Getting past the hype around life settlements

The past few weeks have been a rollercoaster ride for life settlements, which until now have shown themselves to be hugely popular with investors.

That attraction has been understandable. Investors faced with low interest rates and burnt by the performance of traditional investments during the financial crisis have struggled to find a home for their cash that offers an adequate return.

Life settlement products typically provide generous capital growth or regular income payments of around eight per cent a year. The return is uncorrelated with the markets as these investments are backed by second-hand US life insurance policies with no investment component.

So what changed? A fairly innocent statement came from the Malta Financial Services Authority highlighting to investors some issues they should consider. But what followed is near absurd. Rife speculation is resulting in poor information being spouted to investors, often by people with little understanding of these investments.

Two weeks ago, The Times Business carried an article in which the author - who by his own admission has never worked with these investments - referred throughout to policies backing life settlement products as stranger-originated life insurance policies (Stoli). Stoli refers to very specific types of insurance practices and it is almost unthinkable that mainstream products would ever include them.

Stoli is rather nasty. It typically involves an investor paying someone to take out the insurance policy in the first place, with the sole intention of using it as the basis for an investment. This is risky. In particular, there is a danger of the policyholder being encouraged to give fraudulent information to try to enhance the return for investors since there is no genuine desire to take out the cover other than to make a profit.

Conventional life settlements are much more pedestrian and pose considerably less risk to investors. They relate to real policies which are no longer needed and where an elderly policyholder (for these policies are sold by the over 65s, and often help fund their retirement) wants a better return than to surrender it to their insurer for a paltry sum.

There have been other claims made against life settlements that simply lack credibility. They included tipping life settlements as the new asset class for securitisation, drawing parallels with US subprime. These are entirely different financial activities. Securitised subprime mortgages were victims of over-exposure to a collapsing US property market. By contrast, life settlement backed products carry little to no market risk, which is the very reason they have been popular with investors looking for greater diversification.

There is also scant evidence that much securitisation of life settlements is taking place, unlike the $1.4 trillion of subprime loans, which accounted for 15 per cent of the US mortgage market, according to a July 2007 report by AMP Capital Investors. Even if the market grows, life settlements are not that difficult to value as they do not carry the level (and therefore fluctuations) of market risk. It is also reasonable to assume we will never again witness the chronic mispricing of securities as that which took place during the boom. As Joshua Coval at Harvard said to The New York Times in September: "(Life settlements) do not have risks that are difficult to estimate and they are not, for the most part, exposed to broader economic risks."

What is frustrating about the inaccurate discussion of life settlements is that it shrouds their potential usefulness. Because the return from life settlements is linked to life expectancy, it can be predicted with relative certainty allowing investor returns to be structured. There are very few investments that can indicate the likely return without involving risky derivatives and substantial counterparty risk.

With life settlements, investors have recourse to the underlying assets. Meanwhile, they have learnt the hard way that traditional returns can change on a whim - a €100,000 investment in European stock markets in July 2007 would be worth around €65,000 today. For some investors, especially those approaching retirement, this is more than a paper loss. They cannot simply sit and wait for recovery.

The benefits of life settlements are hard to ignore and may explain their quiet success in spite of the wearying hyperbole. Steady increases in institutional capital is also increasing product quality and allowing the industry to mature. Buying into a pool of life settlements also gives investors the protection of greater diversification and the due diligence afforded by specialist financial institutions to manage risk. These relate to life expectancy forecasts and liquidity, although these are managed highly conservatively in mainstream products to protect investors.

Ultimately, it is a combination of informed investors and policy sellers who will determine the future of life settlements, in which the ability of investors to assess the appropriateness and potential risks is key. The same can, and should, be said of any investment. Erroneous speculation in the pursuit of a good headline does precious little to help them.

The information contained within this article does not constitute investment advice or a solicitation for sale. MFSP Financial Management Ltd is licensed by the MFSA.

Mr Pace is executive director of MFSP Financial Management Ltd.