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.

These companies are generally based offshore, are not regulated by the Financial Services Authority (FSA) or subject to its compensation scheme, and cannot be promoted to retail investors.

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

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