Investigating life settlement funds
These funds invest in a portfolio of US life assurance policies (some of which can be worth millions of dollars), which have been sold at a discount by ailing policyholders to third-party buyers in order to fund medical costs or just enjoy their last years of life.
The fund managers continue to pay the policy premiums, and when the original policyholders die the funds receive the payouts, which are distributed to investors as income.
The TLP market exists only in the US, having emerged after 1996 when US law was changed to allow AIDS sufferers to sell their life insurance to a third party to help pay their medical bills. As the prognosis for survival has improved for AIDS, making those policies (known as viaticals) a much less reliable bet for a rapid payout, the market has shifted its focus to older individuals likely to succumb to the inevitable, rather than younger people with specific medical problems.
It has become big business in the US, with banks and other institutions using the policies for income. Conning Research & Consulting estimates that the volume of trade in TLPs stood at around $2 billion in 2002, was close to $12 billion by 2009 and forecasts the market to reach $21 billion by 2012.
In the UK, it has been possible to tap into the American TLP market over the past seven years, via a choice of 18 offshore, unregulated funds.
TLP funds are, in effect, a monitored gamble on life expectancy. Fund managers aim to select life policies of people likely to die within a few years, whether of old age or because they are ill.
A diversified portfolio may contain around 600 holdings, selected on the expectation of a steady stream of maturing policies.
These funds are only available through independent financial advisers, but they have clear headline attractions for advisers and their clients.
First, they pay a consistent and extremely attractive income: the EEA Life Settlement fund, for example, has a benchmark target of 8% net of charges and has delivered on average 9.44% a year since launch in 2005.
Second, TLP payouts have a very low correlation with conventional asset classes, such as equities, bonds or property, movements in interest rates or currencies, or global events. They also provide automatic diversification for any conventional portfolio.
The UK market may be in its infancy, but it has already felt the flak of controversy. It has attracted further criticism recently, not least from Peter Smith, head of investment policy at the Financial Services Authority. In a speech to the European Life Settlement Association in February, he made it clear that the FSA views TLPs as "complex products with a number of inherent risks," suitable only for "sophisticated investors". So where lie the potential problems?
One of the biggest is the inherent difficulty of accurately forecasting when someone will die. Medical developments may well lengthen life expectancy. Indeed, as Smith pointed out in his speech: "The profile of those policyholders most likely to sell their life policies in the US secondary market means that these are the very people whose life expectancy is likely to change significantly with medical advances."
Jeremy Leach, managing director of TLP fund provider Managing Partners (MPL) – and a former director of the defunct Shepherds Select fund – agrees this is a problem. Increasing life expectancy means not only that the expected income does not materialise on schedule, but also that more must be paid out in premiums, eating into total returns. The result is that the model on which the whole fund is based becomes increasingly inaccurate.
"We have to assume people will continue to live ever longer and that means recalculating the life expectancy and revaluing each policy on a monthly basis," he says.
Moreover, even if actuarial calculations are accurate, financial crises can mean a run on assets of every type – not just those affected by falling markets.
In a specialist, relatively illiquid market such as this, that means trouble – investors not being allowed to withdraw money, or distressed policy sales. Professor Merlin Stone, an expert on the traded life policy market, says that "some funds had to sell policies at below their modelled value" during the credit crunch.
There are also problems to do with the fact that all the TLP funds available in the UK are currently unregulated. Worse, according to recent research carried out by MPL, five out of six fund managers, selling a total of 15 funds into the UK IFA market, are using unregulated subsidiaries to do so. MPL itself comes out with a halo, as its UK subsidiary is authorised by the FSA. "We should be accountable for the information we give advisers," stresses Leach.
But as things stand the onus is entirely on the IFA, says Russell Golledge, an adviser with Crystal Financial Management. "It's the adviser's responsibility to ensure the client is a sophisticated or experienced investor; but IFAs also have to do all the due diligence on the funds and their professional advisers, which is difficult when they're complex investments registered in offshore centres, such as the Cayman Islands," he adds.
Golledge uses EEA Life Settlements and MPL Traded Life Policies. "We like them because they're open and forthcoming. They are similar in that both target policies from the over-80s and have an average life expectancy of four years maximum; they both also have one of the big four accountancy firms as auditor, and a big-name custodian in the US."
Regulatory change may – perhaps – be afoot with the introduction of a new Regulatory Committee set up by the European Life Settlements Association (ELSA) to work with regulators. But it's likely to be a slow process, says Stone. "Typically, it takes 20 years for an asset class to become regulated and understood. This market is only really six or seven years old."
Another problem with TLPs is their opaque charging structure and often eye-watering performance fees. According to Merlin Stone, at least five funds operating in the UK charge a performance fee.
"The performance of TLP funds is typically around 10% a year, and because they're sold on the basis of steady growth people think that's the real return," says Golledge, "but in reality some of these funds could generate up to 25% if it weren't for charges."
The EEA fund, for instance, takes 75% of any margin over 8% net of all charges – and that's on top of a 1.5% annual charge.
Leach takes the high ground here too, as the MPL fund does not charge a performance fee. "It's a moral hazard to charge one, because you're incentivising the manager to boost fund performance," he explains. "These funds mark their value according to a model, not the real market, and the manager can tweak that model to influence performance."
Nonetheless, he thinks there's a place for TLP funds for sophisticated investors – though they'll need at least £35,000 to invest, and must meet at least two of the FSA's criteria for investment in a complex asset class: have £500,000-plus of accessible assets, trade at least 10 times a quarter or work in financial services.
"TLP funds will always be Marmite-type products, loved or hated, because they are so complex. But they're very clever because of that unique smooth return. The important thing is that fund providers are fully transparent, so that IFAs and investors can understand the risks," says Leach.
This article was originally published in Money Observer - Moneywise's sister publication - in December 2010.
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