A new report by Professor Merlin Stone of the Bristol Business School says that institutional investors have significantly stepped up their investment in traded life policies (TLPs) over the last year as they seek assets uncorrelated to equities or bonds amid the market turmoil. However, the report warns against the growing practice of securitisation of TLPs that is being conducted by institutions across Europe.

TLPs are US-issued, whole of life assurance policies sold before the maturity date to allow the original owner to enjoy some of the benefits during their lifetime.

The report, entitled The Market for Traded Life Policies, estimates that investment in TLPs from both institutional and retail investors has risen by more than 50% over the last year. Professor Stone points out that the combined assets of the five largest funds distributed in the UK grew from $405.2 million on 1 November 2007 to $621.4 million on 1 November 2008. The report estimates that investment by institutions into these funds rose from $303 million to $466 million, or 54%.

Managing Partners Limited, a leading provider of TLP funds and sponsor of the report, has seen investment in its own Traded Policies Fund rise from $38.8 million to $100.8 million, or 160%, over the 12 months to 1 November 2008, of which around 75% has come from institutions.

However, Professor Stone highlights the increasing use of TLPs in securitisation instruments as an area of concern. TLPs are being used to back special purpose vehicles in a similar way to the securitisation of mortgages that lay at the heart of the global financial crisis. However, Professor Stone says the early maturing policies have often been taken from these portfolios and they are less likely to deliver the returns needed to support the notes they back.

Professor Merlin Stone said: “The returns delivered by just about any other asset class over the last couple of years stand in stark contrast to those delivered by TLPs. There aren’t many other investments that have delivered double-digit returns in the markets we have seen in that time and institutional investors are increasingly recognising the value of TLPs as an asset class. However, institutions still need to beware - the growing use of securitisation instruments with TLPs is fraught with risks for unwitting investors.”

Jeremy Leach, Managing Director of MPL, said: “The market events of the last year have proven the real value of TLP funds’ ability to deliver steady, predictable returns, no matter what is happening to other asset classes. Institutional investors have now caught on to the impressive returns delivered by TLP funds and are investing ever increasing amounts into them. So much so, we can now list five of the world’s top 20 banks and five of the UK’s top 10 life offices among the institutions now investing in our own Traded Policies Fund.

“Professor Stone is right to show concern over the growing use of TLPs in securitisation instruments, however. Some of the securitisations are deeply flawed and institutions would be much better to invest in TLP funds, which offer better, more secure returns and better liquidity with lower charges.”

Professor Stone’s paper identifies a number of key reasons for rapidly growing demand from institutional investors for funds investing in TLPs:

Steady returns: TLP funds offer steady, predictable returns that make them an ideal asset for pensions to use as part of a liability-driven investment (LDI) strategy.

Greater choice: The TLP market was worth around $13 billion in 2005, but it is expected to grow on average by around $5.92 billion a year between then and 2030, when it could be worth around $161 billion.  This means that there is much greater choice and opportunities for TLP fund managers when deciding which policies to buy, which should have a beneficial impact on performance.

Reduced risk: TLPs are guaranteed to grow in value because in the vast majority of cases, the maturity value is known at the outset and the price offered for policies is always at a substantial discount.  This certainty means that TLPs remove some of the risk associated with more mainstream investment asset classes.

Improved life expectancy estimates: The TLP fund management industry has dramatically improved its life expectancy estimates.  The industry has been able to develop more robust claims data and improve its actuarial models, improving the quality of TLPs held in its funds.

Low correlation: The performance of TLPs is not tied to other asset classes such as equities and bonds.  This provides investors with another opportunity to diversify and reduce risk.

Track record of attractive returns: TLP funds have been able to deliver consistently attractive returns for less risk. For example, the institutional GBP share class of Traded Policies Limited, an open-ended investment company managed by Managing Partners Limited (MPL), has returned 32.16% between its launch on 31 July 2005 and 1 December 2008. Over the last 12 months, it has returned 10.47%.

Improved regulatory environment: New regulatory codes covering the TLP market have recently been passed in a growing number of US states which will contribute to the growth potential of the market by providing an environment in which it can flourish.

In reviewing the TLP market generally, Professor Stone has also identified a number of other risks that investors need to be aware of.  These include:

Life expectancy estimates: If the life expectancy estimates turn out to be inaccurate and the average life assured lives longer than predicted, the return on that policy will be lower.    The fund manager needs to purchase a large number of policies so that the risk of inaccuracy is balanced by spread.  They need a strong claims experience which can be factored into a robust actuarial model to ensure that the returns on their fund are smooth as opposed to spiked.   Fund managers should ideally obtain at least two life expectancy estimates on larger policies that it plans to purchase and reject them if there is too much disparity between them.

Premium Liability:  In addition to the impact on yield, if the average life expectancy on a policy turns out to be inaccurate and premiums must be paid for longer than anticipated, this will reduce the net asset value.

Currency Risk: TLPs are US dollar-denominated assets. However, any fund that has non-USD share classes can be hedged to reduce currency risk.

Liquidity: The TLP market is similar to most other financial markets in that assets are freely traded. However, the timing needed to settle a trade is longer than in many financial markets due to the specialized nature of this asset class. For this reason, liquidity risk may arise if the sale of one or more policies takes longer to complete.

Counter party risk: There is a risk that the insurance company that issued a policy which a fund has purchased may default on its obligations to pay out upon maturity of a policy. This risk is reduced by policy spread or by diversifying across a range of insurance companies’ policies and also by the fact that each US State operates a compensation scheme that indemnifies policyholders against insolvency of the issuer.  Professor Stone says that a fund manager has to demonstrate a spread of assets, and in the case of TLPs, this means a spread of insurance companies taking into account their different credit ratings.

Contestability law - In the US, contestability law prohibits an insurer from repudiating a claim on any grounds once a policy has been in force for at least two years. This risk can be avoided by not buying contestable policies. However, there is a risk that the two-year period may be extended to five years at some stage.

This entry was posted on Tuesday, December 2nd, 2008 at 3:13 am and is filed under Managing Partners News. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.