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Despite being debased by mis-selling scandals, traded endowment and traded life policies have a new life in the secondary market, finds Lynn Strongin Dodds

The words "endowment policy with profits" often trigger memories of one of the UK's worst mis-selling scandals. It might be surprising to discover, then, that the secondary market for traded endowment policies (TEP) is enjoying brisk business. Large institutional investors, particularly in Germany, as well as high-net-worth individuals are attracted by their low-risk characteristics and steady returns.

The hitch is that TEPs are no longer being issued and their shelf life is finite as most policies expire in the next seven to nine years.

According to Dan Farrow, chief operating officer of AAP, the UK's largest specialist in the buying and selling of with-profit endowment policies, there are about 8m policies in existence, with the average policy worth between £15,000 and £20,000 (€21,500-28,700). Most were originally taken out about 25 years ago although many holders have sold them before the maturity date. It is estimated that more than £10bn-worth of policies have been surrendered and this has fuelled a healthy and active second-hand market.

Endowment policies' main attractions are stable performance and low risk. The returns on with-profits policies are determined by three elements: the basic sum assured - a cash sum that is guaranteed provided the endowment is held until maturity, as well as an annual bonus, which is added depending on how well the underlying fund performs each year. Once bonuses are given, though, they are guaranteed for as long as premiums continue to be paid until the policy's maturity. There is also a terminal bonus - a discretionary lump-sum payment paid at the end of the policy.

The main reason why endowments have performed badly in recent years is the poor stock market performance between 2000 and 2003, according to Jeremy Leach, managing director of Cayman Islands-based fund management group Managing Partners MPL.

This meant that the reserves of many insurers fell dramatically and cuts in bonus rates followed. Insurance companies have taken advantage of the recent boom in stock markets to slowly build up their reserves. Despite the lower bonuses, though, the payments have still generated returns that are higher than other low-risk alternative investments, such as UK gilts.

"A well-balanced fund will deliver 6-7% per annum," Leach notes. "This may not sound spectacular, but it is a good steady return which makes TEPs an ideal holding in a wider portfolio. The main drivers to buy are that shorter-term policies add liquidity to a portfolio, they have a set maturity date so investors know exactly when their policy will pay out, plus there is no cost in releasing them."

"TEPs are a perfect investment for pension funds pursuing a liability-driven investing (LDI) strategy because they help match assets with the liabilities over the long term," says Farrow. "They are not high risk and can be seen as a halfway house between cash and high-grade bonds. They are especially popular with German institutions that are more conservative than their UK counterparts [and] that until recently have had a lower interest and inflation rate environment. Germans investors also have an inherent tax advantage in being part of a closed-end fund."

 

UK investors might have had less of an appetite for TEPs because of the mis-selling scandal. Endowment policies with profits first gained prominence in the 1980s as popular long-term investment vehicles that were seen as a perfect way to pay off mortgages. In fact, in the 1980s and 1990s they accounted for about 75% of all mortgages sold.

Investors paid a monthly premium and in return were guaranteed a minimum amount that would be paid out after a specified number of years. Investors were drawn by the potential for additional returns generated by the annual and maturity bonuses. Premiums paid by investors were directed into a with-profits fund. It looked good on paper but often the risks and ramifications of being tied to the stock market were not fully explained to policyholders.

For example, many did not fully understand that there were no guarantees ensuring a full payout of the mortgage sum nor did they realise that the banks and building societies were raking in generous commissions. The volatile stock market conditions in the late 1990s as well as the spectacular crash in 2001 exposed the cracks, and investigations were opened into selling practices. In the end, the House of Commons treasury select committee estimated that as many as seven in 10 policies face a shortfall, and that six in 10 had been mis-sold.

The majority of investors bailed out after the stock markets plummeted at the beginning of the century. Although they had the choice of selling an endowment back to the insurance company, many opted to sell their with-profit policies via market makers such as APP, which then sold them on, at a premium, to groups like The Protected Asset TEP Fund.

The main appeal of the market makers is that they do not charge the policyholder but the buyer of the fund. An insurance company will give the holder a cash sum but many believe the surrender values do not reflect the true value of the portfolio.

Although investors can access TEPS through a number of funds, the retail crop is beginning to dwindle. Barclays Global Investors BGI Endowment and the BGI Endowment Fund III have closed and Allianz Global Investor Funds are due to wind down in 2010.

The largest TEP fund, the Protected Asset TEP Fund, is an open-ended investment company and is still going strong. Geared towards retail and institutional investors, at the end of August it had assets under management of £586.5m. Its portfolio consists of such household brand insurance names as Standard Life, Norwich Union Prudential General Accident, Royal London, Co-operative, Britannic Assurance and Clerical Medical.

As for investments, the life offices in the Protected Asset TEP Fund invest in a diversified portfolio comprising fixed interest, property, and UK and overseas equity. However, as Leach points out: "The challenge for investors is to identify those funds that have the greatest potential. TEPs are correlated to equities and bonds and it is very important for investors to do their homework on the insurance companies to see who paid bonuses and who took them away."

Another issue is dwindling supply against a background of greater demand, mainly from German institutions. "One of the problems is that investors have to buy a great deal of policies if they want to accumulate scale, and that is difficult to do," says Simon White, head of investment trusts at AGI. "Also, the TEPs market is fading in the UK. I think that today and going forward there are more opportunities in US traded life policies (TLPs). There is an ongoing supply and they provide an interesting and diversified asset class for those wanting to take different risks." White is not alone in his predictions. A recent UK study, conducted by the Bristol Business School and sponsored by MPL, estimated the market for TLPs would rise from $13bn (€9.1bn) a year in 2005 to a staggering $161bn by 2030, as the number of elderly Americans increases and more retirees choose to cash in life policies before their maturity to receive some of the benefits during their lifetime.

TLP funds, which packages up these policies, are also low-risk investments that slot easily into an LDI strategy. Returns are slightly higher than TEPs at about 7-9% but the main difference, according to Leach, is that they are not correlated to mainstream asset classes. "The returns of TEPs are tied to the assets that insurance companies invest in. TLPs, on the other hand, 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. You know exactly how much they will pay out."

The other contrast is that, unlike TEPs, the market has enjoyed dramatic growth and is poised for more. According to MPL figures, institutional assets are estimated to have soared 50% this past year, led by US and continental European institutions, while assets held on behalf of retail investors jumped 75%.

The market's prospects were not always so bright and its origins do not make for easy reading. These policies first emerged in the US during the AIDS epidemic in the 1980s when victims sold their life policies to pay for their care. They became known as viatical settlements, or policies sold to people who have a terminal illness or with perceived life expectancy of three years. These investments did not perform well because new drugs extended the life expectancy of Aids patients and life expectancy opinions became notoriously incorrect.

From the 1990s, the TLP market has been focused on the population aged over 65 for whom life expectancy forecasts are likely to be more accurate, reducing the level of risk in TLP funds. Again, the major concern remains that sellers of these policies will live longer than expected. To mitigate this, according to Leach, fund managers are advised to buy a large number of policies across a wide range of insurance companies to spread the risk. In addition, the study recommends that fund managers 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.

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