during a time when decent returns are becoming increasingly difficult to find tLPs could be the answer to investors' prayers
Finding investments likely to make decent returns can be pretty tricky right now. The argument for buying at the bottom of the market can be hard to make to the nervous investor, but for those who are taking a pessimistic view of equities over the medium term, a new investment class from the US could be worth considering.
Invisible in the UK until now, traded life policies (TLP), also referred to in the US as life settlements or viatical policies, involve the purchase of a life insurance policy from someone who is terminally ill and decides to access some of their insurance benefit early rather than it being left to their estate.
Selling their policy instead of surrendering it allows people (mainly the elderly) with conditions such as cancer, leukemia, heart disease or multiple sclerosis, to gain access to cash while still alive to improve their quality of life.
Buyers of collective funds of TLPs meanwhile, benefit from an investment free from equity exposure, which has a guaranteed return, as sadly death is a given, with annual returns of about 12%.
In the US, the traded life industry is one of the fastest growing in the personal and institutional investment market, with growth from $1m in 1989 to $2bn in 2001. And in the over-65 age group, further growth is anticipated, as the fastest growing, largest and most affluent sector of the population sees the value in accessing a proportion of their insurance early.
Over-insurance appears wide-spread, with 1999 figures indicating that there was $492bn of life assurance in force for 65-78 year olds.
In the US, selling a policy can be tax-efficient and sellers are well protected by legislation. This well-established investment class has won over individuals and institutions alike. In 1999, there were more than 50 market makers and acceptance from all major US life companies including Prudential, Metropolitan and AIG for their policies to be reassigned in this way.
Elsewhere in the world, individual investors have not until recently been able to take advantage of this market. However, a handful of British and international investment banks have been investing heavily in traded life contracts as a complementary asset class. Despite this, TLPs have not been universally welcomed. But before running through some of the issues, it is worthwhile stating why we support it.
First, it is worth pointing out that in terms of policy sales the TLP market will be largely limited to the US. The US has privately funded welfare and with almost no safety net, therefore US citizens are well insured.
This level of insurance does not exist elsewhere, largely as a result of the introduction of critical illness insurance elsewhere in the world.
The similarity with critical illness is stark as research shows that policies are sold to pay medical bills, living expenses, upgraded medical care and mortgage settlements ' none of which can be considered frivolous or whimsical. TLPs give terminally ill and senior citizens the power to make important financial decisions about the remainder of their lives.
Quite simply, the individual investor or the corporate fund manager gets a guaranteed eventual return. Annualised returns can vary considerably depending on the maturity date of each policy which is obviously unknown at outset. This may be unacceptable to some investors, who would prefer the added predictability of a collective fund.
Being conservative, the returns from a collective fund should be in the region of 12%, excluding charges, and commission. The smoothed return is a result of statistically predictable mortality, years of empirical terminal illness data and a simple discount model for the purchase of policies. A TLP is a simple instrument with a guaranteed maturity payout which is uncorrelated to equity markets.
Individual or pooled?
In the US, the investor has two choices when entering the TLP market: the first is to buy a single policy, most likely to help with set future events such as school fees planning. The downside to this is that the investor is gambling on one company's future performance and one individual's life expectancy.
The alternative, which we favour, is to buy multiple policies through a fund. Pooling policies means that you will achieve an averaged claims experience which increases predictability of returns, enabling a smooth investment growth to be achieved. This is likely to have much more widespread appeal among investors as returns can be smoothed across the portfolio of policies ' that is, in the case of traded life contracts, variances in life expectancy will not lead to higher vulnerability in levels of overall return.
To ensure the highest possible returns, most fund managers will not just take a random selection. And unlike almost all other markets it is possible to make very accurate predictions, given the life assured's personal details. The accuracy of the data further improves as the future life expectancy increases. Very short-term prognoses can be less accurate as the patient may react differently to medication, with the life assured living longer. While this may seem morbid, the life insurance industry has been making the same predictions for over a century.
It is a fact that in the US, people who sell their policies need access to money, and without the introduction of a welfare state there is little that can be done about this. Some clients may feel uncomfortable with the concept of buying into second hand life policies and an adviser will need to have enough information to allay any concerns of this type.
The industry is now well-established and reputable, but some will no doubt remember the early days of the market, where along with the appearance of the pretty much inevitable few individuals interested in exploiting the then relative lack of regulation and compliance for personal gain. Sadly, there were also some genuine errors made by reputable companies and legislators.
In the early days of Aids, for example, the limited information available led to significantly inaccurate life expectancy calculations, however, as our research and experience has grown, this issue no longer exists.
Essentially, the fledgling market faced three issues: 'cleansheeting,' 'wet ink' transactions and the exclusion of existing beneficiaries who need protection.
Cleansheeting is the fraudulent practice, whereby applications for life assurance are submitted containing incorrect medical information, often with sums assured below the levels at which life companies make underwriting checks.
We avoid this by dealing only with specialist market makers. Investors are further protected by only purchasing policies outside the contestability period so, while we do not approve of fraud, even if a policy we purchased for the fund was cleansheeted at inception, the pay-out is still secured.
Wet ink transactions are those where perfectly healthy people take out an assurance contract with the specific intention of immediately selling the policy. The way to avoid this problem is by only buying policies that have been in force for some time.
Perhaps the issue of most concern is guaranteeing the exclusion of existing beneficiaries. The traded market now focuses on buying policies from older lives assured where the chances of there being dependent beneficiaries is far smaller.
In addition, a full compliance regime helps keep check on agents with most companies insisting that the policyholder take legal advice prior to making the sale. Beneficiaries under a policy are also asked for their written consent to the sale.
While nothing can completely eliminate all poor practices, the introduction of regulation in 1988, and further regulation in 1993, 1997 and 1999 coupled with compliance and licensing has ensured that sharp practices are rarely encountered today.
In an environment of stock market uncertainty we expect the TLP market to grow significantly in both the UK and Europe.
Joined as head of strategy, multi asset, in June
Group income protection
Nine in 10 do not have income protection
Set to become part of Single Financial Guidance Body