Calculating IRR in Life Settlements: A Practical Guide for Investors

The Internal Rate of Return (IRR): The Ultimate Metric of Success

In the world of life settlements, the IRR is the single most important metric for evaluating the profitability of an investment. It is the discount rate that makes the net present value (NPV) of all cash flows (both positive and negative) from a particular investment equal to zero. For a life settlement, the cash flows are:

• Initial Outflow: The purchase price of the policy.
• Ongoing Outflows: The premium payments required to keep the policy in force.
• Final Inflow: The death benefit received upon the insured's passing.

The IRR Formula in the Context of Life Settlements

The formula for IRR is complex and typically requires financial software or a spreadsheet to calculate. However, the concept is straightforward:

NPV = Σ [Cash Flow / (1 + IRR)^n] = 0

NPV = Σ [Cash Flow / (1 + IRR)^n] = 0

Where:

• Cash Flow is the cash flow for a given period (positive or negative).
• IRR is the internal rate of return.
• n is the number of periods.

A Step-by-Step Example of IRR Calculation

Let's consider a simplified example:

• Purchase Price: $200,000
• Death Benefit: $1,000,000
• Annual Premium: $10,000
• Life Expectancy: 5 years

Year 0: -$200,000 (Purchase Price) Year 1: -$10,000 (Premium) Year 2: -$10,000 (Premium) Year 3: -$10,000 (Premium) Year 4: -$10,000 (Premium) Year 5: -$10,000 (Premium) + $1,000,000 (Death Benefit) = $990,000

Using a financial calculator or spreadsheet, the IRR for this series of cash flows is approximately 29.8%.

The Impact of Longevity Risk on IRR

The biggest variable in the IRR calculation is the timing of the death benefit. If the insured in our example lives for 10 years instead of 5, the IRR drops to approximately 13.9%. This illustrates the important importance of accurate life expectancy underwriting. Investors must model the IRR across a range of scenarios, using the survival curve from the LE report, to understand the potential downside of their investment.

Portfolio-Level IRR Considerations

Sophisticated investors in life settlements do not evaluate IRR on a policy-by-policy basis. Instead, they construct a portfolio of policies with a diversified range of life expectancies, face values, and premium requirements. The goal is to create a predictable stream of cash flows at the portfolio level, smoothing out the inherent uncertainty of individual policies. The IRR of the portfolio is then the key performance indicator for the investment strategy.