Life settlement funds are investment vehicles that purchase existing life insurance policies, take over their premium payments and receive the policies’ death benefits when the insureds die.
By pooling multiple policies, these funds give investors access to an alternative asset class whose potential returns are driven primarily by policy pricing, life expectancy and the timing of insurance payouts.
Key Takeaways
- Returns come from the difference between policy acquisition costs, premiums and eventual death benefits.
- Returns depend heavily on longevity, as longer lifespans delay death benefits and increase costs.
- Whole life and universal life policies are commonly considered for life settlements.
- Life settlement funds can diversify portfolios but remain exposed to liquidity, valuation, premium and longevity risks.
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The information in this article is for general guidance only, does not constitute financial, legal, or tax advice, and may have changed since the time of writing.
What are life settlement funds?
Life settlement funds are investment vehicles that acquire portfolios of existing life insurance policies through the secondary life insurance market.
Rather than investing directly in stocks, bonds or other conventional securities, these funds invest in life insurance policies that have been sold by their original policyholders.
The underlying policies are typically purchased at a discount to their eventual death benefits.
The fund then holds the policies as investments, with their value ultimately tied to the death benefits they are expected to generate.
A key characteristic of life settlement funds is portfolio diversification.
Instead of investing in a single policy, a fund can hold policies covering multiple insured individuals with different ages, health profiles, policy values and expected life expectancies.
This helps spread longevity risk, which is the risk that an insured person lives longer than expected and delays the fund's receipt of the policy's death benefit.
Life settlement funds are therefore considered an alternative investment because their underlying returns are driven primarily by insurance policies and mortality outcomes rather than the performance of traditional financial markets.
Their potential returns are influenced by factors including policy acquisition prices, future premiums, life expectancy and eventual death benefits.
While life settlements may have relatively low direct correlation with traditional asset classes, this does not make them risk-free.
Longevity, liquidity, valuation and premium costs can all affect investment performance.
How do life settlement funds work?
Life settlement funds generally follow a process that begins with identifying and underwriting eligible policies and ends when the fund receives the death benefit.
Between those points, the fund is responsible for maintaining the policies and managing the costs associated with them.
The process typically involves four key stages:
1. Policy selection and underwriting.
The fund identifies policies that fit its investment criteria and assesses factors including the death benefit, policy type, premium requirements, insurer, insured's age and health, and estimated life expectancy.
2. Policy acquisition.
Once a policy passes the fund's underwriting criteria, the fund purchases it from the policyholder.
The seller receives the negotiated settlement amount, while the fund becomes the policy owner and beneficiary.
3. Ongoing premium payments.
The fund must continue paying premiums to keep the policy active. These payments are a significant component of the investment's cost.
If the insured lives longer than expected, the fund may have to make premium payments for substantially longer than initially projected.
4. Receipt of the death benefit.
When the insured dies, the fund receives the policy's death benefit.
Its eventual return reflects the death benefit received relative to the acquisition price, premiums, fund expenses and the length of time the investment was outstanding.
What types of life insurance policies do life settlement funds purchase?
Life settlement funds typically focus on permanent life insurance policies that have sufficient death benefits and economic characteristics to make a secondary market purchase viable.
These may include:
- Whole life insurance
- Universal life insurance
- Variable universal life insurance
- Other forms of permanent life insurance, subject to the fund's investment mandate
The policy type is only one part of the assessment.
A fund also considers the size of the death benefit, current and future premiums, policy guarantees, insurer strength, policy ownership history and the insured's expected longevity.
The age and health of the insured can be particularly important.
A life settlement buyer needs to estimate how long the policy is likely to remain in force before the death benefit becomes payable.
The fund is effectively comparing the cost of acquiring and maintaining the policy with the expected value and timing of the eventual death benefit.
This is why two policies with identical US$1 million death benefits can have very different investment values.
If one requires significantly higher future premiums or is associated with a substantially longer expected lifespan, a fund may be willing to pay considerably less for it.
Funds may also impose their own eligibility criteria around policy size, insured age, insurer ratings, premium structure and expected life expectancy.
The precise requirements depend on the fund and its investment strategy.
How are life settlement funds taxed?
Tax can arise at three levels: the policyholder, the fund and the investor, with different rules applying at each stage.
1. Policyholder: If a policyholder has a US$200,000 tax basis in a life insurance policy and sells it for US$350,000, the US$150,000 gain may be taxable under applicable US rules.
The entire US$350,000 settlement is not necessarily taxable.
2. Fund: If a fund acquires a policy for US$600,000, spends US$150,000 on premiums and later receives a US$1 million death benefit, the US$250,000 economic difference is not automatically taxed as a US$250,000 capital gain.
The fund's legal structure and applicable tax rules determine how the proceeds are treated.
3. Investor: Investors may then face tax on income, gains or distributions passed through from the fund. For non-US investors, certain US-source income can also be subject to 30% withholding, although tax treaties and exemptions may reduce the rate.
There is therefore no single tax rate for life settlement funds.
Investors should assess the fund's structure, treatment of returns, withholding requirements and the tax rules in their country of residence before investing.
What are the advantages and disadvantages of life settlement funds?
Life settlement funds can offer portfolio diversification and potential returns that are less directly tied to stock and bond markets, but they also carry significant longevity, liquidity, underwriting and premium risks.
Advantages of life settlement funds
Potential diversification from traditional markets. Life settlement returns are driven primarily by mortality and longevity outcomes and the economics of the underlying policies rather than directly by stock or bond prices.
This can make the asset class potentially useful as a diversifier.
Access to an alternative asset class. Life settlement funds provide investors with exposure to the secondary life insurance market without requiring them to individually source, underwrite and administer insurance policies.
Portfolio diversification within the asset class. A fund can hold policies covering numerous insured individuals rather than concentrating the investment in one policy.
This can help spread individual longevity risk.
Potential for attractive risk-adjusted returns. If policies are acquired at appropriate prices and life expectancy estimates are accurate, the difference between acquisition costs, ongoing premiums and eventual death benefits can create a potentially attractive return.
Limited direct dependence on equity markets. Because the underlying economic driver is the timing of insurance payouts, life settlement funds are not directly dependent on corporate earnings, interest-rate movements or stock-market valuations.
Disadvantages of life settlement funds
Longevity risk. The central risk is that insured individuals live longer than expected.
A longer lifespan means the fund may have to pay premiums for additional years while waiting for the death benefit.
Illiquidity. Life settlement investments generally do not offer the same liquidity as publicly traded stocks or bonds. Investors may have limited opportunities to exit before the underlying policies mature.
Uncertain timing of returns. Even when a policy has a defined death benefit, the timing of that payment is uncertain.
This makes the duration of the investment difficult to predict precisely.
Premium risk. Future premiums are an ongoing liability.
If policies remain in force for longer than projected, the fund may need to commit additional capital to maintain them.
Underwriting risk. Life expectancy estimates are forecasts rather than guarantees. Errors in these estimates can materially affect the expected return.
Counterparty and insurer risk. The investment ultimately depends on the insurance policies remaining valid and the relevant insurers meeting their obligations.
Fraud, disputes over policy validity or insurer failure can create additional complications.
Regulatory complexity. Life settlement regulation varies by jurisdiction.
The regulatory status of the underlying transaction and the investment vehicle can also differ depending on how the fund is structured and marketed.
Fees and expenses. Investors may be exposed to fund management fees, acquisition costs, servicing expenses, insurance premiums, administration costs and other charges.
These can materially reduce the return generated by the underlying policies.
Life settlement funds vs life insurance
Life settlement funds are investment vehicles that seek returns from acquired life insurance policies, while life insurance is designed primarily to provide a death benefit and financial protection to beneficiaries.
With life insurance, an individual pays premiums to maintain coverage, with the insurer paying the death benefit to the policy's beneficiaries when the insured dies.
A life settlement fund, by contrast, purchases existing life insurance policies from policyholders and assumes the associated policy obligations.
The fund seeks to generate a return when it eventually receives the policies' death benefits, after accounting for acquisition costs, premiums and other expenses.
The distinction is important for investors. Buying into a life settlement fund does not provide personal life insurance coverage or a death benefit for the investor's beneficiaries.
|
Feature |
Life Settlement Funds |
Life Insurance |
|
Primary purpose |
Alternative investment |
Financial protection |
|
Underlying asset |
Portfolio of acquired life insurance policies |
Individual insurance policy |
|
Investor/owner |
Fund or investment vehicle |
Policyholder |
|
Source of potential return |
Death benefits minus acquisition and carrying costs |
Policy benefits and, for some policies, cash value |
|
Main economic risk |
Longevity and policy costs |
Premium affordability and coverage needs |
|
Liquidity |
Generally limited |
Depends on policy structure |
|
Investment objective |
Generate returns |
Protect beneficiaries |
For the policyholder, the two arrangements also have different purposes.
A conventional life insurance policy is generally maintained so that beneficiaries receive financial protection after the insured's death.
In a life settlement, the policyholder instead transfers ownership to a third party in exchange for a payment during their lifetime.
Conclusion
Life settlement funds are ultimately an investment in uncertainty that can be priced.
Unlike a bond, where the maturity date is known, or an equity investment, where valuation can change with market sentiment, the key unknown here is when the underlying economic event will occur.
That makes the quality of the assumptions behind a fund potentially more important than its headline return target.
A fund that consistently pays the right price for uncertainty may prove more compelling than one simply projecting the highest returns.
For investors, life settlements are best viewed not as a substitute for conventional assets, but as a specialized allocation where underwriting discipline can determine whether an unusual source of risk becomes an unusual source of return.
FAQs
Who is the owner in a life settlement?
The purchaser becomes the new owner and beneficiary of the life insurance policy, while the original policyholder receives the settlement payment and gives up their rights to the policy and its future death benefit.
What is the typical amount of money a life settlement pays out?
A life settlement typically pays more than the policy’s cash surrender value but less than its death benefit, with the offer shaped mainly by the insured’s life expectancy, the policy’s value and the cost of maintaining it.
Who is a life settlement broker?
A life settlement broker is an intermediary who helps policyholders sell their life insurance policies by sourcing and comparing offers from potential buyers.
Are life settlements a good investment?
Life settlements can be a good investment for investors seeking alternative returns, but they are not suitable for everyone.
Their potential returns must be weighed against longevity risk, illiquidity, ongoing premium costs and the uncertainty of when the underlying policies will pay out.
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