Martin Fagan investigates the rise of insurance policies as an attractive defensive asset class.

It has taken a banking crisis, a stock market collapse, a global credit crunch and interest rates falling to almost zero per cent to make endowments fashionable again.

Twenty-five years ago, endowments were seen as the Swiss army knife of financial products, suitable for everything from paying off your mortgage to school fee planning.

But their fall from grace was as swift as it was spectacular – the accusations that the policies were mis-sold and constant headlines in the financial press that dwindling bonus rates meant the maturity payout might not cover the outstanding mortgage on a home, all contributed to their near-demise.

‘With-profits endowments are often given a bad press,’ says Brian Goldstein, chairman of the Association of Policy Market Makers (APMM). ‘But the last performance survey, published at the end of 2008, showed an average annual return of 8.3 per cent over 25 years. This means that with-profits policies outperformed the average of Balanced Managed, UK All Companies and UK Equity Tracker funds and both instant-access and 90-day notice accounts over 15, 20 and 25 years. It also shows that, over 25 years, the average endowment returned more than double the average instant-access account.’

Back in vogue
So if endowments have never been as awful as they’ve been made out to be, why are they suddenly fashionable again? ‘I think it is the way they were perceived by the investing pubic,’ says Ian Cotgias, senior actuary at Surrenda-link Investment Management, the advisory and management arm of Surrender-Link, which has been trading endowments since 1990. In that time, the firm has traded more than £1 billion of policies.

‘The connection with mortgages was where all the bad publicity in the 1990s stems from. Because they were sold on the back of unrealistic expectations, this has detracted from their benefits as an investment class.’

Cotgias believes the ‘smoothing’ effect of the bonuses – where gains in good years are held back to bolster bonus payments in years when markets have performed less than spectacularly – is an ‘enigmatic feature’ that makes endowments attractive. The strong guarantees of the sum assured and the accrued bonuses are augmented by the protected nature of life companies’ with-profits funds.

A degree of protection
‘In a life company, the with-profits fund is ring fenced and, because assets have to match liabilities, the life company can’t raid the with-profits fund to pay out as dividends to shareholders,’ says Cotgias. ‘They are also backed by the FSA’s financial compensation scheme. They offer good stability in falling markets because the maturity values are slow to adjust to the falling market. Surrender values adjust more quickly to a falling market and are slow to adjust to a rising market, which is one of the reasons it is better to trade your endowment than surrender it back to the life company.’

With-profits endowments are a distinctly British product. And, as each policy is written on the life of an individual, all are unique, but they have features in common: the monthly premium, the term of the endowment (usually 25 years) and the basic sum assured. When the policy finishes its term, the accumulated annual profits and the basic sum assured are paid to the policyholder. This can be augmented by a ‘terminal’ bonus, but this is discretionary and isn’t guaranteed.

A contrasting model
In the USA, they do things slightly differently. They don’t have traded endowment policies (TEPs) but they do have traded life policies (TLPs), otherwise known as ‘life settlements’. So what’s the difference between the two?

‘They differ in very important ways, which affects their performance as asset classes,’ says Jeremy Leach, managing director of Managing Partners Ltd (MPL), an investment house that also offers advice and consultancy on the acquisition of TLPs.

‘A TEP is an asset that is tightly correlated to all the other major asset classes – shares, bonds, property and cash – none of which are doing brilliantly at the moment. When you buy a TEP, you’re buying a savings plan and projected maturity value at a fairly hefty outlay, and your return is the maturity value minus the purchase price and the monthly premiums you’ve paid.’

A TLP differs in that it is a ‘whole of life’ insurance policy that lasts for the lifetime of the holder – it is basically life assurance – and they are always assignable so can be traded or sold on. The buyer of the policy pays the premiums and when the policyholder dies, the buyer gets the insurance payout.

‘A TLP has absolutely no value to the holder,’ says Jeremy Leach. ‘The buyer is negotiating the price up from zero, so is more in control of locking in an eventual return. In the USA, 93 per cent of life policies lapse because the holder stops paying the premiums. In 2008, that meant $1.4 trillion – yes, trillion – of life cover lapsed without value. If someone needs cash, it is better to raise it on a life policy that has no value to them than selling the family home.’

Weighing up the prospects
Leach says that both TEPs and TLPs have three factors – premium, longevity and final value – two of which are known and one unknown. ‘With a TEP, you know the monthly premium, you know when the policy will mature but you don’t know how much the payout will be,’ he says. ‘With a TLP, you know what the premiums will be, you know how much you’ll get but you don’t know when you’ll get it.’

For the UK life industry, the business involved with writing new with-profits endowment policies is almost non-existent. When the endowments that life offices issued back in the 1980s and 1990s are either surrendered or mature, the market could dry up. But that is not the case with TLPs.

A recent report by the Pensions Institute predicted that the market in TLPs will grow more than tenfold in the next few years. The market is currently worth around £6.5 billion; according to the Institute’s estimates, it could soon be worth £80 billion.

A report published in December 2008 by Professor Merlin Stone of the Bristol Business School estimates that, in 2006, approximately $23 trillion of death benefit existed in the USA and that $1.5 trillion of new life cover is sold each year. However, most of the people involved with the TLP market are keen to dispel any thoughts in the minds of investors that TLPs are the same as their predecessors, viatical settlements.

An improved formula
‘Viaticals were most definitely the bad old days,’ says Peter Winders, a director of EEA Fund Management (Guernsey) Ltd, which manages the EEA Life Settlements Fund. ‘Viaticals boomed in America following the emergence of the AIDS epidemic in the late 1980s, as most of the disease’s victims were gay men who had none of the traditional life insurance policy arrangements and needed funds to meet costly medical bills. With mortality rates high and life expectancy short, viatical settlements were mutually beneficial to seller and investor.’

However, advances in medicine meant that some patients began to outlive their prognoses, and some went into complete remission. Others even managed to outlast their investors. This prompted a few unscrupulous souls to portray themselves as desperately ill and sell their policies repeatedly, knowing full well that they would probably survive to a grand old age.

‘Equally unscrupulous investors then decided to take advantage of a deteriorating situation,’ says Winders. ‘Some collected money but never invested it. Others sold on policies to individuals who had little understanding of what they were buying. The result was a rather sleazy mess. Nowadays, life settlements offer a completely different market, with reputable firms taking every step to ensure there can be no return to the scandals of old.’

Spreading your risk
For investors interested in what Managing Partners’ Jeremy Leach calls ‘a steady asset class completely uncorrelated to all the other major asset classes’, the black art of actuarial science proves that the best way to access TLPs is through a fund of TLPs.

Just as holding shares in a single company is hugely risky, so is holding one TLP, as the person on whose life the payout depends might live longer than you. Lots of policies in a portfolio means not only diversification, but also a reduction in volatility as the accuracy of the actuaries’ mortality tables means a steady stream of maturing policies.

‘Wherever you look, the story is broadly similar in terms of negative returns from
all major asset classes – apart from life settlements,’ says Andrew Walters, financial director at Policy Selection Ltd (PSL), which manages the Assured Fund. ‘Stock market volatility in 2008 saw many investors making a flight to cash to shield against falling equity values. But that cash is now doing nothing as the Bank of England has slashed its base rate to the lowest level in history.’

Consistent and stable returns
Walters believes that investors are looking for more reliable investment vehicles that offer a degree of consistency. ‘Older investors, in particular, now face the stark reality of being in negative territory with their cash, as savings accounts are not keeping pace with the cost of living,’ he says. ‘Given the current volatility in global stock markets, investors wanting a core capital growth investment alternative to bonds and gilts – and of course cash funds – will be attracted to our fund.’

According to Walters, since going live in January 2005, the Assured Fund has now delivered 48 consecutive months of positive returns. The Fund’s Sterling Class B – available for investment by private retail investors – has outperformed rival asset classes such as equities, bonds and gilts over the past four years, with an average return of just over ten per cent a year.

Managing Partners’ Jeremy Leach says he expects its fund of TLPs to return around nine per cent per annum. ‘It is a boring asset class but with a realistic level of return,’ says Leach. ‘TLPs do deserve their place as a core asset. In a balanced portfolio, you should have access to assets that are cyclical – shares, bonds and property – but these can be stabilised by something a little more mundane that’s not correlated to the cyclical assets. And that’s where TLPs come into their own.’