Should you make room in your portfolio for this morbid new asset class?
Death and profit are uneasy companions. A little-known type of fund offers investors a chance to punt on when people will die. How do these funds work? Are they ethical? And what are the risks?
They're known as 'Life Settlements Funds'. In the US, a 'Whole of Life' insurance policy can be sold on by its owner, who gets the chance to cash in while still alive. The buyer pays a large discount to the face value, keeps the insurance premiums going from their own pocket, and eventually picks up the full benefit when the original life pops its sneakers.
For example, a policy on my life might promise to pay out $1,000,000 when I die. In the States I might get an offer of, say, $600,000 for it today. In the UK it's different: you need to be diagnosed terminally ill to get what we Brits call a 'viatical settlement'. But our American friends can sell their policies at any time.
All the investor has to do is keep the premiums up to date and wait for me to die. If I survive eight years from the date of sale the investor's annualised return will be a reasonable 6.59%, ignoring the cost of paying the premiums.
The sooner I fall off my perch, the higher the return for the investor. If I die after only twelve months, his return is a whopping 66.67%. But if I last as long as a teetotal Japanese vegetarian his annual returns will be far lower.
And this is precisely what unsettles some people about this emerging asset class: is it right to make more money because a person dies more quickly? We're not talking about killing anyone; this isn't the Tony Soprano Fund. There is no connection between the death of the insured and the behaviour of the investor. But many people still feel queasy at the indirect link between death and profit.
People in glass houses
Many Fools will hold FTSE 100 trackers containing life insurers like Aviva Plc (LSE:AV). These companies all 'profit' from death in some sense. Anyone living off an annuity has a similar moral position: if they live to be 100 or more they will have benefited from those who retired and keeled over a week later.
So, if we're going to brand life settlements 'unethical', we should have a close look at our own portfolios first.
Diversification
In a life settlements fund, the portfolio manager will diversify his holdings along similar principles to a mainstream fund manager: for different industrial sectors, read different medical conditions; for different countries, read different life expectancies; for corporate credit risk and duration, read life assurer solvency and mortality assumptions.
Now private investors in the UK are able to invest in funds containing anything up to 200 different policies. The idea is that, the more policies in the fund, the lower the overall risk. It's the same principle as holding a mixture of different shares in your portfolio to reduce the risk of any single company going under.
The great appeal of a life settlements fund is that the returns have nothing to do with the performance of mainstream bond and equity markets. This makes them very attractive from a portfolio theory standpoint, because holding lots of different assets with low correlations to each other can provide higher returns for a given level of risk.
During the 2008-2009 market falls, many life settlements funds ticked along steadily, oblivious to the chaos, producing steady percentage returns in the mid-teens. The charts for these funds look like a dream: smooth, straight lines moving up the page without a blip.
So have we finally found a genuine low-risk, high return asset class? Not quite. There are some serious risks to worry about behind the scenes.
Risks
For a start, life policies produce a liability on the fund's balance sheet until they pay out. They are 'negative carry' assets, which means that it costs money -- the insurance premiums -- to hold them. This can expose the fund to a liquidity crunch. If a premium is ever missed, the 'asset' becomes worthless.
And just what is the 'asset' anyway? Nobody knows for certain when they'll shuffle off. Actuaries produce detailed tables of mortality assumptions, and these are used to estimate when each insured life will probably die. So the value of a fund at any time is tied to a major assumption.
Although the fund may appear to increase in value day by day, all that is really happening is that the policies in it are one day closer to an assumed death date. No actual monetary value has been added to the fund. It's all just 'maybe money'.
This, sadly, has provided scope for fraud. More than one fund of this type has been caught using optimistic mortality assumptions to inflate values. And more than one fund has collapsed entirely from a lack of liquidity when several big investors all demanded their cash at once. Like many products that promise to 'reduce risk', they really only swap market volatility for other, less obvious, risks.
Life settlements might be for you, but take great care with them. They are definitely not 'low risk' assets. They are highly specialised funds.
Avoid any fund with a short track record, too few policies, or unusually high performance relative to others. There is a good chance you'll struggle to get any money back. But as a small part of a wider equity and bond portfolio, and in the hands of a knowledgeable investor, they could be useful.
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