With P/E ratios at historic highs and bond yields near all-time lows, concern about diversifying client portfolios against equity risk has piqued interest from Registered Investment Advisors (RIAs) in alternative assets—particularly assets that are not correlated (or lowly correlated) to either equity or bond markets.
With high P/E ratios at extreme highs, investors are betting that future productivity will increase significantly over today’s productivity levels. To the extent that expected future productivity doesn’t materialize, stock prices will drop. Typically this equity risk has been offset with investments in bonds.
With the yield-to-maturity of the AGG at 1.48% at the time of writing this blog, RIAs can’t simply allocate client portfolios to this low-yielding bond benchmark to offset equity risk while still justifying charging their ~1% fee.
A low bond-yield environment means that diversifying equity risk with bonds is no longer an option.
Furthermore, in a rising interest rate environment investing at bonds at near historic low yields will result in future losses.
In comparison to bonds in this low yield environment, alternative assets can potentially provide significantly higher risk-adjusted returns—but RIAs are typically weary of these assets as it’s difficult to identify those assets and managers that could improve returns and diversify risk from those that could cause heavy losses to client portfolios.
Life settlements is one such alternative asset class that is growing in popularity amongst institutional investors due to the uncorrelated nature of its underlying cashflows—but has yet to fully gain significant traction in the RIA community. Part of the reason is an overall lack of awareness, but another is due to the fact that investment in funds that invest in life settlements are typically restricted to accredited investors in private funds.
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 who might not be aware, a life settlement is the sale of an in-force life insurance policy by the original policy owner to a third party. 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.
Life Settlement Transaction
In a life settlement transaction the owner of the policy sells his policy to the buyer for a cash payment.
The buyer then pays the premiums on the policy going forward and receives the death benefit upon maturity of the policy.
The transaction is a win for the seller and the buyer. The seller receives more for selling the policy to the buyer than they would get if they simply cancelled the policy. The buyer is a sophisticated investment company that knows that aging insureds on life insurance policies are more likely to be less healthy now than when the policy was originally purchased.
So there is a mortality arbitrage here for the buyer since the cost of the expected future premiums on the policy are significantly less than the death benefit. If the buyer can accumulate a diverse selection of policies, the buyer is essentially acquiring a stream of future cashflows that is not dependent on whether the equity markets or interest rates go up or down. The uncorrelated nature of these cash flows is what has drawn the interest of very large and sophisticated institutional investors like Berkshire Hathaway, Fortress, Apollo, and Blackstone who have collectively invested billions of dollars in the asset class.
In the wake of high P/E ratios and low bond yields these past few years, investment has increasingly entered the life settlement space mainly from large institutional investors. A goal of the asset class should be to increasingly offer access to the space to RIAs and their retail clients with superb technical skills and a focus on efficiency. This is exactly what Colva Capital aims to do.
To learn more about what RIAs should look for when investing in life settlements, read our life settlement white paper here or contact us at [email protected]
