After the collapse of Lehman Brothers in 2008, one of the few asset classes which seemed to keep rising - other than government bonds - were traded life policies (TLPs).
Funds bought American life policies from holders who no longer wanted them and typically had a limited life expectancy. The funds carried on paying the premiums on the policy and collected the full face value at maturity – typically much higher than what they had paid for it originally. Whether the markets were moving down or up, policyholders continued to pass away, and policies continued to mature.
The behaviour of TLPs seemed completely unconnected to the wider financial turmoil. They became the ultimate uncorrelated investment.
However, the crucial word in the TLPs market was “traded”, or how frequently the policies changed hands – in other words, how liquid they were. As Andrew Walters, the finance director of Policy Selection’s Assured, Secured Life and Life funds, explains, liquidity dried up in the market after the Lehman collapse.
“All trading ground to a halt,” he says. Funds needed extra liquid assets of their own to fund their activities and keep returns on the path that had been set by their models.
In addition to withdrawals by investors, funds needed to have enough cash to cover premium payments, as well as hedging out massive swings in the dollar and its impact on returns for sterling investors. (News analysis continues below)
Fears over premiums were also exacerbated as underwriters revised American life expectancies upwards, and in particular life expectancies of the often wealthier, advised type of policyholder who would be more likely to sell a life policy in the first place.
Now that investors fear a new Lehman moment in the eurozone, providers of retail life policy funds are trying to prepare investors for another market drought.
Walters says his funds have responded in several ways, and lists four examples. First, after June 2009, the Assured fund in particular allowed investors to withdraw only at net realised value, or the value the policies would fetch if they were not allowed to mature and were sold at their current realisable price in the market.
”It lulls people into a belief they understand how it works, whereas in fact they probably don’t”
Second, the fund ensured it had enough cash at its disposal to cover at least 12 months’ worth of premium payments, even if life expectancies went completely against the fund and no policies matured during that year.
Third, the fund took out a line of credit in case it wanted extra money to help pay its expenses.
“You can also execute a bond issue out of Belgium to fund redemptions,” Walters adds, although he says such a scheme is not in place on the fund at the moment.
Fourth, Walters launched a new Life fund to buy policies from third parties and take advantage of low valuations. He says this fund holds at least 24 months’ worth of premiums in cash.
Other retail providers also aim to stick to the 12-month rule on premiums. Peter Winders, the marketing director at EEA Fund Management, which runs a large life settlement fund, says the fund aims to hold 8% in cash at any one time to cover 12 months of premium payments and has only ever had 1-2 percentage points more or less than that at any one time.
However, Winders says the fund also receives $10m-15m (£6.3m-9.5m) in cash from maturing policies a month, enough to cover premium payments 1.6-2.5 times over. EEA medically assesses the seller of each policy and selects policies with shorter periods until they mature. The investors in a fund are also diversified by size and geography, meaning the largest withdrawal from a single investor would represent only 1.3% of the value of the fund.
Some providers underline, however, that although covering premiums and withdrawals is key, it is also dangerous to underestimate how much cash is needed to hedge out currency movements between sterling and dollars.
Jeremy Leach, the group managing director at Managing Partners, which runs the Traded Policies fund, also aims to keep enough cash to fund 12 months’ worth of premiums and any withdrawals by retail investors. But he also says he sets aside a considerable amount of liquidity to cover hedging costs.
Leach says that before Lehman collapsed, funds often used currency forwards, or agreements to buy and sell currency on a certain date at a set price, but the collateral that funds needed to post on their forward transactions ballooned in some cases after Lehman collapsed and sterling fell massively against the dollar.
Leach adds that it is more efficient at least to use a certain quantity of currency options, which give you the option of buying currency at a set rate on a set date, but do not leave you with any obligation to do so.
However, some providers do not consider that any of these measures go far enough to protect retail investors.
Patrick McAdams, an investment director at SL Investment Management, says 12-month liquidity is probably too short term and prefers a 24-month period.
McAdams adds that his firm does not market its TLP investments to retail investors, including most advised retail investors. This is because investors and advisers have to be sophisticated enough to understand the risks of managing liquidity in what is a complex and unusual field.
“The liquidity component of this asset class is why it is not suitable for retail investors,” says McAdams. “Most independent financial advisers are also retail investors. They’re relying on the people selling the product for information. They aren’t doing the independent work an institutional investor would do.
“It’s easy to explain it in a way which sounds very simple and makes sense, but it lulls people into a belief they understand how it works, whereas in fact they probably don’t.”
Leach says Managing Partners will deal with retail investors as long as they are sufficiently sophisticated, but he warns that financial advisers must be selective about who they put in that category.
“The judgment call is really down to an IFA,” he says.