Academic journal article Journal of Risk and Insurance

Measuring the Performance of the Secondary Market for Life Insurance Policies

Academic journal article Journal of Risk and Insurance

Measuring the Performance of the Secondary Market for Life Insurance Policies

Article excerpt

INTRODUCTION

The secondary market for individual life insurance policies in the United States has grown from about $200 million in 1993 to $44 billion in 2010. (1) The market began with policies on individuals with less than 2 years of life expectancy (called viaticals) and grew to include those with more than 2 years of life expectancy (life settlements). Our data source includes both; hence, we refer to these life insurance investments collectively as viatical life settlements investments (VLSI). Except for recent work by Braun, Gatzert, and Schmeiser (2012) (hereafter BGS) and Davo, Resco, and Barroso (2013) (hereafter DRB), there is little research that systematically analyzes the return characteristics of these investments. We add to this line of research.

BGS provide a detailed analysis of the performance of an index of 17 open-end life settlements mutual funds, covering December 2003-June 2010. They also provide an excellent overview of the life settlements market and the life settlements mutual fund industry. DRB combine two life settlements mutual funds with fixed income and equity index funds over September 2006-February 2010 to form efficient portfolios. To our knowledge, our article is the first to examine the risk and return characteristics of an index composed of direct life insurance policies, including 1,724 policies with a face value of about $300 million. Specifically, we develop a quarterly index of VLSI returns starting from the fourth quarter of 1993 through the fourth quarter of 2009.

We provide three advances compared to BGS and DRB. First, we use data on individual VLSI contracts instead of mutual fund portfolios. This allows us to show that VLSI returns differ across disease types; for example, VLSI from AIDS patients have relatively low returns. Second, we cover a longer sample period; thus we are able to illustrate how major VLSI-related events lead to VLSI return volatility. Third, we use the repeat sales method to compute a VLSI return index, because the method was created by Bailey, Muth, and Nourse (1963) to handle infrequently traded assets such as VLSI. It is used to compute the widely quoted S&P Case-Shiller real estate price index.

Our results are in line with those of BGS and DRB in many respects, except we find that the returns of VLSI computed using the repeat sales method are much more volatile than those self-reported by mutual funds. Indeed, BGS anticipate this possibility, noting that because life settlements investments are illiquid, fund managers can value their investments with a mark-to-model approach instead of a mark-to-market approach, allowing more leeway to smooth their reported returns. They find little correlation between fund returns and the returns of other assets, but this could be due to artificially smoothed fund returns.

Although our VLSI returns are quite volatile, we confirm that they are still little correlated with the returns of more traditional investments, such as stocks and corporate bonds. Indeed, we illustrate some of the reasons why. For example, during the early years of the VLSI market from 1993 through 1996, our VLSI return series is comparable to that of corporate bonds; however, breakthroughs in AIDS drug treatments extended the lives of many AIDS patients, driving down VLSI returns from 1997 to 1999. Changes in institutional investor demand and supply of VLSI could also affect return volatility. The newness and general illiquidity of the VLSI market could partly explain the high volatility.

Our results show that VLSI earn about 8 percent annually compared to 7 percent for long-term corporate bonds, and 5.5 percent for the Standard & Poor's 500 stock index (S&P 500). If we exclude the market crash between 2008 and 2009 from our sample period, we find that VLSI earn about 7.3 percent compared to 8.5 percent for the S&P 500 and about 7.1 percent for bonds. But the VLSI return volatility is about twice that of the S&P 500, and about four times that of bonds. …

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