A Physical Exam for Life Partners

Includes: AIG, LPHI
by: Jeff Borack

Life Partners Holdings Inc. (LPHI) was recently the “idea of the week” on Sumzero.com, a website I like to use for networking and to find new investment ideas. I decided to take a look at LPHI, and I was pleasantly surprised to find that the business model resembles Deckers (NASDAQ:DECK), a business I love. They both operate with zero debt and have solid EBIT margins, meaning the bottom line shouldn’t be too volatile and there’s almost zero bankruptcy risk. But more importantly, both companies are growing at a spectacular rate despite negligible reinvestment. They take the money they earn each year and either pay a dividend, repurchase shares, or put cash in the bank.

LPHI’s capital expenditure in the LTM was $400k, compared to cash flow from operations of $26.5 million and net income of $30.5 million. This is typical. However, they have managed to grow revenue at a CAGR of 56.2% since 2002, and EPS at a CAGR of 56.0% since 2003. Is this sustainable? Absolutely not. Is LPHI most likely undervalued at 10.6x earnings with a 5% dividend yield? I think so.

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 (NYSE: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 loser in this transaction is the life insurance company who was hoping the policy would simply lapse so that it 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 of 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 to Read

This is only part one of my write-up. In part 2 I take a look at some of the risks and problems that LPHI faces, and in part 3 I share my model and explain my valuation.

Author's Disclosure: long LPHI in my kaChing portfolio.