Investors must be cautious and understand longevity risk before investing in the growing life settlements market, according to consulting firm Mercer.
"Mercer believes this asset class has the potential to offer an attractive return stream. Investors can capture an underlying risk premium, which is effectively an arbitrage against the insurance company," Mercer senior associate Ryan Bisch said.
"Structurally, this pricing inefficiency should remain over the medium term, providing investors with positive risk premia. However, short-term imbalances could cause fluctuations in the level of the returns available, so investors should be aware of this volatility."
Life settlements are an alternative investment and provide investors with secondary market exposure to life insurance risk.
"Life settlements provide a genuine alternative because they are based on bearing longevity risk as well as exploiting structural inefficiencies in the life insurance market, rather than mainstream capital market risk premia," Bisch said.
"Investors need to be cognisant that with this type of strategy they are bearing longevity risk - the potential that people will live longer than expected.
"Understanding the intricacies of this risk is critical, and for many institutional investors already exposed to the risk of mortality improvement, such as defined benefit pension schemes, life settlements may not in fact be appropriate."
Estimated deal flow for the market was $5.5 billion in 2005, rising to $11.7 billion in 2008 and dropping to $8 billion in 2009.
However, Mercer expects the market to rebound during 2010, Bisch said.
"With the asset class set to grow, Mercer expects to see more interest from sophisticated investors in the region. It says that while there are advantages, including portfolio diversification, investors should proceed with caution," he said.
