The good news is that they can generate reliable returns of up to nine per cent a year that are refreshingly uncorrelated with those of other asset classes. The bad news is that they are opaque, illiquid, vulnerable to mis-selling - and they rely upon someone's death to pay out.
Welcome to the world of life settlement funds, also called traded life policies (TLPs) and often dubbed 'death futures'. TLPs first developed in the US during the 1990s, when early Aids sufferers cashed in life insurance policies in order to pay for their medical care.
The market has changed significantly since, in particular with a distinction being drawn between policies with such short life expectancies - "viaticals" - and those of senior citizens with longer but more predictable life expectancies.
The market for the second-hand life assurance policies has ballooned to $30bn (£19bn), from less than $2bn in 2002, according to estimates by Conning Research & Consulting.
Jeremy Leach, managing director of Managing Partners Limited, a fund manager that specialises in life settlement funds, says: "People don't appreciate how big the US life insurance policy market is. It represents 25 per cent of the US economy and currently $23 trillion worth of life cover is in issue. As policy owners don't regard life insurance as an asset it has quite a high lapse rate as, for example, it may not be affordable, or they don't need it anymore."
The advantages
Elderly Americans sell their life insurance to investment companies and hedge funds for a cash sum. An investor then buys the legal rights to the policy and continue to pay premiums. The investor collects the entire death benefit of the policy upon the death of the life insured. The sooner that happens, the fewer premiums the investor has to pay and the quicker they cash in the life insurance - sometimes for a hefty reward.
Life settlement funds represent a unique opportunity to purchase policies at a significant discount to the fixed maturity amount, or death benefit, that is underwritten by US life insurance companies. Darius McDermott of independent financial adviser (IFA) Chelsea Financial Services, says: "The argument for these investments is that they are uncorrelated to equities - achieving returns by purchasing US life policies from individuals with a maximum life expectancy of eight years, before cashing them in when policy holders die. This gives these investments an extremely low correlation to equities."
The downsides
Why aren't TLPs more popular, given their obvious attractions? The answer is that there are many risks, and regulation of the asset class is still in its infancy.
A survey of the industry commissioned by Managing Partners Ltd and published in August, says that TLPs are too complicated for investors to be sure they would behave as expected if they were securitised in a special purpose vehicle, as is becoming more common.
"Securitisation offers what looks, to the buyer, like a solid asset that has the benefit of spreading risk over a long period, [but] it's riskier when the underlying assets are not well understood," says Merlin Stone, professor at the UK's Oxford Brookes, De Montfort and Portsmouth universities and author of the report.
They can also be illiquid and expensive to set up. Mr Stone says: "Transparency is always best for the investor and at the moment, there is a choice between straightforward funds and these complicated [securitised] vehicles," says Mr Stone, who argues the risk is heightened by TLPs being a relatively new asset class.
TLPs' reputation is also tainted by their connectino to Keydata, the structured product provider that collapsed last year. Keydata was a significant life settlement product issuer that had money invested with Luxembourg-domiciled life settlement vehicles SLS Capital and Lifemark. It emerged that £103m of life insurance policies managed by a Luxembourg business, SLS Capital, and sold to Keydata investors as Secure Income Bonds 1, 2 and 3, had been "misappropriated".
Gavin Haynes, investment director at IFA Whitechurch Securities, says: "For UK investors the collapse of the Keydata investment that invested in this area has been a high profile example of the dangers of how such funds are structured, and the regulators have concerns."
Regulators take an interest
The US Securities and Exchange Commission (SEC) has created a task force to look at the products following the financial crisis. It was concerned about the opaqueness of the products and the disparity between valuations for policies. The trading of life settlements has drawn comparisons with the residential mortgage market, where mortgage-backed assets were widely mis-sold and very few people actually understood the underlying value.
This group published a report at the end of July recommending life settlements be reclassified as securities, effectively bringing those who invest in them under the protection of federal securities laws. The report wants to regulate buyers, sellers and underwriters working in the life settlement market and apply a baseline level of conduct (see links at the foot of the page) http://www.sec.gov/news/press/2010/2010-129.htm)
Back in February the Financial Services Authority (FSA) warned that marketing of traded life policies had "major flaws" and it would be "very concerned" to see the market increase rapidly. Experts hope the UK regulator will follow the SEC's lead and take some more action.
Mr Haynes says: "These funds are opaque. While there has been some very impressive low volatility past performance quoted by providers, liquidity and also the lack of regulation of this area of investment is a worry."
Life expectancy is another well-known risk, along with currency risk, given that policies are in US dollars. Typically, the policy is sold when the original owner is over 65, so has a life expectancy that can be estimated with relative precision. This is important because how long the seller lives is the key variable that defines the value of the policy.
"For this type of investment to work they must be valued accurately, and this entails the difficult job of getting mortality assumptions correct. Should subjects live longer it will reduce the return on the investment. In this process, there is a lot that can go wrong. And this is not factoring in currency risk - the policies are US-dollar denominated - or complex charging structures," comments Mr McDermott.
The moral dimension
For some investors, this type of investing could also be perceived as morally contentious. Patrick Connolly of IFA AWD Chase de Vere says: "The market for these investments started to grow rapidly as a result of the AIDs pandemic in the 1980s, but for investors, the advent of life-extending antiretroviral drugs to treat HIV meant policies taken on the mortality of HIV patients had diminished returns.
"The ethical conundrum was clear: when the fund was performing, it would be difficult to boast at a dinner party about the fact portfolio returns that were based on the early demise of HIV patients. Since the pandemic a distinction is being drawn between policies with such short life expectancies, and those elderly Americans with longer but more predictable life expectancies."
| WHAT IFAs THINK OF TLPs |
|---|
"When we look at products we like to look to have a good look under the lid. These investments lack transparency, have opaque charging structures and could run into problems with liquidity. The assumption-based valuations will always be open to scientific scrutiny as new developments in healthcare come on line." - Darius McDermott, Chelsea Financial Services "The complexity of products in this area make it very difficult to ascertain the true risk/return profile of this area of investment and if we cannot fully understand how to measure risk we would not be comfortable holding it in a clients' portfolio." - Gavin Haynes, Whitechurch Securities "The promoter of the fund often has an interest in making the assumptions favourable to the fund's marketing rather than presenting a more realistic picture - this means that the performance of the fund can fail to meet the expectations of investors. In recent years, projections have been shown to be over optimistic and returns have been hit as people have not died as quickly as the funds needed them to." - Patrick Connolly, AWD Chase de Vere |
A changing market
Most of the products on the market now are collective investment schemes. Mr Connolly says: "The market has changed. Before the credit crunch it was easy for hedge funds to borrow money and buy life settlement policies. However, when credit dried up they have needed to pay this money back and so have tried to sell policies back into an illiquid market, driving prices down."
One of the well-known funds on the market is the EEA Life Settlements fund, which has returned around 9 per cent to investors in the past year after charges. It buys insurance policies of Americans with an average life expectancy of 36 months, and the fund has a size is $902m. In January 2008 it was worth just $50m, so has grown enormously.
Mr Leach of Managing Partners Ltd says: "Our principal fund is the Traded Policies Fund, which is nearly seven years old now and delivers around nine per cent a year after charges. We have not seen much deviation in returns throughout the financial crisis. Prior to 2007, a lot of sophisticated investors had some familiarity with the asset class but not the time or energy to put into being comfortable with it as an area for investment, however, there has been a significant uplift in activity in recent years." Managing Partners Traded Policies Fund invests in a pool of 275 lives.
Funds that invest in TLPs with the right diversification of policies, prudent actuarial analysis and due consideration to increasing life expectancies can deliver steady, incremental returns of 8-10 per cent a year that are uncorrelated to other financial markets, says Mr Leach, adding that the positive performance of several TLP funds in recent years proved this to be the case despite some of the worst market conditions imaginable.
He adds: "Investors need to look at transparent, open-ended investment funds with reasonable track records and conservative charges from product providers with authorised distributors in the UK. They should avoid those funds that have performance fees because this raises the issue of moral hazard and secondly because funds are buying an asset class with a fixed maturity value and limited upside potential, so the only way to gain alpha is by having conservative annual management fees."
