Finding investments likely to make decent returns can be pretty tricky right now. The argument for buying at the bottom of the market can be hard to make to the nervous investor, but for those who are taking a pessimistic view of equities over the medium term, a new investment class from the US could be worth considering.
Firmly established in the US but invisible in the UK until now, viatical policies invest in the products as an asset class.
The word viatical comes from the Latin word viaticum, or provision for the journey. With a viaticum, the Roman soldier was given supplies for his journey into battle, possibly the final journey of his life.
In the US, they are also referred to as life settlements or traded life policies. They involve the purchase of a life insurance policy from someone who is terminally ill and who wants to access some of their insurance benefit rather than it being left to their estate.
Selling their policy instead of surrendering allows people with serious conditions to maximise the funds available to them to improve their quality of life.
Purchasers of collective funds of TLPs benefit from an investment free from equity exposure, which has a guaranteed return with annual return rates likely to come in somewhere between 9 and 12 per cent.
In the US, the traded life industry is one of the fastest growing in the personal and institutional investment arena, with growth from $1m in 1989 to $2bn in 2001.
In the over 65 age group, further growth is anticipated, as the fastest growing, biggest and most affluent sector of the population sees the value in accessing a proportion of their insurance early.
Over-insurance appears widespread, with 1999 figures indicating that there was $492bn of life insurance in force for 65-78-year-olds.
Selling a policy can be tax-efficient and sellers are well protected by legislation. In 1999, there were over 50 market-makers and acceptance from all major US life companies including Prudential, Metropolitan and AIG for their policies to be reassigned in this way.
In the UK, individual investors had not until recently been able to take advantage of this market but a handful of British and international investment banks have been investing heavily in the traded life contracts as a complementary asset class.
Before running through some of the issues, it is worthwhile stating why we support TLPs. We think the TLP market is quintessentially American.
The US, where Shepherds buys its policies, has privately funded welfare and, with no safety net, it is hardly surprising that heavy insurance is common. Research shows that policies are sold to pay medical bills, living expenses, upgraded medical care and mortgage settlements – none of which can be considered frivolous or whimsical. TLPs give terminally ill and senior citizens the power to make important financial decisions about the remainder of their lives.
What's in it for investors?
The individual investor or the corporate fund manager gets a guaranteed eventual return, although annualised returns can vary considerably, depending on the maturity date of each policy which is obviously unknown at outset.
This may be unacceptable to some investors, who would prefer the added predictability of a collective fund. Being conservative, the returns from a collective fund should be in the region of 9-12 per cent, excluding charges, and commission.
The smoothed return is a result of statistically predictable mortality, years of empirical terminal-illness data and a simple discount model for the purchase of policies. A TLP is a simple instrument with a guaranteed maturity payout which is uncorrelated to equity markets.
Future life expectancy Expected rate of return
12 months 12%
18 months 21%
24 months 28%
36 months 42%
48 months 50%
60 months 60%
72 months 72%
Individual or pooled?
In the US, the investor has two choices when entering the TLP market. The first is to buy a single policy, most likely to help with set future events such as school fees planning. The downside is that the investor is gambling on one company's future performance and an individual's life expectancy.
The alternative, which we favour, is to buy multiple policies, placing them in a fund. Pooling policies means you will achieve an averaged claims' experience which increases predictability of returns, enabling a smooth investment growth to be achieved.
This is likely to have much more widespread appeal among investors as returns can be smoothed across the portfolio of policies. In the case of traded life contracts, variances in life expectancy will not lead to higher vulnerability in levels of overall return.
In order to ensure the highest possible returns, most fund managers will not just take a random selection. Unlike almost all other markets, it is possible to make very accurate predictions given the life assured's personal details. The accuracy of the data further improves as the future life expectancy increases. Very short-term prognoses can be less accurate as the patient may react differently to medication, with the life assured living longer. While this may seem morbid, the life insurance industry has been making the same predictions for over a century.
Covering the issues
It is a sorry fact that, in the US, people who sell their policies need access to money and, without a welfare state, there is little that can be done about this. Some clients may feel uncomfortable with the concept of buying into secondhand life policies and an adviser will need to have enough information to allay any concerns of this type.
The industry is now well established and reputable but some will remember the early days of the market, when, along with the the inevitable few interested in exploiting the then relative lack of regulation and compliance for personal gain, there were also some genuine errors made by reputable companies and legislators.
In the early days of Aids, for example, the limited information available led to significantly inaccurate life expectancy calculations. But, as our research and experience has grown, this issue no longer exists.
Essentially, the fledgling market faced three issues – cleansheeting, wet ink transactions and the exclusion of existing beneficiaries who need protection.
Cleansheeting is the fraudulent practice whereby applications for life assurance are submitted containing incorrect medical information, often with sums assured below the levels at which life companies make underwriting checks.
Shepherds avoids this by dealing only with specialist market-makers. Investors are further protected by only buying policies outside the contestability period so, even if a policy bought for the fund was cleansheeted at inception, the payout is still secured.
Wet ink transactions where healthy people take out an insurance contract with the specific intention of selling the policy immediately. Since Shepherd only buys policies that have been in force for some time, there is no exposure to such practices.
The exclusion of existing beneficiaries who need protection is perhaps of most concern. The traded market now focuses on buying policies from older lives assured where the chances of there being dependent beneficiaries is far smaller. In addition, a full compliance regime helps keep check on agents, with most companies insisting that the policyholder takes legal advice before making the sale. Beneficiaries under a policy are also asked for their written consent to the sale.
While nothing can completely eliminate all poor practices, the introduction of regulation in 1988 and further regulation in 1993, 1997 and 1999 plus compliance and licensing has ensured that sharp practices are rarely encountered today.
In an environment of stockmarket uncertainty, we expect the TLP market to grow significantly in the UK and Europe.