SL Investment Management, one of the largest life settlement product providers outside the US, is urging potential investors in life settlement funds to ask ten questions during their diligence processes to ensure a sound choice of investment manager.
The FSA’s comments on the secondary life market at the recent European Life Settlement Association’s conference were welcomed by SL Investment Management.
However, the regulator’s comments neglected much needed detail for potential investors, given the rising interest in the ability of such funds to provide low correlated steady returns.
Jeremy Brettell, chief executive, says: “We agree that the market needs a shakeout but investors need detail now to make informed decisions. Responsible managers should have no qualms about offering bespoke and transparent help and support to investors. This is our approach and it is the honest and diligent approach to take.”
SL Investment Management recommends asking the following questions:
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. 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 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
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 US. Some funds have yet to solve these issues.
