The growing trade in life insurance policies

Posted by robin in Financial Articles Saturday October 25, 2008 8:38 pm

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If you’ve given up on the stock market, here’s an alternative that’s been a beneficiary of the slump…

It has been called a “new asset class”. A term that makes me a little twitchy given the way today’s new can be tomorrow’s discredited. The concept of selling hotel bedrooms was once ”a new asset class”. It’s leading protagonist, Guestinvest, is now in administration. But let’s give it the benefit of the doubt for now and see what it might do for an investor…

The main thrust is that it will earn investors a reliable 7-10% a year, uncorrelated to the stock market.

That’s right ‘uncorrelated’. Meaning it doesn’t matter a tinkers cuss if the FTSE 100 or any other index explodes into orbit or implodes into our bruised globe’s inner core, all things being equal it should churn out said return.

Okay, so what is it? Well, this is not a subject that is going to score highly on the sexy investment scale but that could be to its credit.

We’re talking about investing in second-hand life insurance policies!

Still there?  Let me explain…

The idea is investors buy life insurance policies from people who don’t want them any more. Once the policy has been ‘assigned’, its new owner continues to pay the premiums but collects on the pay out come the day the life assured pops his/her clogs. These have been dubbed “death bonds” in the media and it’s certainly not everyone’s idea of turning a buck. Certainly, it’s a doubtful one for Sharia compliance.

But it can actually be quite a good deal if done right. It’s not uncommon for life assurance policies to become obsolete to the owner - circumstances change, kids grow up etc… When this happens, the policyholder has two choices. Continue the policy or cash it in for a meagre return. Step forward the third party investor who pays more than the insurance company and and so gives the seller a better deal. 

For the investors, they know exactly what to expect on day one because the sum assured is known and fixed. What they don’t know is when to expect their pay day. So they underwrite the life assured to assess how long he/she is likely to last. Most policies that are traded are on people with life expectancy under 15 years. As such the business focuses on senior citizens.

Why it’s a US business…

It wasn’t always that way. The original idea for flogging life assurance policies surfaced in America in the 1980s during the AIDS epidemic. It was a way those afflicted could raise cash in a hurry to finance medical treatment. It proved a better deal for the sufferers than the investors as new drugs extended the life expectancies of once terminal cases. The concept survived that experience to refocus on seniors, whose life expectancy can be measured with greater certainty.

Is this ethical? asked the Pensions Institute in a recent report. Well, it’s not the first business to trade on mortality, it noted citing pension schemes, life assurance and annuities by way of example. 

This is another innovation from our cousins across the pond. This market is excusively the trading of US life policies. Why?

Well, the answer is there is a unique feature with US policies. It is the rule on non-contestability. This means life insurance policies cannot be challenged on the basis of non-disclosure or suicide after they have been in force for two years. The same cannot be said of life insurance policies in other countries. In addition, the US is a vast market for life insurance, the world’s largest and the ageing baby boomer generation is thought to swell the group who may consider trading their life insurance policies.

The investment concept is still pretty novel. and last year an estimated $12-15bn worth of policies were transacted according to Doug Head, Executive Director of the Life Insurance Settlements Association. Though he can’t be sure as data on the market is patchy and some States do not always disclose on the subject.

“A $50bn market in a year or so is not unreasonable,” adds Mr Head as strapped seniors rummage around in the closet for assets after house prices, share portfolios and 401k’s (US SIPP equivalent) evaporate in the credit crunch. 

In the UK, there are a number of funds which invest in “Senior Life Settlements” or “Traded Life Policies” which have enjoyed steady progress. Most buy a portfolio of life insurance policies and promise investors 7-10%pa growth with very low volatility. The funds can be expensive and usually penalise investors not willing to commit for at least five years. They are mainly targeted at affluent and experienced investors though there are a couple of more accessible offerings in the form of structured products.

My interest in this “new asset class” extended to a seminar and a rather fine lunch too, Though I was little clearer on the potential pitfalls afterwards…

For what it’s worth these, for me, are some of the question marks:

1. US Insurers hostile

US insurers don’t like this upstart traded life policy market. One life company exec grudgingly admitted that “it’s growing and it’s here”. From the insurer’s perspective, they may get more premium income but they will pay out on more policies too. Whether they are in a position to and inclined to do anything about it is unclear to me. But I would expect the potential collective clout of US life insurers to be not insignificant. 

2. Uneven regulation

There is no Federal legislation on the trading of life policies. That means it is decided at State level. With 50 States, that means potentially 50 sets of rules and some of them don’t even have any in place yet. Plenty of scope for entanglement there and much reliance is placed on US operatives for guidance and the execution of transactions. One unfortunate legal case has a family contesting the paying away of life insurance claiming they didn’t know the policy had been sold. This is likely an exception as best practice in the trading of life insurance policies requires all beneficiaries to sign away their interest.

3. Incontestibility rules

If you can set up an insurance policy in the US and are ‘economical with the actualite’ in your application, it doesn’t matter after two years. Some investors have been moved to invest in others setting up life insurance policies with the intention of buying them after two years. The dubious practice of stranger originated life insurance policies, so called STOLIs, calls into question the notion of insurable interest and has meant some are pushing for the two year rule to be extended to five years. Perhaps this could happen I’ve no knowledge, perhaps it could go altogether. What does appear clear is that the linchpin of this market is lodged in the US incontestability rules and without them there is no market. 

4. Tax rules can change

As in the UK, the proceeds from US life insurance policies are tax free. But tax rules can and do change…especially when governments, hot from bailing out the financial system, need to raise cash. One UK fund specialising in traded life policies has even made provision for the potential of a withholding tax.

5. Financial strength

Strong life insurance companies don’t usually go bust. But given what has gone bust this year, the once remote prospect now appears distinctly plausible. In the UK, the insurers are feeling the heat of collapsing asset prices -shares, commercial property, corporate bonds - on capital adequacy and there is speculation on the need for recapitalisation. The Prudential lost 29% of its market value in the week ending 17 October. Aviva lost 25% and Old Mutual 18%. “After banks, will life assurers be the next casualties of the credit crunch?” asked the FT a few days later.

In the US, leading insurers Metlife, Prudential Financial, Hartford Financial and Genworth are down 51%, 2.5%, 69% and 78% over one year. Investor concern over their debt and stock market exposure was flagged by the FT on 2 October . If a life insurer went bust there are, I understand, guarantee schemes at State level subject to pay out limits, typically between $300,000-750,000.

6. Complexity

Theis is not the easiest investment to fully understand. A warning in itself as Buffett long ago counselled to invest in what you understand. Much depends on the quality of the underwriting for this to work and there are plenty of advisers in the food chain contributing to high costs. For a UK investor, this is all being set up and negotiated a long way away and it is very difficult to fully understand the risks being undertaken. The memorable line from ex-US Defence Secretary, Donald Rumsfeld  appears apposite: there are known knowns, there are known unknowns and there are unknown unknowns.

All the funds available to UK investors are based offshore meaning should the worst happen to your investment recourse is via the jurisdiction in question (foe example - the Channel Islands, Luxembourg, the Cayman Islands) which may or may not provide a cushion equal to that under the UK investor guarantee scheme. 

A complicated bet

All told, the trade in life insurance policies is an interesting one at this time when the Credit Crunch has exposed the limitations of much supposed diversification of risk. 

With ageing demographics on its side, it may well prove it is here to stay. But it is young and the enduring quality of its investment proposition has yet to be fully established. It is moving from the fringes of the investment scene to ever greater legitimacy as institutional investors, desperate for safe haven diversification, gain exposure. It is worth bearing in mind, however, this looks a complicated business and some way short of the straightforward bet some might suggest.

  

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