One of the most prudent principles to apply when looking to construct a well-diversified portfolio is to include assets that are uncorrelated, that is, do not move in the same return direction at the same time.

To this end, life settlements have no relationship with other financial investments and can offer a stable source of income, and the asset class has been gaining attention worldwide as investors seek fixed income alternatives in a low interest rate environment.

However, many SMSFs are unfamiliar with life settlements as an investment option.

The underlying assets of life settlements are life insurance policies. Investors can make money on the assets by buying the policy to receive the benefit payout at maturity on the death of the original policyholder.

When someone buys a life insurance policy, they pay premiums throughout their life and upon death the policy pays a death benefit to their beneficiaries.

In Australia, if a policyholder decides they no longer need life insurance, they simply stop paying premiums and their policy lapses.

The experience in the United States though is different. There, life insurance policyholders can sell their cover due to a 1911 US Supreme Court ruling that a life insurance policy is private property and can be bought and sold just like equities or real estate.

This decision allows US consumers the ability to surrender their policy to the life insurance provider for a payment or they can sell it on a secondary market. The price an investor will pay for the policy depends on factors such as the insured person’s age and the death benefit payout amount – or face value – of the policy.

Research from the London Business School in 2013 found life cover owners collectively received over four times more for their policies if they sold them on the secondary market rather than surrendered them to the insurance provider.  As a result, many US consumers choose to sell their unwanted insurance policies on the secondary market.

The secondary market for life insurance policies is known as the life settlement market and it is open to investors situated all over the world.

When an investor in the life settlement market buys an insurance policy from its original owner, the investor takes over responsibility for paying policy premiums, and when the original policyholder passes away, the investor receives the death benefit payout.

Life settlement funds buy a range of life insurance policies on the secondary market and group them into a pooled fund. The fund pays the premiums and receives the death benefit payouts of all of the policies it includes. Funds can also resell policies on the secondary market to other investors.

The fund manager then distributes the payouts among the investors in the fund. Life settlement fund manager Laureola Advisors forecasts annual returns in its life settlements fund will be in the range of 7 per cent to 11 per cent in Australian dollar terms.

Including a diversified range of insurance policies in a pooled fund means investors receive a consistent stream of income as policies in the portfolio pay out at various times.

Managed returns

Life settlement managers can influence returns in their funds by being selective about the policies they buy.

The return on investment in life settlements is based on the final payout, or sale price if the policy is resold, less the upfront cost to buy the policy and the total cost of insurance premiums needing to be paid.

Actuarial calculations can be used to predict the policyholder’s life expectancy, which determines how long the fund will be paying premiums before a payout is due.

But funds can take a deeper dive into the health and well-being of the policyholder to make a more detailed assessment of the expected return. Laureola Advisors, for example, has medical experts in its team to assess policies before they are included.

There are market factors at work too. There is competition among life settlement investors for life insurance policies, so managers must strike a balance between getting the right policies at the right price and missing out to competitors that may agree to buy more quickly.

As in any managed fund, investors pay fees for these management services.

As the underlying investments are relatively illiquid, the funds may impose a lock-up period or charge redemption fees for early withdrawal. For example, Laureola Advisors has a soft lock-up of three years during which investors wishing to withdraw will be charged a redemption fee. After that period, investors can exit any month without charge.