Benjamin Franklin quipped some 300 years ago that in this world nothing is certain but death and taxes. Today, a growing number of wholesale investors are heeding the first half of this observation, through an emerging product known as a life settlement fund. STEPHEN SHORE reports.
Life settlement funds purchase US life insurance policies from people who are typically over 65, and typically are expected to die in less than 10 years. Obtained at a heavy discount, the funds pay the remaining premiums on the policies until their ‘maturity’, whereupon the full face value of the policy is paid out by the insurer. Life settlement funds claim they can provide stable, high returns for investors, and offer an opportunity for people to unlock some of the equity tied up in an unwanted policy.
With the average surrender value of a life policy offered by the insurer being around 6 per cent of the face value, the average 30 per cent offered by a life settlement fund appears to be an attractive option for some elderly people. Selling life policies in the US became popular last year, according to Mark Todd, chief executive of Life Policies America, a California-based vendor of life settlement funds. “Prior to sub-prime, people just did reverse mortgages,” he says. “Following the housing downturn, people are now exploring new areas where equity can be released.”
Life settlements are now starting to gain traction in Australia as an alternative asset class. The Life Settlements Wholesale Fund, based in Queensland, is currently the only registered fund offering such a product to Australian investors. According to its manager of institutional business, Mark Brigden, the fund sources only US life insurance policies because of the greater market depth for high value policies, and a piece of US legislation known as the ‘non-contestability clause’ which makes American life policies a lot less risky.
Under that clause, once a policy has been held for two years, insurance companies in the US lose their contractual right to withhold payment if they discover that the policy holder was less than forthright in their initial disclosure of personal details. Therefore, a third party can purchase a two-year-old US policy secure in the knowledge that there’s little chance it won’t be honoured.
In Australia, insurance companies can check a customer’s information at any time and decide that the policy is invalid – even after a claim has been made. Property Investment Research (PIR), an independent research firm, calculates that, depending on tax rate, investors in the Life Settlements Wholesale Fund can expect after-tax returns of between 8.37 per cent and 11.55 per cent.
Institutional investors, including a number of major superannuation funds, have recently made allocations to the Life Settlements Wholesale Fund as a diversification play. The fund ended 2007 with almost $700 million in funds under management, a 632 per cent increase on the year before, with the directors claiming forward commitments will take the fund well over $1 billion in 2008.
Victorian Funds Management Corporation (VFMC), the $41 billion government-owned funds manager, made its first investment (of an undisclosed size) in mid-2007. According to Leo de Bever, VFMC’s chief investment officer, life settlements are attractive because of their lack of correlation with any traditional asset class. Indeed, betting on how briefly a person is expected to live could only be positively correlated – tenuously – with shorting companies making progress in medical advancements.
According to PIR, the likelihood that medical advancements will extend life is one of the major factors likely to negatively impact returns on life settlement funds. Stephen Knott, director at the Life Settlements Wholesale Fund, says that while this is an important consideration, he believes there is a difference between life expectancy – that is, the age one can be expected to live on account of one’s social and environmental circumstances – and longevity, that is, the maximum age a human being can reach under ideal circumstances (around 120 years). “Human longevity has not changed over the past 100 years,” Knott says. “Only the number of people who reach that age has changed.” Even if there is impact from medical advancement, it won’t be dramatic. “We try to be as conservative as possible. The average age of our policy holders is 80 years, so there is not much room for downside.”
Dominic McCormick, chief investment officer at Select Asset Management, says that while life settlement funds look ideal on the surface, without the right structure the projected returns could be easily undermined. For example, the Life Settlements Wholesale Fund purchases policies sourced in the US, but does not hedge its currency exposure. While an institutional investor may have no trouble balancing this risk, a retail investor purchasing what appears to be a low-risk proxy for fixed interest may in fact end up bearing a lot of volatility, McCormick says.
The slide of the US dollar combined with the surge in the Aussie currency toward the end of 2007 was a prime example of just what could go wrong, he believes. During 2006/07 the Aussie dollar increased 14.5 per cent against the greenback, reducing capital growth in the Life Settlements Wholesale Fund’s $A units to 4.69 per cent, while the $US units enjoyed growth of 19.92 per cent.
Knott says that hedging currency is a possibility regularly reviewed by the managers of the fund, but points out that doing so would increase fees. “We recommend investors take a six-year view, which should be enough time to balance currency fluctuations.” Another concern expressed by investors is the potential conflict of interest that could arise from the Life Settlements Wholesale Fund’s structure of sourcing polices from two US-based dealers – Baltimore’s LSP and Florida’s CMG Surety – which together own 50 per cent of the Queensland fund’s responsible entity.
Select’s McCormick said a potential concern was that those source companies – with 100 per cent stakes in themselves – could stand to gain more from marking-up and on-selling of policies than trying to find the best value for the life settlements fund. Aware of this perceived potential conflict, Knott counters that the source companies do not currently raise funds on their own account. “There is no mark-up in between; the companies charge the market-rate 2 per cent fixed fee [for sourcing policies] and every transaction is recorded for transparency,” he says.
Morningstar doesn’t currently have a rating for the Life Settlements Wholesale Fund, but head of research Anthony Serhan says that at face value it sounds like a big liquidity risk. The fund claims it has up to 10 per cent of its assets held in cash, and a stand-by credit facility available should this not be sufficient.
There is also a healthy secondary market in the US in which the institutional investors trade policies among themselves, should a liquidity problem arise. But Knott stresses that life polices are not like bonds and heavy trading is not an efficient way of delivering returns. “We buy and hold the policies because the best return is in the maturity,” he says. Life settlement funds will receive another fillip for growth in Australia if Mark Todd, from Life Policies America, follows through on plans to launch an Australian-domiciled version of his firm’s fund.