Investor Advice Sheet: 10 Key Questions to ask Life Settlement Fund Managers.

Transcription

1 Investor Advice Sheet: 10 Key Questions to ask Life Settlement Fund Managers. Best Practice Advice for Investors Q4, SL Investment Management 8-11 Grosvenor Court, Foregate St, Chester, CH1 1HG, UK T: +44 (0) E: W:

2 Top 10 Questions to ask A Growing Market. The secondary market In Traded Life Settlement Policies has grown rapidly in recent years. With growing vendor awareness of the secondary market, the increased desire of investors to seek low-correlated returns, an increasingly mature market infrastructure, and the growth of the senior population in the US, the market is expected to continue to develop and grow. Analysts state that US seniors aged 65 and over currently control over $420 billion of life insurance. *Conning Research estimates that the face value of secondary Life Settlements in 2008 reached $11.8 billion in face value, resulting in a market penetration of 2.8%. As of 2009, Life Settlements market reached $19 billion in face value. Data from the US Census Bureau** indicates that this age group is expected to grow from 38 million today to 71.5 million by Assuming that the ownership rates and average policy death benefits remain static, and the penetration rate increases to 10% by 2030 due to growing awareness of the secondary market, the Life Settlement market is expected to grow to $80 billion per annum by The Life Settlement market is expected to grow to $80 billion per annum by Delivering Investor Returns Life Settlements are life insurance policies issued by US life insurance companies insuring mainly US lives, which are traded in the secondary market. Investors buy the legal rights to the policy and pay premiums before making a return by collecting the entire death benefit of the policy upon the death of the life insured. Policies are purchased at a price above the cash-in value offered by the life insurance company, but at a significant discount to the final fixed maturity value (death benefit). Policyholders are typically aged 65 years or older. The basis of value for an investor is the excess in future fixed death benefit over the acquisition price, premiums paid and any expenses. The primary determinant of investor return is accurately estimating the life expectancy of the insured: Life Settlements are a longevity risk-based investment. Therefore, accurately assessing the right price for each policy acquired is fundamental. Consequently, using actuarially robust policy pricing and portfolio valuation methodologies is vital to generate an attractive investment performance.

3 Potential investors in Life Settlements should ensure that they have satisfactory answers to ten critical questions from their Investment Manager. The Importance of Fiduciary Standards: However, accurate asset valuation is just one element of managing risks associated with a life settlement based investment product. * Conning Research and Consulting Inc 2009 **US Census Bureau Annual Estimates of the Resident Population by Sex and Five-Year Age Groups for the United States: April 1, 2000 to July 1, 2008 (NC-EST ) 10 Key Questions A more comprehensive assessment for any fund manager or advisor should include other aspects and SL Investment Management recommend that potential investors in Life Settlement funds ask ten critical questions during their diligence processes to ensure a sound choice of investment manager. 1. (Where) Is the Manager or the Fund Regulated? The regulatory environment provides investor protection by enforcing certain behaviours on the Manager and in some cases can even provide some degree of compensation. Knowing the regulatory environment your Manager is operating within is important. 2. What due diligence does the Manager perform at acquisition? Some past Life Settlement transactions have included cases of dubious legality, from outright fraudulent activity to so-called wet paper transactions, which fall under the more modern definition of Stranger-Originated Life Insurance (STOLI). Furthermore incomplete documentation may prevent policies from being sold on in the market at a later date. It is important that the Manager perform its own due diligence on policy packages or that it delegates this function to a suitably qualified third party to review cases. 3. How are policies valued? There is no consistent approach to the valuation of Life Settlement policies in the market and this gives a wide range of reported performances. Life Settlement policies are an unusual asset class in that they give rise to substantial realised gains on early maturities that are offset to an extent by unrealised losses on policies that remain in force. It is not usual for policies to be sold on at a profit, although this can happen. Additionally it is important to consider how much a valuation basis may deviate from a realisable value particularly with open-ended funds where if policies

4 are overvalued, redemptions may lead to draconian gate-keeping measures on redemptions. To what extent are actuarial models involved and how robust is this. 4. How are parties remunerated? It is normal for funds and companies to disclose in some detail the fees on a fund structure and it is worthwhile comparing these stated fees against the fee outgo in a company s reports and accounts. Origination fee arrangements are typically disclosed in much less detail and it is worthwhile exploring how the fee process and controls work for the origination process. In particular it is worth asking what proportion of the origination price goes to the Manager; the Provider; the brokers and advisers; and to the policy owner. Funds that remunerate advisers should provide full transparency on their remuneration structure. Avoid funds that are not prepared to openly disclose their fees and remuneration packages. 5. How are fees calculated? Some fees may be expressed as a proportion of value or price whilst others are a proportion of Face Value. The Face Value of a policy is the amount that will be paid on the death of the life insured. Typically this will be three to five times the size of the value or price of the policy. When comparing providers and funds an investor would be advised to bear this in mind. Performance fees are another important consideration. In a market where there is very little uniformity in valuation methodology there is considerable scope for abuse in arriving at performance fees. How the performance fees are calculated is a key consideration and front-loaded fee structures are best avoided. 6. How does the Manager approach liquidity provision in its funds? Life settlement portfolios generally require liquidity to meet premiums and expenses. Failure to meet these will result in a loss of value because policies will lapse. Liquidity provision is therefore a key to the operation of a successful life settlement fund and there needs to be a combination of a liquidity facility and non-policy liquid assets in the fund. Liquidity is especially important to open-ended funds because whilst it is simplicity itself to maintain liquidity when a fund is receiving subscriptions, it is a different matter when a fund begins to suffer net redemptions. For example, SL Investment Management operates a liquidity banding whereby action is triggered if cash and facility levels fall below a certain pre-determined level and where investment is capped based on holding sufficient assets to withstand sustained periods of limited income. The liquidity is stress-tested both using stochastic models and deterministic models. 7. How are mortality and longevity dealt with? Mortality in the elderly population is always improving and it is important when assessing policies to consider how their likely mortality is going to emerge. Life Expectancy is an actuarial term which means the average time remaining for which an individual will live. Some people will die before this date and some will die after. It is important that a fund manager is aware of this and allows for this effect both in the valuation and in any forecasts or liquidity planning. This should be on a rolling basis to reflect actual mortality experience across the whole portfolio not simply one calculation at the outset of the fund.

5 8. How does the manager approach the operational risk within life settlements? The legislation and licensing and the practical realities of running a life settlement fund means that there will be numerous third parties involved. Investors are dependent upon all of these functions operating properly. Tracking the status of the insured lives, renewing documentation, payment of premiums and other unglamorous functions need to be performed and the Manager needs to ensure that these are monitored and reported on and, where necessary, remedial action is taken. The impact of policies lapsing can be quite dramatic. 9. How are conflicts of interest managed? Some funds may combine certain functions. For instance some Managers also provide sourcing services and may have their own internal valuation services. The life settlement market is a new market and specialist providers of such services are not available and so it is neither uncommon nor unethical for such conflicts to exist. It is important, however, that parties involved in the transaction disclose such conflicts and can explain how they are managed. 10. Is the fund tax efficient? In 2009 the IRS issued new guidance on taxation of life settlement transactions. This brought much-needed clarity to the market but also created a number of problems for funds and companies that held such policies in countries that did not have a suitable tax treaty with the United States of America. Some funds have yet to solve these issues.