Aside from the “ick factor” discussed above, there are a few risks that must be carefully managed:
1. Extension Risk There is no way to be sure when the investment will pay off, because there is no way to predict when the insured will pass away. Investors are guaranteed a certain payoff, but as the term is extended, the return on investment is decreased. This is the main risk, and investors manage this risk by spreading their investments among several different deals (as discussed in detail below).
2. Credit Risk Stability of the insurance company is critical, but easily managed. This is a very low risk because life insurance companies are heavily regulated. Most investors will only invest in a life settlement where the policy is issued by an “A”-rated life insurance company that is licensed and regulated in the US No fly-by-night insurance companies based in a foreign island beyond the reach of US regulators.
3. Interest Rate Risk As with any investment in debt, timing of repayment is important because market conditions change. As interest rates increase, new investments yield higher returns, so older investments generally become less desirable. Will you miss out on higher interest rates while you are waiting for the life insurance policy to be paid off?
4. Fraud This is the risk that is hardest to manage, and which drives many would-be investors away. There have been many reported scams and Ponzi schemes orchestrated by fraudulent life settlement companies. The typical scenario is for the life settlement company to sell shares in life insurance policies that do not really exist. The life settlement companies are not large, well-known firms, so it is very difficult to reach a level of comfort with them. This is my personal reason why I have not invested in life settlements.
Credit Risk?
One of the attractive aspects of investing in life settlements is the low credit risk, which is the risk of a debt not being repaid. Most of the other chapters in this book include large sections addressing how the debt can be collected through lawsuits, foreclosures, sheriff’s sales, evictions, etc. Investors who buy life settlements face extremely low credit risk because the debt is owed by life insurance companies that are considered to be about as financially stable as any private company can be.
Life insurance companies are regulated by each state and are required to maintain reserves to cover all liabilities. They are inspected by state regulators, and if reserves fall too low, they are placed into receivership and sold to larger life insurance companies. Several life insurance companies have existed for over a hundred years through the World Wars, the Great Depression, the dot com stock market crash, etc. Warren Buffet’s “Berkshire Hathaway” company invests in life insurance companies, and the largest US banks hold billions of dollars in life insurance policies. Nothing is absolutely certain in life, but “A”-rated domestic life insurance companies are about as close as you will see. Of course, investors should stick with policies issued by “A”-rated life insurance companies with recognizable brand names and licensed in the US—nothing based in some tropical island.
