Here is an illustration of how life settlements work, using a hypothetical example of a single policy sold by an 80-year-old man. It assumes that he has a life expectancy of five years, is insured for $1,000,000 upon death and pays an annual premium of $40,000.

Initial investment $350,000

Future premiums over 5 years $200,000

Total investment cost $550,000

Payment on death of policyholder $1,000,000

Returns $450,000

While this example is based on a one-party policy, most investors buy into units from a pool of life settlements offered by fund managers. This reduces their risks from increased life expectancy, fraud or one-party exposure. At the same time, it gives buyers greater liquidity and flexibility to increase their investment.

Second life

Life settlement is the new darling of traded policies, but it isn't alone. Viaticals and Traded Endowment Policies are two other products available in this asset class.

Viaticals

This product was developed in the early 1990s when companies bought over the life policies of terminally ill Aids patients. However, viaticals lost its investment value as life expectancies of Aids patients were prolonged with new drugs.

Traded endowment policies

Working on the same principle as life settlements, investors buy over endowment policies. However, unlike life settlements, there is no fixed assured sum and the value of the endowment policy is susceptible to market fluctuations.

This article was first published in The Business Times on November 29, 2008.