Background and Economics
LPHI brokers life settlement transactions in which seniors with lowered life expectancies sell their life insurance policies for significantly less than face value (policy payout) but significantly more than the cash surrender value (what the insurance company is willing to buy policyholders out for). Seniors get access to cash and are relieved from having to continue paying premiums, and investors can potentially get a decent return on investment if the mortality estimates turn out to be accurate.
Because investment returns are higher when the insured dies ahead of schedule, there’s a natural revulsion to this type of transaction. AIG got some negative publicity when they securitized an enormous pool of life settlements, dubbed “death bonds”, earlier this year. Not only do investors benefit when the insured dies more quickly, but this is also a situation where the oldest and sickest members of our community are making important financial decisions. Every few years, there will naturally be a crop of slimy jerks trying to take advantage of grandma, followed by negative PR and new regulations. It also doesn’t help that the real looser in this transaction is the life insurance company who was hoping the policy would simply lapse so that they can avoid payout after decades of contributions. Naturally insurance industry lobbyists have a field-day when scheming fraudsters are exposed. Luckily, because the press-relations risk is so high, and because PR is so important for large banks at the moment, some Wall St. firms are avoiding this market despite the opportunities (evolution from 2007, 2008, and 2009). Potentially reduced competition for policies is a nice tailwind for a company that managed to grow at an enormous rate even when the highly sophisticated competitors were active.
On the other side of the supply/demand equation is investors buying policies (or pools/pieces of policies), most of who are institutional or high net-worth clients, and have already seen attractive and steady returns on these investments completely uncorrelated with stock markets. It’s difficult to get a sense for what the average rate of return is for these investments as each deal is structured slightly differently. But from what I’ve gathered anecdotally, returns seem to be in the 8-15% range. Despite how these transactions are structured like a bond, the payouts are extremely volatile and equity-like. For anyone interested in life settlements, A.M. Best gives an explanation of how they’re valued and how they rate life settlement securitizations. For anyone interested in learning more about how the market is evolving, Maple Life (a key LPHI competitor) has a great synopsis on their website.
LPHI management targets a specific (undisclosed) IRR in pricing policies with the intention of being fair to both the investor and insured. In a recent conference call, management said their target IRR was in excess of 10%, and the CEO is optimistic investors can double their money in approximately five years, implying an IRR of 15%. But this isn’t the type of product that’s appropriate for someone who needs liquidity. Not only are life settlements difficult to transfer (liquidity risk), but the policy owner is required to continue making premium payments until the insured dies (liquidity risk squared). Some investment pools are structured so that future premiums are “pre-paid” by the investor, but the usefulness of this is dependent on accurate estimations (and luck). In any case, the existing base of life-settlement investors should be liquid, institutional or very high net-worth, financially sophisticated, and seeking uncorrelated equity-like returns over a long-term investment horizon. It stands to reason that this demographic will probably continue to reinvest in life settlements as long as the overall experience remains positive, and given the uncertainty investors still have about stock markets, it stands to reason that life settlements might continue to attract new investors as well.
With reason to believe that both the supply and demand for policies will increase over the next few years, LPHI stands to benefit from continued market growth. Plus, with a good supply of cash and no debt, LPHI is in a position to keep some policies on its books, further boosting EPS growth. But one other factor that should also boost growth is the securitization market. LPHI has historically avoided doing business in states that might define life settlements as securities. But recent efforts to develop the necessary legal procedures to securitize pools of life settlements will allow LPHI to sell policies in any state. Other companies have tried to securitize pools of life settlements without much luck, but on a small scale, the benefits could be highly significant to a smaller player like LPHI.More Next Week
This is only part one of my write-up, I hope it was enough to get readers interested. Next week, I'll be publishing part 2, where I take a look at some of the risks and problems that LPHI faces. And hopefully in 2 weeks I'll be done working on this, and ready to publish part 3, where I share my model and explain how it works.
Disclosure: long LPHI in my kaChing portfolio.