life settlement is the sale of an in-force life insurance policy to a third party for an amount greater than what the insured could receive from simply canceling the policy. In return for providing the seller with a cash payment, the third-party purchaser (investor) owns the life policy, pays all premium payments going forward and eventually receives the entire death benefit at the time of the insured’s death.
A life settlement allows the current policy owner (seller) to exit his investment in an asset that he or she no longer needs or can no longer afford. For the buyer, the investment offers a great risk-adjusted returns and cashflows that are not correlated to market or interest rate risk.
A life settlement transaction provides benefits for both the seller wishing to exit the investment and the buyer looking to acquire an investment that is uncorrelated to market or interest rate risk. A life settlement fund is simply an investment in many policies from different sellers as opposed to just one single life settlement transaction. By acquiring multiple policies, life settlement funds can help diversify the mortality risk.
For those looking to invest in a life settlement fund, there are several characteristics to look for in a fund as well as the life settlement fund manager:
1. Actuarial and insurance expertise
The core determinant of returns in the life settlement space are tied to the actuarial and insurance expertise of the fund manager. Just as you wouldn’t want to invest in a real estate fund with managers that have no direct experience in real estate, you wouldn’t want to invest in a life settlement fund that doesn’t have deep life insurance and actuarial expertise. This type of expertise allows funds to identify undervalued policies in the market place, and properly manage mortality, insurance, and tail risk.
2. Open versus closed end structure
Open-ended life settlement funds offer investors a greater ability to exit the investment early and typically come with lower investment minimums. However, in exchange for this liquidity, open-ended funds typically have higher fees, lower returns, and are largely dependent on subjective valuation practices. Closed-end funds in comparison have significantly higher investment minimums and limited ability to exit the investment early. However, in exchange for this limited liquidity, investors in closed-end life settlement funds receive more investor friendly fee structures and transparency in the return profile. To learn more about the pros and cons of investing in open-ended life settlement funds versus closed-end life settlement funds, read our article here: The Problem with Investing in Open-Ended Life Settlement Funds
Life Settlement funds are inherently tax-inefficient. That’s because the majority of the gains are taxed at ordinary income rates for investors—similar to how coupon rates from bonds are taxed. Due to the inherent tax-inefficiency of the asset class, it’s important that funds consider this in both the structuring of the fund as well as in the purchasing of policies within the fund in order to make the investment as tax-efficient as possible.
Only about 8% of the policies that would qualify for a life settlement transaction are actually sold in the life settlement market place. The main reason the other 92% are not sold is simply because those policy owners do not know that selling their policy on the life settlement is an option. Furthermore, the 8% of policies that are sold in the life settlement market are often sold through broker channels which can eat up 15% to 30% of the total offer for the policy.
By focusing on developing proper education and sourcing channels, life settlement fund managers can develop their own proprietary channels that will both increase supply and reduce transaction costs which will result in higher returns for their life settlement funds.
For more information on what to look for in a life settlement fund, read our white paper: Investing in Life Settlements: Providing greater risk-adjusted returns and portfolio diversification through uncorrelated assets
Who is Colva Capital?
Colva Capital is a premier alternative asset manager in the life settlement space. Since the 2018 Colva Capital’s team has helped raise and manage funds with over $100 million in AUM today. Colva’s actuarial team has analyzed over 10,000 life insurance policies since 2011 and has deep life insurance experience in both identifying undervalued policies and structuring investments in the space that are tax-efficient and minimize tail risk.
Colva aims to create the most cost-efficient and tax-efficient vehicles for investing in life settlements.
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