Is Elsa's life settlement code a step in the right direction?

The code seems a bit waffly to me - and a bit pointless - why bother stating that you are going to comply with laws and regulations - I dont think you need a code for that!

Probably the biggest issue for me is the way in which the policies are valued.

Unlike other assets, where the value is what the market says it is, the value of these policies is made up by those promoting the funds (they say that actuaries calculate what the policies are worth, but that's just technical language for "making it up").

The value of the policies will go up and down - in accordance with demand, supply, changes in life expectancy, and the relevant discount rate for the sum insured and premiums, the cost of hedging the currency risk etc. The value of the units in the fund will reduce when demand reduces, supply increases, life expectancy increases, discount interest rates (probably the redemption yield for Treasuries) rise, and when the cost of hedging rises.

But what happens is that the price of units only ever goes up. Until there's a crisis, and the poor investors get told that the value of their units isnt what they thought it was.

So, to make the sector work, realistic valuations need to be applied, and the funds need to produce better information about what assets they hold (one or two companies have started to do this).

And, the funds need to be independently audited on a more regular basis - nobody really trusts the providers of these funds any more, so if a well known auditor were to provide confirmation that the fund does actually hold the assets it says it does - perhaps every six months - then people might feel more comfortable.

I agree with Phil Wise. The idea of a Life Settlement Plan looks a good idea in principle/on paper, which is why so many fell for the idea of an "uncorrelated assets class".

The problem is with the number of cooks involved, with no head chef taking responsibility and all those named running for the hills when something does go wrong (as with Keydata) and leaving the poor IFA the only one still in the Kitchen when the Food Standards Agency arrives.

Even now it's there is some debate as to whether the Keydata plans were UCIS or even CIS or where they fall on the FSAs regulatory landscape.

As an alternative to a purchased life annuity or an insured bond, they had to be considered and then whichever of the three looked least suitable discounted, but I think a lot of us now wish we had discounted the Keydata plans and NOT PLAs or insured bonds with clearer FSCS protection

I agree that the valuation of the policies is the major issue.

The value at which policies can be bought and sold will vary in accordance with market conditions.The actual value of the policies within a fund will not actually fluctuate if they are bought on a "buy and hold" basis.

Within th Traded Policies Fund, run by Managing Partners, the valuation of the policies is undertaken by a third party actuarial company and audited on an annual basis by BDO.

The revaluation is done on the basis of pushing out the life expectancy (LE)fractionally as each month passes. This is going with the assumption of an 80 year old having a longer LE than a 79 year old as they have already achieved the greater age. Thus by continually reviewing the LE, there is always some value in the maturity of the policy, rather than the straight-line valuation method that produces a toxic tail.

The problem with Keydata/Lifemark was that it was marketed to be held within an ISA, the upshot of which produced a tax bill that could not be met from the fund. Also in the background there is a suspicion of fraud due to misappropriation of funds. Both of these points have little to do with the underlying investment in Life Settlement policies.

This asset class is still relatively new. the statistics for suitable policies coming on to the market in the future are quite impressive. Many US states are introducing rules similar to our own Open Market Option rules because many Elderly Americans are not aware that their policies actualy have a value. The effect could be likened to getting equity release out of properties. in 2007, 85% of policies lapsd paying $0, nil! 12% of policies paid the death benefit. 3% of polciies were surrendered to the carrier and 0.1% of polcies traded according to the American Council of Life Insurers.

Policies are provided by many life insurance companies and normally with a credit rating of AA or higher.

As you may have picked up, I am in the life settlements business and am frustrated that this asset class is given such a bad press. If the fund is well managed, with good levels of liquidity to cover premiums and redemptions, it really can produce consistent positive returns.

I would trust life settlement funds more if they had every now and then a negative month. I am personally very suspicious of any fund that can grow 9-10% pa without there ever being a negative month. As has been said above, valuation of these funds is the key.

I would also like to see some sort of indication of the current surrender values of the funds. ie, where would the fund stand if there were mass withdrawals and the fund suffered a liquidity crisis. Again, one would hope that this wouldn't happen, but at least some understanding of the potential downside in the event of a firesale would be useful.

I agree that it does look rather unlikely to have constant positive returns.

The method of valuation stems from the original calculation involving the purchase price of the policy and the coverage of premiums through to a conservatively based life expectancy figure.

The constantly upward valuations are the effect of equitably unwinding the value of the policy by pushing back the LE each month to reflect the survival of the policyholder for that further month.

The Traded Policies Fund is run on a "buy and hold" principle and the expectation is to hold policies until maturity. The trick is to hold a sufficient spread of policies between providers and also within a fairly narrow age range. So that there is always a natural turnover of money into the fund.

The purchase of smaller policies not only enables this spread to be achieved easier, it also means that it takes us to a less affluent demographic within the fund. Somebody with $5,000,000 of life cover is likely to be able to afford the best medical help and live longer than someone with a much smaller policy.

The re-selling market for life settlement funds is like any other in that price is in line with market forces of suppy and demand. Therefore, the timing of any sale is important.

We protect ourselves from some liquidity issues by having clauses within our fund, similar to MVR in endowments. Therefore, a large investor needing to withdraw from the fund will agree at the time of investment that any losses from a forced sale within the fund will be covered by the large investor and not passed on to the remaining fund investors.

Obviously, like any other investment fund, in any asset class, large withdrawals could cause liquidity issues and due to the nature of life settlement policies, we would require time to cover mass surrenders.

I agree that it does look rather unlikely to have constant positive returns.

The method of valuation stems from the original calculation involving the purchase price of the policy and the coverage of premiums through to a conservatively based life expectancy figure.

The constantly upward valuations are the effect of equitably unwinding the value of the policy by pushing back the LE each month to reflect the survival of the policyholder for that further month.

The Traded Policies Fund is run on a "buy and hold" principle and the expectation is to hold policies until maturity. The trick is to hold a sufficient spread of policies between providers and also within a fairly narrow age range. So that there is always a natural turnover of money into the fund.

The purchase of smaller policies not only enables this spread to be achieved easier, it also means that it takes us to a less affluent demographic within the fund. Somebody with $5,000,000 of life cover is likely to be able to afford the best medical help and live longer than someone with a much smaller policy.

The re-selling market for life settlement funds is like any other in that price is in line with market forces of suppy and demand. Therefore, the timing of any sale is important.

We protect ourselves from some liquidity issues by having clauses within our fund, similar to MVR in endowments. Therefore, a large investor needing to withdraw from the fund will agree at the time of investment that any losses from a forced sale within the fund will be covered by the large investor and not passed on to the remaining fund investors.

Obviously, like any other investment fund, in any asset class, large withdrawals could cause liquidity issues and due to the nature of life settlement policies, we would require time to cover mass surrenders.

Tony

I think you're wrong with regard to valuations.

Like any other asset, the value of a policy is the value it will fetch in the open market, not the value an actuary ascribes to it on a "buy and hold" basis. The policies in the fund need to be valued in a similar way to other illiquid assets, like commercial property, less liquid high yield fixed interest stock etc.

That way you could also minimse the likelihood of a penalty when you have to sell policies.

The problem with the valuation of the policies in the MPL fund is that it is a manufactured valuation (which is why you refer to a "trick" when you describe the valuation method) - surely it would be better to look at the price of similar policies which are being traded in the market month to month, and then use that to determine whether the policies have increased or reduced the value. Commercial property funds often start by looking at the IPD index, and a similar index could be created for life settlement funds, couldnt it?

An annual audit just isnt frequent enough. The last audit of the MPL policies is now over a year old - what investors want is a third party assurance that you have got the policies and the money, not an out of date audit.

You have said that more policies should come on to the market. So there will be an increase in supply. Without an increase in demand, with all other things being equal, the price of the policies will fall. An increase in the supply of the policies has to be a bad thing for those who already hold them.

Philip, you would be right if we were buying and selling policies. The "buy and hold" policy means that we do not have any intention of selling. Therefore, the policy selling value is only ever relevant in extremis. As I already pointed out, a large investor would have to cover that kind of loss rather than affecting the other investors in the fund.

Because we are looking to hold polcies until maturity, we are very careful in policy selection before we actually buy them. Our calculations of price include the sum assured less the expected premiums to a relatively long LE and some margin to give some cover for people outliving the LE. This is the downside of the whole arrangement. We know what the policy will pay out, but not when. Therefore, by constantly revaluing, we can be reasonably sure of the true net value of a policy at any stage in the process.

As time goes on, our expertise in increasing in respect of valuation with experience of maturities and dealing with redemptions over time. Also with a greater number of policies within the fund, the turnover is greater and the fund becomes much more robust.

The extra supply into the market will have a very good effect for MPL. It will give us greater choice and a better price for us in buying.

I believe that the most recent audit is about to be published and look forward to being able to discuss this with you and other interested parties.

Sorry Tony, that argument doesnt work, and I think it hinders the development of your fund and the life settlements asset class as a whole.

It's like saying that people are right to imagine that their house is worth more than it is, as they dont intend selling. We all know that its just not true.

If you are expecting to get a better price for buying policies, then the value of the policies you already hold will go down. People expect investment values to go down as well as up, and they're right to be distrustful of something that only ever appears to go up. If you mark your current assets to market, and the value goes down as well as up, your fund becomes more credible, and people will become less sceptical about the asset class.

I think it would help you if you increased the frequency of the independent audits - one of the problems with life settlements is that people are concerned that you dont have the assets you say you have, and they need more reassurance.

Philip, the purchase of new policies into the fund makes absolutely no difference to the value of existing policies in the fund. The fact that new policies into the fund are bought at better value to the fund will simply mean greater potential for value to the fund.

Using your argument, shares held in an equity fund would all reduce in value if a new share is bought into the fund.

A policy is valued at outset as I explained previously. We know the value that will come out on maturity and the actual value of the policy within the fund is dependent upon how many premiums need to be paid before maturity of the policy. The fact that another policy is bought for less money makes no difference to the ongoing value of the existing policies in the fund. Each policy is valued on an individual basis throughout its term and revalued on a monthly basis.

The policies in the fund are valued by the independent fund administrators, Custom House on a monthly basis and an audit is undertaken by BDO on an annual basis. It would be unusual for a full audit to be undertaken more regularly.

We compare our performance to the AAP Life settlements Index.

We have recently obtained a AA rating from Telos and are currently having a report on the fund prepared by AKG.

The Traded Policies Fund is distributed in the UK by Managing Partners Capital, which is registered with the FSA as an Appointed Representative of Sturgeon Ventures LLP. This means that we strive to provide all our literature and information up to the quality and clarity that is demanded by our regulation by the FSA.

Our problem is that other funds within the asset class have not been managed so well. Some have suffered liquidity problems to the extent that they have stopped allowing withdrawals.

At the other extreme, mismanagement and miss-selling of life settlement based funds have not done the asset class any favours.

I can see that you have a good understanding of the asset class and would be delighted to provide any further information that would be helpful to you.

I would recommend that you read the Merlin Stone report that has recently been published and we also have an Offering document and Due Diligence document that will provide you with some idea of the mechanics of the fund.

Alternatively, we run regular Masterclasses at our office in Chichester and often around the country.

Tony, if a fund owns an equity, and the value of that equity reduces, so too does the value of the fund.

According to your argument, if a fund owned an equity, it would simply value the equity according to some formula it had agreed with an actuary, rather than according to what it was worth in the market.

I like the concept of traded life policies, but I dont believe that the valuation method used is robust.

I've read the Merlin Stone report, and have met with one of your representatives and looked closely at your fund. In fact, I quite like your fund.

But, as a result of the poor valuation methodology, I find it difficult to recommend to anyone other than a very sophisticated investor, who may understand why the value quoted by you is only applicable if you have sufficient liquidity to pay out redemptions, and if you dont, it could be way different.

I think it would be good if the asset class could be turned into something more marketable.

I think you would be better creating a UK investment trust (thus avoiding most of the liquidity issues), having the benefit of proper UK regulation, and allowing investors to determine the price of shares. This would help the asset class to build credibility, and might give you the possibility of launching credible open ended funds in the future

Philip, thank you for your comments, I shall take them back to the board for their consideration. As you probably realise, UK regulation is quite complicated for an offshore fund, using monthly dealing and based on life settlements.

Believe me, we are keen to do anything that would increase the credibility of the asset class as can be seen from our FSA regulation of the UK distributors and the pursuit of ratings such as Telos and the AKG report.

Unfortunately, the asset class has had some horror stories in the past, which causes us problems on a daily basis!

Tony - I agree with Phil Wise's comments at Philip Wise

Oct 26, 2010 at 10:58.

In principle the idea of Life Settlements are fine, but in practice you need to look to do what Phil W has said as the FSA speech in February 2010 means no adviser in their right minds will use anything of this ilk for mainstream clients without it.

The FSA has doen a good hatchet job on the asset class. However, we did respond to Peter Smith and I have summarised the response below.

The FSA is right to raise concerns about products in the traded life policy market. But all of these concerns - and more - were raised in the Merlin Stone Report 2008, which pointed out that rapidly growing popularity of TLPs has its dangers and that TLPs are still widely misunderstood, even by institutions. The growing use of securitisations is a particular concern.

"But none of this detracts from the fact that funds that invest in TLPs with the right diversification of policies, prudent actuarial analysis and due consideration to increasing life expectancies can deliver steady, incremental returns of 8-10% a year that are uncorrelated to other financial markets. The positive performance of several TLP funds in recent years proved this to be the case despite some of the worst market conditions imaginable.

"Investors need to look at transparent, open-ended investment funds with reasonable track records and conservative charges from product providers with authorised distributors in the UK. They should avoid those funds that have performance fees because this raises the issue of moral hazard and secondly because funds are buying an asset class with a fixed maturity value and limited upside potential, so the only way to gain alpha is by having conservative annual management fees.

"IFAs have a tough job because they need to assess this asset class and it is only right that the product provider or promoter provides the information to assess suitability and risk."

It is a shame that the asset class as a whole has come under fire because closer inspection of the funds available show quite different investment strategies and charging strcutures. Obviously, all of this will not make the choice of the IFA any easier as the research required takes a lot of time. I have done research into the various funds available and would be delighted to provide it should anyone wish. The information is all on the various websites and in the public domain, but it was not all that easily available and took quite a while to collate.

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I could be being think here, but I'm a bit simple and so are my clients. while I get everything Tony is saying and would not be averse to using Life Settlements, even AFTET the Keydata debacle, I you not talking about UCIS which requires the client to be a sophistictaed investor and all that goes with that which NONE of my clients are?

The sophisticated client definition is open to interpretation. If you refer to the FSMA PCIS order it will define a provide a definition of a sophisticated investor. However, if you refer to COBs 4.12, category 2 - promotion is allowed to a person for whom the firm has taken reasonable steps to ensure that investment in the collective investment scheme is suitable and who is an established or newly accepted client of the firm or of a person in the same group as the firm. The source of this is the FSA factsheet on UCIS.

As previously outlined, the Keydata problems were not really related to the Life Settlement policy based funds other than the fact that they should never have been put into an ISA product, being unregulated. This caused a tax liability that the fund could not cover from liquid funds.

Open to interpretation would be fine if it were not the FOS, PII and FSA we are talking about. No disrespect to you Tony, but you need to sort that out with the F-pack before any IFA in his right mind will consider Life Settlements.

Sorry to post off the record, but being positive about teh idea of Life Settlements (which I am, but only the idea, not the in practice) is likely to get me attacked by certain other IFAs, which I could do without at the moment

As you know, the FSA is far better at pointing out the error of your ways than giving actual meaningful guidance.

I am sorry that you would become a social pariah by thinking about life settlements. It could be worse, they used to nail people to crosses!

The ELSA Code of Practice reflects the association’s commitment to transparency and best practice. As such it calls for openness and clarity in all areas, from origination right through to the relationship between fund managers and investors.

However, the Code is much more than an overarching call for transparent practice and contains clear guidelines that specifically address problem areas within the industry and the particular concerns of the FSA regarding retail investment in the asset class.

STOLI (Stranger Originated Life Insurance):

Under ELSA’s Code, investment in STOLI policies is prohibited: members may not purchase polices they believe were issued without a valid insurable interest at policy origination.

Life expectancy estimation:

ELSA’s Code requires investment managers to use ‘conservative’ life expectancy estimates and to detail the number of different companies used to provide life expectancy estimates and what methodology has then been used to feed this information into overall projections. This provision quickly flushes out whether greater weight has been given to more favourable estimates, a common practice that ELSA is keen to reduce.

Portfolio liquidity:

Fund managers must calculate and report on the expected time period until an insolvency event would occur, if no new cash flow were to be committed to the product. If no liquidity facility is to be deployed, the marketing literature should clearly explain why this is not required.

Fees and commissions:

ELSA´s Code calls for full disclosure of all fees and commissions charged, as well as transparency on the roles and responsibilities of all the parties involved, from the origination of policies right through to the day-to-day management of a fund.

ELSA also highlights performance fees as being of particular concern, as they are not always aligned with the interests of investors, notably when the party benefiting from a fee based on fund value also provides input into the valuation. The Code specifically requires that the fund or product structure should be subject to independent valuation in order to eliminate the potential for exaggerating performance to increase related fees.

Concentration of risk:

ELSA’s Code of Practice states that life settlements should not comprise a significant percentage of an individual investor’s portfolio. It requires product providers to stress to their distributors the role of life settlements in enabling diversification within the investment portfolio and that the percentage of investor money committed should be a fair reflection of that diversification.

Fund managers must review above average capital investment via a distribution partner and above average volumes of sales.

Our Code is a living framework, intended both to encourage and reflect the development of the European life settlement industry in the years ahead. As the market continues to mature, the Code will be updated to ensure that it continues to best serve the needs of the life settlement investor. To this end, I would like to invite all members of the industry to offer comment and feedback on the Code.