The economic and market crises of the last twenty years have taught us that correlations between capital market segments are not stable — and they tend to rise in such situations. In particular, the liquidity squeeze in 2007 demonstrates the impact of this on the fortunes of pension plans around the globe. The emergence of increasing correlations has encouraged exploration into alternative assets such as infrastructure, private equity and hedge funds as managers seek to diversify and explore new sources of uncorrelated returns. Longevity securities are part of an emergent asset class which gets at the core of this issue.
The meaning of life
Longevity assets are American fixed income-oriented securities that derive their value from life spans either at the individual or population level. In their derivative form as longevity swaps, these securities provide the ability for pension plans and annuity providers to manage the risk of unanticipated life extension by hedging the added expense of additional months of benefit payments. These fixed-for-floating contracts are structured between organizations with opposite longevity exposures like life insurance providers and pension plans.
In their cash-market form as life market/settlement securities, longevity assets provide the potential for excess returns for comparable credits in a bond-like exposure. Investors in these instruments buy the legal rights to a life insurance policy and pay the premiums until the death of the insured. US seniors, no longer needing (or wanting) their life insurance coverage, are highly motivated to sell policies in the secondary market. “Settling” an insurance policy is far more monetarily advantageous than surrendering (or lapsing) it as the secondary market offers significantly higher resale values for policies held by individuals with impaired lives. Surrender values are fixed by regulation and cannot be adjusted for health impairment. The difference in pricing ranges generally from six to ten times.
This market also represents a good opportunity for investors to participate in a low correlated asset that exhibits stable returns since the pricing is not connected to broader economic fundamentals but rather life expectancy. Billions of dollars worth of life insurance policies were being either surrendered or allowed to lapse, at a considerable financial detriment to the consumer. Some estimates indicate that as much as 80% of outstanding life insurance in the US does not result in a claim.
The growing focus of pension managers on generating alpha via their asset allocation decisions impacts the risk-return profile of their portfolios. That is, the drive for asset diversification may increase the potential for greater returns but also potentially exacerbates the level of risk borne. Clearly, alternatives are welcome.
Recent market experience has seen a marked change in the correlation between the traditional asset classes of cash, bonds and equities. Ordinarily, one would expect to see a degree of fund flows between the asset classes, such as a flight to security quality during a time of market turmoil: a negative correlation. However, over the last two years, many asset classes fell in unison. As the market declines occurred, volatility of returns dramatically increased. Furthermore, looking forward to the next decade, many investors are now expressing concern about a resurgence of inflation.
The life markets have provided investors a low volatility/low correlation instrument for high credit-rating (i.e., ‘A’ and greater) securities (see accompanying chart). Over the last three years, annualized total returns to stocks were -15.9%, to corporate bonds, 14.9%, to real estate -37.7% and to commodities -20.6%. The AA Partners Life Settlement Index (AAP) returned 12.4% annually. Correlations between AAP and stocks, bonds, real estate and commodities were -0.09, -0.18, -0.14 and 0.09 respectively. By contrast, the correlation between stocks and real estate was 0.83 and with commodities, 0.51 over the period. Not much diversification there. Annualized monthly standard deviation of the AAP was 2.9% and for the Barclays Aggregate Bond (AGG), 5.9% since the beginning of 2007. Obviously, an exposure to life markets greatly benefited investors who participated.
There are a number of things that potential investors in longevity may be tempted to worry about – possibly to avoid added portfolio complexity. The life markets industry was born almost 100 years ago with the US Supreme Court decision, Grigsby vs. Russell in 1911, in which the court stated that life insurance is an asset owned by the insured. As such, the insured has the right to sell it.
A criticism levelled at the secondary market for life insurance is the ethical aspect of benefiting from the death of a policyholder. Conversely, though, managers seldom fret about insurance companies profiting from their annuity products which, of course, share the same interest in mortality. While the ethics argument may appear sound on the surface, the secondary market does in fact provide a valuable source of liquidity for US seniors. Various articles published in the US press last year accused the securitisation of life settlements as both macabre and economically destabilising. In response, many observers including the Senate Finance Committee have suggested that these fears are largely unfounded suggesting that the securitisation market is beneficial as it would facilitate both increased demand and rising competition for policies, thereby allowing consumers to obtain the most money for policies they legitimately wish to sell. As well, we have seen a number major investment consulting firms, most notably Mercers, producing research describing the benefits of these strategies.
In 2009, the market witnessed a number of legislative developments and regulatory improvements including the endorsement of the secondary market, as an alternative to policy surrender, by the State Senates of both Maine and Washington State. Over three quarters of US states now regulate the secondary market for life insurance, of which three states now formally endorse, within Senate Bills, the secondary market as an alternative to surrender for policyholders wishing to dispose of their policies. It has been estimated that nearly 90% of eligible settlers now reside in states that have robust state regulation. And recently, the SEC and GAO have formally acknowledged the legitimacy of the market endorsing proper regulation for the industry.
Another concern is the perceived absence of investment scale in the secondary market. But a large number of institutional investors have entered the market in recent years, with a number of global investment banks holding large portfolios on their balance sheets. Worldwide, many large institutional investors (i.e., CalPERs, PME/Schiphol, Cordares, Stichting Pensioenfonds) have invested billions of dollars in life settlements and, last year, several billions of dollars of longevity swaps were entered into by annuity providers (e.g., Aviva) and pension plans (e.g., Babock International). In the spring of 2009, AIG completed the largest securitisation of life settlements to date, with a total death benefit of $8.4 billion, to pay back a portion of its federal government loan. This year, the market has seen a marked increase in investor enquiries from a wide range of investors including pension schemes and family offices.
The market is growing rapidly and is projected to reach $31 billion by 2017. Conning Research estimates that the death benefit value of secondary market life settlements in 2008 reached $11.8 billion in face value, up from $200 million in 1998. Research from Bernstein states that US seniors aged 65 and over currently control over $420 billion of life insurance which means a current market penetration of around 2.8%. Data from the US Census Bureau indicates that this age group is expected to grow from 38 million today to 71.5 million by 2030. Assuming that the ownership rates and average policy death benefits remain static, and the penetration rate increases to 10% by 2030 due to growing awareness of the secondary market, we would expect the secondary market to grow to $80 billion per annum by 2030.
The importance of mitigating capital asset volatility has been eclipsed to some extent by risk of longevity extension — life market securities is sometimes perceived as an exacerbation of this longevity risk. However, investment in life settlements can generate investment returns with a minimal degree of correlation to the economic cycle or traditional asset classes of fixed income, equity and cash. Also, importantly, the duration of life settlement portfolios is materially shorter, at five to eight years, than the longevity duration of the typical pension plan.
With growing vendor awareness of the secondary market, the increased desire of investors to seek low-correlated returns, the continued maturation of market infrastructure and the growth of the senior population in the US, the life markets are expected to continue to develop and grow.
John Norman is chief investment officer with Perisen Capital Management Ltd.