Portfolio Construction

As a Portfolio Manager, one is constantly searching for investments that seek to generate positive expected returns but are not correlated with each other. The problem is that most investments are actually correlated to some degree to the global equity market or interest rates.  Therefore, during times of falling equity markets, one’s equity investments will typically decline and during times of rising interest rates one’s fixed income holdings will typicall fall.  The good news is that these two macroeconomic factors don’t always move hand in hand.  Even with these two important levers at the Portfolio Manager’s disposal it is still important to research the marketplace regularly in search of alternative opportunities where the risk involved is not correlated or has a low correlation with equities or interest rates.

The Funding Dilemma

Even with the changes in the health care system brought about by the Affordable Care Act of 2010, commonly known as ‘ObamaCare’ which included expanding Medicaid to single adults, offering cost assistance for premiums, healthcare costs in the US remain prohibitively expensive.  It is an unfortunate reality that some people will contract terminal illnesses which may result in early death.  These individuals will usually have significant healthcare needs and based on the high cost of healthcare, some people may be pushed into bankruptcy.  Most life insurance policies only pay out when the life assured passes away and do not pay out whilst they are still alive when they need it most.  Many of the insured individuals need funds for medical or living expenses and are thus forced to look to using their 401(k) or selling property to pay for the care they need.  Often this is not enough to cover their healthcare costs and the life assured look to unlock value from their life insurance policies for additional capital.  Most traditional financial institutions will not lend to people in this situation and capital is hard to come by.

Often when there is a demand and supply funding mismatch, the private market steps in to fill the gap.  As life insurance finance is a small, niche market, there are few industry participants.

As a result of this funding shortfall, small firms set themselves up using private capital to buy policies or provide

loans to individuals with policies who require immediate access to capital. The firms use an individual’s life insurance policy as collateral against the funding made to the individual. At the time of death, the proceeds of the policy are first used to repay the loan and interest and the balance is paid to the life assured’s beneficiaries, in the case of loans.  If the life assured wanted more capital than a loan and sold their policy, the life assured’s beneficiary will receive the difference between the policy purchase and the amount the life assured spent on living or healthcare costs that remains in their estate.

The industry has continued to develop and now many more people with late stage illnesses can monetise value from their life insurance policy and also provide capital for their family with any residual amount when they pass away.

This Alternative Credit strategy has become increasingly popular as it provides liquidity to the family during their time of need.  Typical net returns over a 24-36 month period have ranged been between 10-14% per annum. 1

Risks and Costs of the Strategy

The correlation to traditional sources of return (equities and bonds) is low.  From a portfolio management perspective the risk of investing in a pool of life insurance contracts is that the collective lives of the insured may live for significantly longer than the medical prognosis.  If this happens the return on the funding will be lower than expected.  This risk is similar to that of a life insurance company whose risk is that the pools of insured lives live for a significantly shorter time.

Often, there is an origination cost to the loans or brokerage cost on the purchase of the policies as the structuring of the transactions is often complex.  There may also be legal costs associated with loans or purchases.  From an investor’s perspective, a high turnover of loans would be undesirable as the cost of origination, legal and/or brokerage costs would weigh on the portfolio return.  The investor’s objective is for the collective loans to have a maturity that falls within the normal distribution range.

The market risk of the strategy is that the life insurance contracts have less value than expected because the life assured lives longer than expected and the premium costs reduce the net proceeds more than expected.  There is also credit risk in this strategy that is based upon the credit worthiness of the life insurance carriers and their ability to pay out the benefits as per the policies.

Another risk factor of this strategy is illiquidity.  After the loans are made there is usually a limited or no secondary market for these investments and the maturity/term of the investments depend on the life assured mortality. This asset class therefore will not appeal to those who demand liquidity or to those who believe they will demand it in the near future.

As with all portfolio management, diversification is important.  Ensuring that there is diversification across the types of medical conditions of the life assured helps mitigate systemic risks.  Finally, ensuring that there are an adequate number of investments in the portfolio and they are adequately diversified will reduce the idiosyncratic nature of individual investments.

Summary

Unearthing uncorrelated return streams is challenging. Those investors who can accept the illiquid nature of the asset class could benefit from the illiquidity risk premium and the risk premium within this inefficient market. Like all inefficient markets the opportunity is there for investors to plug the funding gap that exists in this market and as more participants enter the market the risk premium narrows. We believe that this may be the case for this asset class over time.

As such, if constructed properly and for those who can afford the illiquidity, adding life insurance financing investments could be a good source of risk adjusted returns to traditional portfolios.

1. Nolex Capital LP, Chapford Capital LP and Chapford Diversified LP

Risk Warnings

This document is for information purposes only.  Nothing herein constitutes, or should be construed as constituting, investment, tax, legal or any other advice or an offer to subscribe in any particular financial instrument or asset class or to participate in any investment strategy.  The views or opinions expressed herein do not necessarily reflect the views of MASECO LLP.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Investing in this asset class is for Sophisticated and Certified High Net-worth Investors.  Always consult a Financial Adviser before making a decision to invest.  Past performance is not a reliable indicator of future performance.  The value of investments can fall as well as rise. You may not get back what you invest.

Issued by MASECO LLP, a limited liability partnership registered under the laws of England and Wales (Companies House No. OC337650), which is authorized and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is registered in the US with the Securities & Exchange Commission as a Registered Investment Adviser.  Its registered office is at Burleigh House, 357 Strand, London WC2R 0HS, United Kingdom.

1 Income means adjusted gross income, as reported for federal income tax purposes, increased by the following amounts: (i) the amount of any tax exempt interest income received; (ii) the amount of losses claimed as a limited partner in a limited partnership; (iii) any deduction claimed for depletion; (iv) amounts contributed to an IRA or Keogh retirement plan; (v) alimony paid; and (vi) any amount by which income from long-term capital gains has been reduced in arriving at adjusted gross income pursuant to the provisions of Section 1202 of the Internal Revenue Code.

2 Net Worth is the amount by which your total assets at fair market value exceed your total liabilities, with the following adjustments:

(i) the estimated fair market value of your primary residence is excluded from your total assets; (ii) the amount of any indebtedness secured by your primary residence up to the fair market value of such residence is not treated as a liability; (iii) the amount of any indebtedness secured by your primary residence that exceeds the fair market value of your primary residence is treated as a liability; and (iv) the amount of any debt secured by your primary residence incurred during the 60 days immediately preceding your purchase of any securities of the Company is treated as a liability (even if the estimated fair market value of your primary residence exceeds the aggregate amount of indebtedness secured by such primary residence), unless such debt resulted from the purchase of your primary residence during such 60 day period.

Life Insurance

Portfolio Construction

As a Portfolio Manager, one is constantly searching for investments that seek to generate positive expected returns but are not correlated with each other. The problem is that most investments are actually correlated to some degree to the global equity market or interest rates.  Therefore, during times of falling equity markets, one’s equity investments will typically decline and during times of rising interest rates one’s fixed income holdings will typicall fall.  The good news is that these two macroeconomic factors don’t always move hand in hand.  Even with these two important levers at the Portfolio Manager’s disposal it is still important to research the marketplace regularly in search of alternative opportunities where the risk involved is not correlated or has a low correlation with equities or interest rates.

The Funding Dilemma

Even with the changes in the health care system brought about by the Affordable Care Act of 2010, commonly known as ‘ObamaCare’ which included expanding Medicaid to single adults, offering cost assistance for premiums, healthcare costs in the US remain prohibitively expensive.  It is an unfortunate reality that some people will contract terminal illnesses which may result in early death.  These individuals will usually have significant healthcare needs and based on the high cost of healthcare, some people may be pushed into bankruptcy.  Most life insurance policies only pay out when the life assured passes away and do not pay out whilst they are still alive when they need it most.  Many of the insured individuals need funds for medical or living expenses and are thus forced to look to using their 401(k) or selling property to pay for the care they need.  Often this is not enough to cover their healthcare costs and the life assured look to unlock value from their life insurance policies for additional capital.  Most traditional financial institutions will not lend to people in this situation and capital is hard to come by.

Often when there is a demand and supply funding mismatch, the private market steps in to fill the gap.  As life insurance finance is a small, niche market, there are few industry participants.

As a result of this funding shortfall, small firms set themselves up using private capital to buy policies or provide

loans to individuals with policies who require immediate access to capital. The firms use an individual’s life insurance policy as collateral against the funding made to the individual. At the time of death, the proceeds of the policy are first used to repay the loan and interest and the balance is paid to the life assured’s beneficiaries, in the case of loans.  If the life assured wanted more capital than a loan and sold their policy, the life assured’s beneficiary will receive the difference between the policy purchase and the amount the life assured spent on living or healthcare costs that remains in their estate.

The industry has continued to develop and now many more people with late stage illnesses can monetise value from their life insurance policy and also provide capital for their family with any residual amount when they pass away.

This Alternative Credit strategy has become increasingly popular as it provides liquidity to the family during their time of need.  Typical net returns over a 24-36 month period have ranged been between 10-14% per annum. 1

Risks and Costs of the Strategy

The correlation to traditional sources of return (equities and bonds) is low.  From a portfolio management perspective the risk of investing in a pool of life insurance contracts is that the collective lives of the insured may live for significantly longer than the medical prognosis.  If this happens the return on the funding will be lower than expected.  This risk is similar to that of a life insurance company whose risk is that the pools of insured lives live for a significantly shorter time.

Often, there is an origination cost to the loans or brokerage cost on the purchase of the policies as the structuring of the transactions is often complex.  There may also be legal costs associated with loans or purchases.  From an investor’s perspective, a high turnover of loans would be undesirable as the cost of origination, legal and/or brokerage costs would weigh on the portfolio return.  The investor’s objective is for the collective loans to have a maturity that falls within the normal distribution range.

The market risk of the strategy is that the life insurance contracts have less value than expected because the life assured lives longer than expected and the premium costs reduce the net proceeds more than expected.  There is also credit risk in this strategy that is based upon the credit worthiness of the life insurance carriers and their ability to pay out the benefits as per the policies.

Another risk factor of this strategy is illiquidity.  After the loans are made there is usually a limited or no secondary market for these investments and the maturity/term of the investments depend on the life assured mortality. This asset class therefore will not appeal to those who demand liquidity or to those who believe they will demand it in the near future.

As with all portfolio management, diversification is important.  Ensuring that there is diversification across the types of medical conditions of the life assured helps mitigate systemic risks.  Finally, ensuring that there are an adequate number of investments in the portfolio and they are adequately diversified will reduce the idiosyncratic nature of individual investments.

Summary

Unearthing uncorrelated return streams is challenging. Those investors who can accept the illiquid nature of the asset class could benefit from the illiquidity risk premium and the risk premium within this inefficient market. Like all inefficient markets the opportunity is there for investors to plug the funding gap that exists in this market and as more participants enter the market the risk premium narrows. We believe that this may be the case for this asset class over time.

As such, if constructed properly and for those who can afford the illiquidity, adding life insurance financing investments could be a good source of risk adjusted returns to traditional portfolios.

1. Nolex Capital LP, Chapford Capital LP and Chapford Diversified LP

Risk Warnings

This document is for information purposes only.  Nothing herein constitutes, or should be construed as constituting, investment, tax, legal or any other advice or an offer to subscribe in any particular financial instrument or asset class or to participate in any investment strategy.  The views or opinions expressed herein do not necessarily reflect the views of MASECO LLP.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Investing in this asset class is for Sophisticated and Certified High Net-worth Investors.  Always consult a Financial Adviser before making a decision to invest.  Past performance is not a reliable indicator of future performance.  The value of investments can fall as well as rise. You may not get back what you invest.

Issued by MASECO LLP, a limited liability partnership registered under the laws of England and Wales (Companies House No. OC337650), which is authorized and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is registered in the US with the Securities & Exchange Commission as a Registered Investment Adviser.  Its registered office is at Burleigh House, 357 Strand, London WC2R 0HS, United Kingdom.

Divorce Financing

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Trade Finance

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Alternative Mortgages

Capturing the return stream in this asset class is a variant of traditional lending that banks undertake everyday with our deposits.