A macabre investment that's flying high
To their critics, they are "death futures" - a heartless speculation in the life expectancy of sick or elderly people on the other side of the Atlantic.
To their supporters, they represent a new and appealing asset class; one that is not correlated to the cycle of other financial assets and delivers reliable and extremely agreeable annual returns of 8 to 10%.
And those in the latter camp argue that they're also a force for good, offering cash in this world to those who are about to join the next one.
Life settlement funds are in their infancy and their baptism has not been without controversy, with a couple of early incarnations leaving investors high and dry.
Some critics have even concluded that, with their promise of a regular monthly positive return sounding eerily reminiscent of Bernard Madoff, they are an accident waiting to happen.
However, for those who've invested in funds launched more recently they have so far proved to be a nice little earner that has delivered the goods during a period when other markets have been crashing.
For the uninitiated, life settlement funds invest in the life assurance policies of individuals in the US then reap the rewards when their original policyholders eventually die.
In the UK, the majority of life assurance sold is term assurance - death benefits are only payable during a defined period - but in the US whole life assurance is far more common.
Nevertheless, research has shown that the majority of policies are allowed to lapse without paying out a cent.
Typically, US citizens might take out a policy in their 20s or 30s when they are starting a family; three decades later when the children have left home and have jobs and families of their own, the prospect of continuing to pay the premiums for another couple of decades doesn't seem very enticing.
Most policies have a surrender value for those who want to stop paying the premiums, but it tends to be derisory and many policyholders lapse without even bothering to cash in their policy.
Enter the life settlement funds. Just like the traded endowment products that were popular in the UK until a few years ago, they seek out those ready to give up on their life policy and offer a much more competitive price, which can be as much as 50% of the sum assured on death.
Once they've bought a policy, funds pay the premiums religiously every month until the unfortunate policyholder passes away and then claim their bounty. In a country where wealth is widespread, maturity values of $1 million (£630,000) or $2 million are relatively commonplace.
Unlike other investments, supporters like to point out that you know exactly what the return will be, you just don't know when you'll get it.
The reason the funds invest in policies in the US is a simple one: legislation there means that once a policy has been up and running for two years death benefits are protected from any challenge by the insurer. So the eventual payment is assured to the fund and its investors.
Life settlements really took off in 1996 as a response to the AIDS epidemic sweeping parts of the US.
The Clinton administration introduced the Health Insurance Portability and Accountability Act, allowing owners or beneficiaries of life insurance policies to transfer or sell their benefits to someone who had no "insurable interest" in the policy.
The reason was that many AIDS patients desperately needed to raise money to pay for their healthcare. Sales of policies for those with less than two years' life expectancy were known as viaticals, and eventually sparked interest in a much wider market for life policies.
In the US, banks and hedge funds discovered this asset class; in the UK the idea surfaced of packaging it into a product that might appeal to investors, both private and institutional, looking for an alternative to the main markets.
However, the pioneer in this brave new world soon ran into trouble. In 2006, Isle of Man-based Shepherds Select, set up to offer investment in life settlements, went into liquidation and investors in the UK and elsewhere faced losses of an estimated £22 million.
The reason was that the company Shepherds relied on to source the life policies in the US, Florida-based Mutual Benefits Corporation, had gone into receivership amid widespread allegations of fraud.
A number of its managerial staff were subsequently convicted and sent to prison.
In the UK, it was reported before Christmas that Shepherds' liquidator PriceWaterhouseCoopers is planning to sue former directors Mike Abrahams and Jeremy Leach in an attempt to recover funds for investors.
Both are still active in the life settlements business - Leach runs the company Managing Partners which offers the Traded Policies Fund.
A second more recent scandal involved the company Keydata, which promoted a high-income investment bond that invested in life settlements.
It went into administration last year, with investors owed an estimated £100 million after another fraud involving a counterparty; this time the company charged with managing the investment.
Such episodes explain why some in the financial services industry remain extremely wary of life settlements even though it can be argued that fraud can occur with any asset class.
Today, there are a small number of companies offering investment in life settlements in the UK, and they are enjoying a degree of support from financial advisers and wealth managers.
Nevertheless, life settlement funds are pulling in large amounts of money and gaining wider popularity.
The best known fund, Guernsey-based fund manager EEA Fund Management's Life Settlements Fund, has $733 million (£452 million) under management and received net investments of $368 million last year.
Fund of funds are also among its investors. The fund has achieved 48 consecutive months of positive returns since launch and targets a net annual return of 9 to 10%.
Investment in the funds is usually through buying units or shares valued on the strength of the underlying assets, namely the life insurance policies it owns.
A somewhat different tack is taken in the case of the Opus Life Assets fund, which has just been acquired by private equity group Evans Randall.
In this instance, you can buy debentures - corporate bonds - in sterling, US dollars, euros and Swiss francs, with target returns related to the currency and the term.
Opus confirms that its fund is the only one to have FSA approval, but the company is not regulated by the FSA and your only route to compensation would be via an FSA-regulated intermediary.
The bonds are listed on the Irish Stock Exchange with maturities of five, seven and 10 years and potential target returns of up to 9% per annum. The minimum investment is £5,000.
Another offering is Cayman Islands-based Policy Selection's Assured Fund, which was set up in 2003 and now has more than $400 million under management. Its sterling B shares have achieved annualised growth of 7.62% since launch.
The company is currently relocating its base from the Caymans to Belgium to avert a threatened measure by the US Inland Revenue Service to levy 30% tax on offshore life settlement funds.
If that comes about it will clearly have a significant impact on the returns life settlement funds can generate, and is one example of the unforeseen risk that could stalk these products.
The other significant risks are firstly fraud, given that this is a product area that is fairly opaque and unregulated, and, secondly, the possibility of getting the life expectancy calculations wrong.
If you badly underestimate a policyholder's life expectancy, then not only will the sum assured arrive much later, which means it will have been eroded by inflation, but the fund has to pay premiums for much longer and this reduces the potential return.
Advances in medical science are a real risk for life settlement funds, especially when they are dealing with the impaired lives of those with major illnesses.
Another risk is that of the insurer becoming insolvent and failing to pay out - the financial difficulties of AIG, the US's biggest insurer, providing a cautionary tale.
According to Peter Winders, marketing director of EEA, laws in the US have been tightened significantly in the wake of the Mutual Benefits fraud.
He emphasises that his company's fund has strong governance in place, with funds and assets held by the Bank of New York; BNP Paribas as its custodian; and Ernst & Young as its auditor.
EEA takes an extremely conservative approach to its life expectancy calculations, he says, adding 12 months for each selling policyholder to achieve a margin of error.
Liquidity is also an issue as most life settlement funds offer at best the chance to sell on a monthly basis and if there were a rush of redemptions you might struggle to retrieve your money.
The one thing these funds can't afford to do is let policies lapse because the maturity value would then be forfeited so they would generally have to resort to selling policies or impose a moratorium on redemptions in those circumstances.
On a broader issue, critics say encouraging people who are elderly or sick to sell their life policies is unethical and that they often don't get a fair deal.
In a paper explaining why it would not encourage clients to invest, wealth manager Bloomsbury Financial Planning suggested that policyholders and their beneficiaries would usually do better to carry on paying premiums.
It said: "Future class actions against the life settlement industry could have repercussions for returns and damage the reputation of the industry as well as those of investors who have invested in them."
But Winders says there is no pressure on policyholders to sell; what the funds are offering them is choice.
He adds: "This really is a socially responsible fund. We are giving people money when they are alive and need it, and we are giving them far in excess of what they could get as a surrender value."
EEA's underwriting: how it works
The crucial aspect for any fund buying life insurance policies is to pay the right price. You need to have an accurate forecast of the life expectancy of the insured as the fund has to pay premiums until the selling policyholder dies.
If you get it wrong by, say five years, that can have a dramatic effect on the value of the policy.
Most funds use actuarial tables to look up the life expectancy of an individual whose policy is on offer based on age, gender and other data such as whether they smoke.
EEA focuses on those with relatively short life expectancies of around 44 months on average and then underwrites each individually.
US partner company ViaSource identifies policies that meet EEA's criteria and each is subjected to two independent assessments of life expectancy using specialist doctors.
ViaSource takes the average of these and adds 12 months to build a margin of error.
Medical consultants also err on the side of caution, says Peter Winders of EEA, so although the average life expectancy of those on the fund's books when their policy is purchased is 44 months, the actual average expectancy is around 30 months.
A policy will only be purchased once all beneficiaries on the policy have signed their agreement. The estimated future profit of a life policy is calculated by subtracting the acquisition, future servicing, and other costs of each policy from its "face value".
Once it is on EEA's books, the company's nurses liaise with the insured's medical team so the valuation can be kept up to date.
George Groves of independent financial adviser First Choice Insurance Consultants, says: "I wouldn't put more than 15 to 25% of a client's portfolio into life settlements, but I think this fund is head and shoulders above the others because of the way they value the policies they buy.
"Historically, it has never gone down in any month since launch, and if you don't take the dividend, your gains come under capital gains tax (CGT), which means if you keep it within your CGT allowance you can be taking around 9% each year tax-free."
This article was originally published in Money Observer - Moneywise's sister publication - in March 2010
Generally thought of as being interchangeable with life assurance, but isn’t. Life insurance insures you for a specific period of time, at a premium fixed by your age, health and the amount the life is insured for. If you die while the policy is in force, the insurance company pays the claim. However, if you survive to the end of the term or cease paying the premiums, the policy is finished and has no remaining value whatsoever as it only has any value if you have a claim. For this reason, life insurance is much cheaper than life assurance (also called whole of life).
Issued by life companies and designed to produce medium- to long-term capital growth, but can also be used to pay income. The minimum investment is typically £5,000 or £10,000 and your money is invested in the life company’s investment funds, so the bond can either be unit-linked or with-profits. They offer a number of tax advantages, such as the ability to withdraw up to 5% of the original investment amount each year without any immediate income tax liability. Also, a number of charges and fees apply, such as allocation rates, initial charges, annual charges and cash-in charges. As investment bonds are technically single-premium life insurance policies, they also include a small amount of life assurance and, on death, will pay out slightly more than the value of the fund.
The practice of locating your financial affairs (banking, savings, investments) in a country other than the one you’re a citizen of, usually a low-tax jurisdiction. The appeal of offshore is it offers the potential for tax efficiency, the convenience of easy international access and a safe haven for your money. However, offshore is governed by complex, ever-changing rules (such as 2005’s European Union Savings Directive) and, as such, is the exclusive province of the wealthy and high-net-worth individuals.
Term assurance provides cover for a fixed term with the sum assured payable only on death. Term assurance premiums are based primarily on the age and health of the life assured, the sum assured and the policy term. The older the life assured or the longer the policy term, the higher the premium will generally be. There are generally two types of term assurance. Level term assurance premiums are fixed for the duration of the insurance term and a payment will only be made if a death occurs during the insurance period and with decreasing term assurance, life cover decreases during the insurance term reducing the cash payout the longer the term runs and this is reflected in the premium.
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The amount of cash a policyholder receives from the life insurance company if they surrender (terminate) a life insurance policy before it becomes payable on death or maturity. Surrendering an investment-linked life assurance policy early is likely to be a poor deal as most policies load the majority of the policy’s fees and charges in the early years and so surrendering the policy back to the life company will result in a very low payout.
A type of derivative often lumped together with options, but slightly different. The original derivative was a future used by farmers to set the price of their produce in advance before they sowed the seeds so that after the harvest, crops would be sold at the pre-agreed price no matter what the movements of the market. So a future is a contract to buy or sell a fixed quantity of a particular commodity, currency or security (share, bond) for delivery at a fixed date in the future for a fixed price. At the end of a futures contract, the holder is obliged to pay or receive the difference between the price set in the contract and the market price on the expiry date, which can generate massive profits or vast losses.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
The Financial Services Authority is an independent non-governmental body, given a wide range of rule-making, investigatory and enforcement powers in order to meet its four statutory objectives: market confidence (maintaining confidence in the UK financial system), financial stability, consumer protection and the reduction of financial crime. The FSA receives no government funding and is funded entirely by the firms it regulates, but is accountable to the Treasury and, ultimately, parliament.
Generally thought of as being interchangeable with insurance but isn’t. Assurance is cover for events that WILL happen but at an unspecified point in the future (such as retirement and death) and insurance covers events that MAY happen (such as fire, theft and accidents). Therefore you buy life assurance (you will die, but don’t know when) and car insurance (you may have an accident). Assurance policies are for a fixed term, with a fixed payout, and unlike life insurance have an investment aspect: as a life assurance policy increases in value, the bonuses attached to it build up. If you die during the fixed term, the policy pays out the sum assured. However, if you survive to the end of the policy, you then get the annual bonuses plus a terminal bonus.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.