There's a new kid on the block in the investment product world. It goes by the name of Senior Life Settlement (SLS) Bonds. These products aim to offer a high income, or capital growth - neither of which is guaranteed. To quote from page 12 of a particular SLS Bond prospectus "An investor may potentially lose a substantial portion or all of its (sic) investment".

Life Settlement Bonds are produced by companies who buy life insurance policies (death claims on which are, generally, uncontestable after two years), issued by US companies, on the life of older US citizens. The companies pay the premiums thereon, and receive the proceeds when the insured person dies. Typically, the person on whom the policy is taken out receives a cash payment, upfront, in exchange for promising to transfer - to investors he's never met - full rights to the policy proceeds.

The projected returns on SLS Bonds rely heavily on life expectancy estimates. If the insured's death occurs sooner than the life insurers' actuaries predicted, the investor stands to gain far more than he's paid out in premiums. This makes the life insured the only party to the contract that hopes he or she lives a long time. More later about the effect of increasing life expectancy.

SLS Bond promoters refer to the interest being shown by some big name banks in what, in America, is referred to as STOLI. No, it is not short for the Russian vodka - it stands for Stranger Owned (or originated) Life Insurance.

Some investment banks - whose last foray into securitisation pushed global economies into a tailspin - are following the model used with the packaging of sub prime mortgages, which were supposed to be high-quality and less risky - but proved to be outrageously otherwise. Though we are hardly out of the woods of the cataclysmic experience of low- (or no-) income borrowers being sold sub prime mortgages - which were then bundled, securitized and traded - STOLI policies are now being purchased and their revenue streams securitized and sold again as securitised bonds.

So what are the risks? They lie primarily in what US President Harry Truman is quoted as having said: "The only thing new in the world is the history you don't know." Well, because of the history I do know, I politely declined offers to promote such products. In 1976, planning to set up a life assurance company, I met with re-insurers MunichRe and actuaries Hymans Robertson. My scepticism about such "alternative investments", based on 42 years of self-employment in all areas of financial services, was vindicated at an international financial consultants' conference I attended in Indianapolis last June. These are just a few lines from an 18-page dissertation by a speaker, who is a globally recognised authority on the subject:

"STOLI (the assets backing SLS Bonds) present an inevitable direct conflict of interest - a violation of the spirit, if not the letter, of the insurable interest law in every state in the US. It is in diametric opposition to the very principle underlying insurable interest. Certainly STOLI is great proof that ethics are quickly abandoned and rationalization soon adopted when large amounts of money are readily available. STOLI defies common sense and logic as it places total strangers in a position to speculate on how soon a person will die."

Furthermore, only a few weeks ago, concerns about the suitability of these "alternative investments" were raised at a US congressional sub-committee hearing, chaired by Democratic congressman Paul Kanjorski.

Mr Kanjorski stated that the securitisation of complex financial instruments that few people understood helped lead to the current economic crisis. "It therefore astounds me that financiers are eager to return to the casino culture (my italics) before they had even settled up the bad debts they made on sub prime mortgage-backed securities".

With SLS Bonds, whereas the promotional material highlights the lack of correlation with other investment markets, the prospectus refers to events such as September 11 and its material effects on general economic conditions, consumer confidence and market liquidity - and the sensitivity thereto of SLS Bonds. So are they market neutral or are they not? What should one believe - the adverts or the prospectus?

Another risk is the potential effect of US legislative rulings, and the consequent substantial expenses that SLS funds may incur in legal fees. Forbes magazine (ironically on September 11, 2009) ran an article "Widow's $56 million lawsuit imperils macabre, profitable insurance practice." How many more such lawsuits are in the pipeline?

Another major risk to investors in SLS Bonds is life expectancy. The New York Times recently highlighted: "Another potential risk for investors is that some people could live far longer than expected. It is not just a hypothetical risk. That is what happened in the 1980s, when new treatments prolonged the life of AIDS patients. Investors who bought their policies on the expectation that most victims would die within two years ended up losing money. It happened again last fall when companies that calculate life expectancy determined that people were living longer."

"Even with a maths whiz (actuary) calculating every possibility, some risks may not be apparent until after the fact. How can a computer accurately predict what would happen if health reform passed, for example, and better care for a large number of Americans meant that people generally started living longer?" (Note: health reform has since been passed by Congress, and now awaits the Senate vote!) "Or if a magic-bullet cure for all types of cancer was developed?" How would SLS coupon expectations and bond values be affected?

Remember that actuaries are notorious for consistently underestimating increases in life expectancy - ask any Equitable Life policyholder!

The Economist of 11 June 11, 2009 put SLS Bonds in a nut shell: "There are pitfalls... In May the Senate's special committee on ageing called for more regulation of the industry. Like so many other "uncorrelated" markets, activity dried up late last year. At the same time, actuaries revised up their life-expectancy tables, battering returns. Litigation is on the rise, especially in grey-haired states like Florida."

Conclusion: As the saying goes, when something seems to be too good to be true, it generally is.

This article does not constitute investment advice.

The author is managing director of Financial Planning Services Ltd., which is licensed by the MFSA to provide investment services and insurance brokering business.