What next after life settlements? – the dangers of blanket bans

There has been much talk about US life settlement investments over the last few years particularly in the wake of the Keydata Lifemark and SLS debacle, which continues to cause considerable pain to investors, the FSA and IFAs.

However, the FSA’s announcement that all such investments are toxic and that it intends to ban them for retail investors has quite rightly caused something of a stir in financial services circles and as a precedent threatens far reaching implications.

When Lowes was first approached by Keydata in respect of the company’s life settlement based Secure Income Bonds, it looked a panacea investment – no stock market risk, assets uncorrelated to other pooled investments, ‘guaranteed’ income, and a return of capital at the end of five or seven years.  However, we felt there was insufficient information based on the available literature and so we reserved judgment in anticipation of a more detailed explanation. 

The second issue had a lot of excitement around it from Keydata as the first issue had apparently done well for them, but again, as no one could properly explain the contract model to us, in particular the basis upon which the returns were achieved or losses could arise, we again declined to use the product.

Then, shortly before the third issue came out, at a function in London I was introduced by Keydata to the representative of SLS the Luxembourg-based provider behind the Secure Income Bonds.  The conversation, which underlined our concerns, went something like this:

Keydata: “This is Ian Lowes, he’s a big supporter in terms of our structured products but he needs some convincing on the Secure Income Bond.”

SLS Rep: “Is 3 per cent initial plus 0.5% trail not convincing enough?”

Lowes: “Apparently not.”

SLS Rep: “So what’s your problem then?”

Lowes: “I understand the basis of the US Life settlement market and that there is an opportunity there, but what I need to know is how you structure an investment that takes capital to purchase policies, then needs capital to pay premiums on those policies, the policies mature at some unknown point in the future and yet the investment pays out income from day one?”

SLS Rep: “So you’re a bit of a smart-arse then?”

Lowes: “Apparently.”

Conversation ended!

A week or so later the third issue was launched and whilst it wasn’t a structured product we felt there were far too many unanswered questions and so published our concerns about the Secure Income Bonds and, subsequently, the Lifemark plan as part of the product reviews on our website.

Whilst US life settlements is an investment area we at Lowes have not recommended to clients, we are concerned by the statement from Margaret Cole, the Managing Director of the FSA, that all such investments are “completely unsuitable for most UK retail investors”.

The FSA may be right to be wary of products where the manufacturers are largely based outside of the UK, and so outside the FSA’s authority, but for the regulator to tackle the area by way of a blanket ban on sale to UK retail investors would appear extreme in the least. I would also suggest that it is contrary to one of the principle objectives of the retail distribution review which requires all “independent” advisors to research all retail investment products in order to determine their suitability for any particular client’s needs. It is not inconceivable that there are some clients for whom investments based on life settlement plans would be an appropriate and suitable addition to their portfolio.

These investments are typically based on whole of life insurance policies that have a known ‘maturity’ value – i.e. payment on death of the policyholder – the sum assured.  Unlike the UK market, most have a surrender value stated in the policy document at outset for every year of the policyholder’s life.  As I am sure you will appreciate, as these surrender values have to be stated at outset they are rarely very generous and can’t be changed to take account of the health of the policyholder.  Purchasers of  ‘second hand’ policies know what the final payment will be, they know what premiums have to be paid during the remainder of the ‘term’ and all they have to do is calculate the possible range of returns based on the expected longevity of the life assured.   They will then decide whether the policy is worth more than the surrender value.  In this respect it is not dissimilar to the UK traded endowment market except that you know the exact sum that will be paid at maturity rather than the finger-in-the-air guess of a with-profits investment, but you don’t know exactly when it will be paid. 

There are several companies that take advantage of this market with a view to bringing capital together to buy policies, pay premiums and ultimately reap the benefits when the underlying policies ‘mature’.  Where there is a genuinely pooled resource and the process is managed properly, I see no reason why this entire investment proposition should be singled out as ‘toxic’.

There are of course moral issues in that the gains are achieved as a result of lives assured dying but don’t forget that this happens in the annuity market all the time.  Also appreciate that the original policyholder benefited by achieving more than the surrender value on a policy for which they perhaps could no longer afford the premiums or had no further need for the policy. 

One significant issue that these investments do have is that because the market has not evolved, they are fairly illiquid.  If an investor wants to take their money out of a portfolio then the manager either has to find someone to buy their share, or enough policies have to be sold to realise the cash required.  Likewise, there always has to be enough cash in the portfolio to pay the premiums on the policies.

Ultimately, investors are waiting for the policies to ‘mature’ and by constructing a portfolio with a range of elderly lives assured in different states of health, then a properly managed investment portfolio could provide reasonable returns.

While I am not au fait with the full reasoning behind the FSA’s announcement I am sure the nightmare of the Keydata Secure Income Bonds & Plans has played a significant role.  However, I hope the FSA’s proposal is not simply a reaction to this as this was not particularly a failing of US life settlements as an investment class but rather issues of completely inappropriate structures and also fraud in the case of the former.  

The FSA says its concerns are that US Life Settlement products will fail and investors will lose money. Yet by tarring all these investments with the same brush, in a market with limited liquidity, the FSA is creating a self-fulfilling prophecy. Consumers are already reacting and to date there has been a run on one fund (the EEA life settlements fund) so significant that it has had to be suspended.  It should also be noted that just a few short months ago, March 2011, the FSA authorised a new Life Settlement fund (the Huet Capital Life Settlement fund), albeit as a QIS which does not allow it to be marketed to retail clients.

Aside from that, my main concern is that if the regulator starts imposing blanket bans on whole investment areas that have genuine potential to evolve in a properly regulated manner it not only stifles innovation – and limits consumer choice – but it also begs the question: What next?

Ian Lowes is managing director of Lowes Financial Management