Chartered Financial Analyst Level 2
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59 A third-party broker has purchased life insurance contracts from the original policyholders. The broker now offers to sell these contracts to a hedge fund. An analyst notes the following characteristics of these contracts:
- Characteristic I: The surrender value offered to the insured individuals is high compared to other similar policies.
- Characteristic II: Premiums payable on the policies are low compared to the relatively high risks of terminal illness faced by many policyholders.
Which of these characteristics would most likely be attractive to the hedge fund?
Exam-Like
A
Characteristic I only
B
Characteristic II only
C
Both Characteristic I and Characteristic II
Explanation:
Explanation
Characteristic II would be more attractive to the hedge fund because:
-
Low premiums relative to high terminal illness risk means the hedge fund can acquire these policies at a lower cost while expecting higher payouts due to the elevated mortality risk. This creates a favorable risk-return profile for the hedge fund.
-
Characteristic I (high surrender value) is actually unattractive because it means policyholders have a strong incentive to surrender their policies, which would reduce the hedge fund's potential returns from death benefits.
In life settlement investments, hedge funds want policies with:
- Low premiums
- High mortality risk (leading to earlier payouts)
- Low surrender values (to discourage policyholders from cashing out)
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