Traded life policies: Profiting from mortality

Nadine Wojakovski examines the growth in interest over traded life policies and asks if any ethical worries over the asset class could hold back its growth

Diversification hungry UK financial institutions have been stepping up their efforts in recent times to satisfy their appetite for new asset classes. And their cravings could be at least partially sated by taking a slice of the global multi-billion dollar market of US-issued traded life policies (TLPs).

The asset class claims to offer institutional and retail investors an attractive and comparatively low risk investment that can play an important role in diversification, as mortality experience is not correlated with equity and bond markets.

Viable investment
A growing desire for TLPs has been fuelled by the appearance of various reports presenting it as a viable asset class. One of these, commissioned by fund managers MPL and claiming to be wholly independent in its assessment, was glowing in its praise.

Authored by Professor Merlin Stone of Bristol Business School, it found that investors looking for attractive returns mirroring the same level of risk associated with the much maligned with-profits would do well to consider funds investing in TLPs.

One of the fundamental attractions of the policy – also known as life settlements – is the predictability of their returns. The value of the policies upon maturity is known, so it is possible to secure steady and incremental returns by combining prudent analysis of life expectancy tables with sufficient diversification. The Merlin Stone Report notes that it is possible to estimate, with a high degree of accuracy, just how much profit can be made from a portfolio of policies.

"The certainty that the insured will die at some stage and that the policy has a definite, nominal value means that financial institutions are willing to lend money to both TLP funds and their investors," it states.

TLPs are also very suitable for institutional investors placing a greater focus on liability driven investment (LDI) strategies. Defined benefit schemes now want to match those liabilities with a higher degree of certainty, or less risk. Stone argues that TLPs offer a safe haven from this volatility. This is "because their returns are uncorrelated to these asset classes: they deliver returns irrespective of what is happening to other financial markets or whether the economy is in recession or booming".

Providers
There are a growing number of investment managers now offering TLP products and funds. MPL launched its TLP open-ended fund in 2004 and expects to witness further growth in the coming year. MPL says it has new mandates for pension schemes in UK and Europe for £100m over the next twelve months which would almost double its existing £118m fund.

"I am hopeful it will be more especially for LDI which requires a predictability of smooth returns," notes MPL managing director Jeremy Leach. The "smooth returns" offered by TLPs have been in the region of nine to ten per cent, which are finally looking attractive in current difficult markets.

But, as Leach points out, the last three years have been a frustration: "To show that ten per cent is a really good deal has been hard to convey in light of the better performance of property and equities." The real advantage, he says, is that the track record of funds is typically not volatile as it is based on predictable returns, provided the right actuarial expertise and diversification is used. As Leach puts it: "It's not a complete leap of faith."

Additionally, the fund is offshore so it is tax free and the policies can be included in a SIPP and other tax efficient platforms.

Policy Selection is also marketing its Assured Fund to UK IFAs and institutional investors. It has grown to comprise of 250 policies, compared to 119 at the end of March 2007. The typical face value of individual policies within the fund is $2.9m, and investors are currently enjoying returns of around 11 per cent per annum.

Rogan Redfarn, business development director at Policy Selection, believes that the low volatile stable and predictable returns a life settlement fund can generate is why leading UK institutions are showing interest. "At some point equities and property will look very attractive again – but the same steady investment characteristics of Assured Fund should remain part of an institutional holding in both good and bad times," he notes.

‘STOLI’ (stranger originated life insurance) practices are another type of policy origination but many fund managers appear to be steering clear of them. STOLI encompasses different variations. One is known as ‘Premium Finance’ where the investor funds insurance premiums on a newly issued life insurance contract issued against a US senior who has spare insurance capacity. Another is ‘New issue’ where a newly issued policy is sold (usually within a trust) typically within a few months after policy issuance.

Both methods of creating life settlements can be problematic for various legal and regulatory reasons, notes Redfarn. Assured Fund does not buy any policy that is not passed contestability period (usually 2 years), nor does it participate in ‘new issue’ or ‘premium finance’. Similarly, MPL has deliberately avoided high risk policies, such as premium finance and STOLI policies, where in both cases the insurable interest of the new owner of the policy may be challenged at some stage in the US courts.

Familiarity
It seems that after years of being on the market in the US the UK investors are becoming genuinely interested in understanding the merits of TLPs. "Since the credit crunch we have seen a run for safety attitude amongst asset managers and we are now seeing a continual trend of money coming into the fund," says Leach. He believes the future for TLPs looks good but is mindful that IFAs need to be better informed. Indeed the Merlin Stone report concedes that only 22 per cent of IFAs are very familiar with traded life policies as an investment product which means there is a lot of work needed to raise the profile for UK investors.

Leach would also like to see the US regulation being more transparent in the charges within the bidding process of the policy. Perhaps, with these two obstacles overcome, the TLP market is set for unprecedented growth.

Regulations and ethical investment
Leach is not alone in his concern over legislation. Recently, The Pensions Institute at Cass Business School published a report in which it commented on this very issue amongst other concerns. And death shall have no dominion: Life settlements and the ethics of profiting from mortality assesses the regulatory and ethical concerns for investors in US traded life policies.

While the TLP market has grown rapidly over the past ten years, regulation in the US remains very patchy and inconsistent, says Debbie Harrison, a senior visiting Fellow of the Pensions Institute and co-author of the report. "TLPs are regulated at state and not federal level and some of the largest states have no regulation in place," she explains. This could mean that policyholders might not be adequately advised and might not be offered a fair price for their policies. Inconsistent regulation also raises questions about controls over the accuracy of information used to price policies – in particular, the medical reports on life expectancy. If these are inaccurate, returns could suffer.

Another issue that does not sit comfortably with all potential investors is the ethical one. While the merits of TLP are now well documented, there is still a debate about how ethical this asset class is as it profits from mortality. But, the measured response from the Pensions Institute may cause the fund managers to utter a sigh of relief. "Our conclusion was that provided the market operates to high standards, is fully transparent, and is well regulated, there is no significant difference between profiting from mortality through TLPs and profiting from mortality through occupational pension schemes and annuities, for example," notes Harrison.

Catalyst Investment Group is the primary distributor of two TLP products, or senior life settlement policies, as otherwise known. They are the growth and income products and the Issuer is looking to follow this up with different versions later in the year. Although the pool of the growth and income products has not yet been fully promoted to institutional investors, Catalyst’s head of sales James Haupt believes that this will change in the coming year.

"The big reason for this interest is back to classic features and benefits," he offers. "From an institutional perspective being non-correlated to equity markets with a defined return could be attractive to pension schemes that have to match liabilities. If they know they have to pay 8 per cent disbursements and these products can provide a 10 per cent return (through the income product) that may be very attractive to them."

Responding to the charge that benefiting from someone's death could be a grey area for some investors, Haupt says it is now accepted that when people are surrendering policies it is actually of financial benefit or necessity to them. Moreover, life companies don't offer as much for these policies as the open market, so importantly, the seller will typically be financially better off by selling it for the purpose of a TLP.

Pension funds
Overall, Haupt believes that the model works well for investors. He also says that the big benefit for pension funds is that at any one time there is an obligation to meet a required asset cover of the face value of TLP to provide a healthy buffer over and above outstanding liabilities. So confident is he of the merits of the product that he envisages a doubling of sales in the next year.

In the light of current concerns over regulation in the US, The Pensions Institute report suggests that institutional investors might benefit from the growing development of synthetic structures which replicate direct investment in life settlement portfolios. "The emergence of synthetic structures that replicate an investment in life settlement portfolios could be of considerable interest to institutional investors seeking exposure to older-age US longevity risk," notes Harrison.

She says that these structures could eliminate exposure to policy-related risks, such as reputational risks in relation to how policies are sourced, and cross-border tax risks. But she warns that it is important to remember that the TLP market is in its infancy.

"While sophisticated platforms and synthetic instruments can remove some of the risks for investors, future changes in regulation, law, or taxation, for example, could have significant and unpredictable consequences for the market," she warns.

- Pensions Age August 2008