Life Settlements represent the market for life insurance policies for US policyholders that no longer wish to keep their coverage.Typically, the transaction involves an investor purchasing the policy for an upfront payment to the policy owner and then the investor continues to pay the premiums, either monthly or annually and will eventually receive the policy proceeds at maturity. The typical age of the insured for a life settlement transaction is over age 75 and up to age 90.
The market price that a policyholder receives is based on the death benefit, the cost of the insurance (ongoing premiums) and the age and health of the insured. The industry uses a pricing system of discounting the future cash flows (the cost of the ongoing premiums and the value of the death benefit) over the life expectancy of the insured. The life expectancy (LE) is estimated in months and is typically 50 to 120. The Discount Rate that the market offers is 18% to 20%, and sometimes even higher.
The ability for an investor to earn 20% on A-rated credit is remarkable. The policies trade at this high discount rate because of two primary disadvantages: (1) the “negative yield” or cost of the ongoing premiums, and (2) uncertain maturity. Most investors do not prefer investments of an uncertain amount of capital with an estimated, but not guaranteed, holding period. It is the way that Sundance Strategies addresses these two primary issues that creates the opportunity.
Negative Yield – The way that many investment funds address the cost of ongoing premiums is to raise an amount of capital, say $100M. They then allocate $60M to acquire policies and reserve $40M to pay the ongoing premiums. This is very inefficient because the $60M is being invested at a 20% expected IRR, but the $40M cash reserve is earning maybe 1% until it is used to pay premiums. The risk for this type of investor is that the $40M may not be enough to pay the ongoing premiums until the death benefits start to come in which will help pay the ongoing premiums on the remaining portfolio. If the fund depletes its premium reserve, it must raise more capital or, most likely, start to liquidate the portfolio. It is from these liquidations that Sundance purchases a portion of its inventory.
Senior Financing – The management of Sundance believes that Senior Financing provides a much better alternative to dealing with the unknown cost of future premiums. If the investment fund described above was able to secure financing, then perhaps they would raise $100M, borrow an additional $80M and use $180M to acquire policies. The lender would then arrange a line of credit to fund all ongoing premiums. The death benefits, as received would be used to retire the outstanding senior debt before the net proceeds are paid to the fund. This would allow 3X the policies to be purchased for the same initial capital commitment from the investors, but a much higher IRR on their investment.
Uncertain Maturity – The life expectancy (“LE”) that is provided for the investors to consider when purchasing a policy are from one or more of the industry LE providers. While they are accurate on a pool of policies (100+), they are not definitive on a single insured. Even on a pool of life insurance policies, there can be a standard deviation of a year or two on the average expected LE compared with actual results.
Mortality Reinsurance – One of the best ways to deal with uncertain maturity of a pool of life policies is to purchase Mortality Reinsurance. This is an insurance policy issued to the owner of a pool of life insurance policies that guarantees a minimum annual cash flow from the pool. The coverage is issued for a period of 15 years and guarantees that at least 75% of the death benefits are received as expected. If in any year, say year 5, $100M of death benefits were anticipated and only $50M were received. Then the Reinsurance provider would advance approximately $25M to get the portfolio owner at least 75% of the expected cashflow. In later years, when the death benefits are eventually received, the Reinsurance is repaid.
NIBs – The management of Sundance believes that the best way to capitalize on the life settlement market, to acquire policies with the highest IRR with the minimum risk, is to purchase NIBs. These NIBs receive the net cash flow from a pool of life settlement policies that have (1) long term financing for premiums and (2) Mortality Reinsurance coverage to guarantee a minimum level of performance. By combining these two features, Sundance will use the capital of the company to acquire NIBs on approximately $1B of policies per year. The net cash flow over the life of the NIBs is anticipated to be 30% to 35% of the death benefit. The cost of the NIBs will be about 6% of the death benefit. The IRR of the investment in NIBs is projected to be well above 20% market returns.