Once people know you're an “investing guy” you get to hear about all kinds of interesting opportunities. So when I walked into my shift recently, one of my partners handed me a book titled, “Smartest Doctor In The Room: How Doctors and Dentists Are Outwitting Wall Street” written by a local guy who happened to be a friend of the partner. The book was a short, self-published, rarely bought/sold/reviewed paperback that seemed to be primarily used to hand to prospective clients to explain the investment being sold. As you might imagine, the investment being sold wasn't index funds, the way most doctor and dentists ought to be outwitting Wall Street. The investment was life settlements, or viaticals, where you pay someone more for their life insurance than their life insurance company is willing to pay, make the premiums until they die, and then get the death benefit. Morbid? Of course. But that didn't bother me. What bothered me was the way the investment was being sold.
I didn't like the book all that much for a few reasons, although I think the investment is well worth talking about. Here are the reasons I didn't like the book:
- Appeals to Physician Egos- From the title to the tone of the book, it was designed to make doctors feel like smart investors. The angle of the book is that because doctors are more familiar with the medicalese in these contract owner's medical files that they can evaluate this investment better than anyone else. I don't buy it. I might be able to understand a medical file, but that doesn't make me any better at predicting when someone is going to die (the basis of this investment) than anybody else, especially an actuary. So why isn't this book titled “The Smartest Actuary In The Room: How Actuaries Are Outwitting Wall Street”? Well, actuaries don't have any money to invest, nor do they usually qualify as an accredited investor. A good general rule is that if the only other investors in any given investment are doctors, you probably ought to avoid it.
- The investment can be easily explained on one page. Yet the book is 138 pages. It is filled with a bunch of stories about why someone might want to sell their insurance policy or want to buy somebody else's policy.
- No Lose Investment- The investment is portrayed as a “no lose” situation. The author likes to point out that you're going to get your money, it's just a matter of when. However, there is only one short paragraph in the entire book where he actually admits that you may have to come up with some additional cash if the insured person lives “too long.” All of the charts in the book only go out to about 6 years. I don't know about you, but I get surprised all the time by how long some patients with reportedly terrible diseases live.
- Not Enough Emphasis on Investment Ethics- The book justifies the investment by simply pointing out that the insured is getting more money than they would from the insurance company. Yet the primary profit from investing in life settlements comes from buying the policy for less than it is really worth. I guess you're helping out an old guy in a tough spot, but it sure feels a lot like those “Zero Down” real estate schemes that rely on stealing old peoples' houses at below market prices to be successful.
- Doesn't Explain How He Is Paid- The book emphasizes the “low fees” of the investment, and even goes so far as to quote Jack Bogle extensively about the importance of low fees. But he never does explain how he is paid for putting the investment together. I assure you he isn't working for free.
- Bashes Stock Investing- Like most alternative investment books, he seems to go out of his way to point out all the downsides of investing in stocks, while never pointing out that their benefits (high historical returns, high liquidity, easily diversified, very inexpensive etc.)
How It Works
So how does this investment work? Well, it starts with someone who owns a life insurance policy, usually a permanent one such as whole life or universal life. For some reason, he no longer wants to own this life insurance policy. This might be for several reasons:
- Can't or doesn't want to continue to pay premiums
- No longer has a need for the insurance. This may be due to a change in estate tax laws or because the beneficiary preceded the insured in death.
- Wants to disinherit his heirs.
- Has a need for cash such as for living expenses or long term care
So he goes to the insurance company, where he may be presented with a few options.
- Surrender the policy and take the cash value
- Borrow from the policy
- Sell the policy to the insurance company
- Accelerated death benefits (begun in response to viatical companies)
Then he hears about something else, getting a “life settlement” which will pay him much more than the insurance company will. Plus, unlike borrowing from the policy he won't have to continue to make the premiums. So he goes to a broker, who shops his policy around to a few firms willing to purchase it in exchange for a commission. He finds the firm willing to pay the most (the viator) and closes the deal. He gets his commission, the insured gets the cash, and the viator now owns the policy. So where does the viator get the money to pay the insured? That's where you come in Doctor.
The Investor's Perspective
Some type of analyst working for the viator has looked at the policy and estimates that the insured will die in four years. Let's say there is $200K in cash value in the policy. Premiums are $25K a year. The face value of the insurance is $1 Million. So the viator pays $500K to insured. His broker takes his 20% cut (I have no idea how large these commissions are; could be more, could be less) and pockets $100K. The insured is very happy to now have $400K. The viator now rounds up a bunch of investors. He plans to put 8 years worth of premiums (twice the life expectancy) into an escrow fund, so he needs a total of $700K. So he rounds up 28 doctors willing to put in $25K a piece. That buys 3.57% of the death benefit ($25K/700K). So when the insured keels over, the doc gets $35,700. If he dies after one year, the doc has a return of 43%. If he dies after 2 years, the return is 20%. If he dies at his life expectancy of four years, the return is 9%. If he dies at 8 years, the return is 5%. However, here is where it gets interesting (and isn't mentioned in the book.) The escrow account is now depleted. The doctor is now on the hook for 3.57% of the premiums for the rest of this guy's life. $25K*3.57%= $893 per year. So if the guy miraculously lives a total of 16 years, your return is 0.8%. The return turns negative at year 20. Does that seem unlikely that a guy with a life expectancy of four years would live 20? Of course. But to say there is NO risk of loss seems unwise.
The wise investor will notice that something was left out of my explanation. It was left out of the book too. That's the answer to the question, “How does the viator make any money?” The author vaguely alludes to the idea that he doesn't get paid until the policy matures (the old, sick guy keels over.) So presumably he is being paid with some “free” shares (you are paying for them, just like you're paying the broker's commission and the insured's settlement.) That doesn't mean it is a bad deal for you, but it would be nice if it were a little more clearly disclosed. Certainly whatever he is paid comes out of your return. In investing, you get what you don't pay for.
What I Like About Life Settlements
Now, I might sound negative about this investment based on what I've written above. That's not entirely true. There are several things I really like about this idea.
- Sticking it to the insurance companies-Under this deal, the insured is happy, his broker is happy, the viator is happy, and if everything is done right, the investor is happy. So who are the losers in this deal? Well, the insurance company certainly is. They were hoping to get out of paying the death benefit. The heirs are also losers. If holding on to the policy is such a great investment after paying the broker and the viator, it was certainly a great investment before! If I were the heir, I would have taken over those premiums. Another loser is all the other people who buy permanent life insurance. Since the policy stays in force rather than being surrendered for chump change, the price of insurance goes up for everyone else. I kind of feel badly for the heirs, but I don't have much sympathy for the insurance companies or those dumb enough to buy permanent life insurance policies.
- High Returns– I don't mind giving up some liquidity if I am rewarded for it. The expected returns for this scheme are usually set up to be in the double digits. That's sufficient reward for me.
- Low Correlation– These alternative investment guys (especially the insurance agents) are always bagging on stock investors. That's totally unnecessary. There is no reason why one cannot invest in both stocks AND life settlements (and real estate, and bonds, and life insurance, and P2P Loans etc etc etc.) I love that this investment ought to have a correlation of pretty close to zero with my stock portfolio.
A Few Cautions
A few words of caution before you go out and start investing in life settlements. This area of finance is filled with scam artists and con men. Typically, the con is on those who are selling their polices. If they're really going to die in just a few years, they're selling their policy for dimes on the dollar of what it is really worth. However, that doesn't mean investors can't be conned too. Like any investment aimed at accredited investors, due diligence is required. You had better check out the viator carefully. Be sure somebody else is the custodian of the escrow money. Chances of losing your entire investment seem low unless he runs off with it.
You should also realize that predicting someone's death is a “garbage in, garbage out” process. Viatical settlements really got a bad name in the 1980s with the AIDS epidemic. There were thousands of people who were supposed to die in a year or two. Unfortunately, somebody came up with a bunch of antiretrovirals and all those guys who were supposed to be dead are still walking the streets. You can imagine how those investors made out. The difference between a great return and a mediocre one (that ties up your money for extra years earning low returns) can be just a few years difference in life expectancy.
Diversification matters. Ideally, you could just buy shares of a fund doing this so instead of owning a piece of one or two policies, you would own hundreds. That would sure hedge against somebody living a miraculously long life. But, like most accredited investments, you'll be required to put in $10K, $25K, $50K, or perhaps even $100K into each policy. That makes it tough to be very diversified. Nevertheless, do what you can.
Read the medical reports. Make sure it really does sound like the insured isn't going to live much longer. If they won't show you the reports, find another viator to invest with.
Make sure the viator has some skin in the game. Even if he is getting a few “free” shares, he ought to also have purchased a significant amount of “real” shares like yours.
What do you think? Have you invested in life settlements? What was your experience? Would you consider it? Why or why not? Comment below!