In the last decade, there has been an explosion of investment in the alternative asset class known as “life settlements.” A life settlement is the purchase of a life insurance policy by a third-party investor from the policy owner for less than the policy’s death benefit. The primary source of investments in life settlements has been from U.S. and European-based institutions. As the market has continued to grow, industry participants have begun reaching out to investors in other parts of the world, including Asia, Latin America and Australia. Recently, there has been interest in obtaining funds from Middle Eastern and other Islamic countries. There are, however, unique issues associated with courting Islamic investors. Specifically, many of these investors can only invest in assets that comply with the principles of Islamic finance.
Islamic finance is a mode of finance which derives its principles from the Koran and the Sunnah (the traditions of the Prophet Muhammad). The Islamic finance paradigm is based on a series of prohibitions: 1) There may be no investments in certain goods and services deemed to be unethical (Haram) (i.e., alcohol, pork-related products, gambling-related activities, etc); 2) the charging of interest (Riba) is strictly prohibited; and, 3) there may not be excessive uncertainty or risk associated with the investment (Gharar).
Even though the principles of Islamic finance prohibit the charging of interest, a distinction is made between interest on funds invested and profits received as the result of the success of a business venture. In permitting profits as opposed to interest, Islamic finance allows partnership contracts. There are two principal forms of partnership contracts: 1)mudarabah, and 2) musharakah.
Mudarabah: This is a form of contract structured by an investor and an entrepreneur. The investor supplies the capital to the business on the condition that the resulting profits are distributed in pre-agreed proportions, while the potential of all capital loss is borne by the investor. Mudarabah investments offer the opportunity for pure finance in the sense that the investor can invest without having to personally manage the capital investment.
Musharakah: This contract is very similar to a conventional partnership arrangement where each party contributes capital and each partner has management rights in proportion to their investment. However, the share of profit for each investor is determined as a proportion of the final total profit rather than a ratio of capital invested. In the event of a loss, each investor can only lose up to the amount invested in the project.
Both mudarabah and musharakah are non-debt creating modes of financing. Unlike many non-Islamic financing transactions, the principal amount of funds and a fixed profit cannot be guaranteed. Therefore, the entrepreneur or business is not required to pay back the total amount of financing, nor can they be required to pay a fixed amount of profit.
A third form of Islamic-compliant investment structure, which often use mudarabah or musharakah vehicles as the issuer, is called Sukuk. Generally, sukuk are asset-backed, stable income and tradable trust certificates that grant investors a share of the asset together with the cash flow and risks associated with such ownership (i.e., a direct participation program). Unlike a typical bond, in which the bond represents a contractual debt obligation whereby the issuer is obligated to pay to bondholders on certain specified dates, principal and interest, sukuk holders possess an undivided beneficial ownership in the underlying asset. The primary condition of the issuance of sukuk is the existence of assets on the balance sheet of the issuer.
Given the particular restrictions of Islamic finance, the question arises whether investments in life settlements can be made Shari’ah compliant. As a threshold matter, it must be determined if the underlying asset, life insurance contracts, areShari’ah compliant. Conventional insurance is structured as a contractual relationship between an insurance company and consumers where in exchange for a fee the insurance company agrees to compensate a policy holder in the event of a loss. Some Shari’ah scholars have determined that conventional insurance involves excessive risk or ghrar because the timing of the payment is so uncertain. A policy holder could receive the death benefit after paying one month’s premium or might never receive the death benefit. There is also a concern about riba since insurance companies tend to invest funds in government bonds and other interest bearing investments.
If direct investment in life insurance contracts is forbidden under principles of Shari’ah, can a third-party investment in the asset be structured in a manner consistent with the requirements of Islamic finance? While the Accounting and Auditing Organization for Islamic Financial Institutions, the non-profit group that defines the acceptable standards for various areas such as accounting, governance, ethics, transactions and investment, does not appear to have addressed life settlements as an investment, it appears possible that such an investment could be structured in a manner to render it Shari’ahcompliant.
Ghrar: As part of a life settlements transaction, thorough underwriting is done on the insured life including the receipt of a life expectancy certificate, which provides an actuarial projection of the insured’s remaining life expectancy. The assurance of policy maturity within a relatively set range should remove sufficient uncertainty from the transaction to overcome concerns that the investment involves ghrar. Additionally, a lump sump purchase price, representing the net present value of the death benefit, is paid to the policy owner, thus the gambling component that exists when a person directly takes out a life insurance policy (i.e. the concern that the policy owner could receive a huge windfall) does not exist.
Riba: It could also be argued that the investor’s desired discount rate, used to calculate the purchase price, constitutesriba, rendering the investment non-compliant. However, the discount rate is functionally no more than the anticipated profit that the investor desires under the terms of the investment. This is not a situation in which money is being charged for the use of money; instead, a tangible asset is purchased and the profit derived there from is a function of the accuracy of the life expectancy projection used to purchase the policy. Conceptually, this is no different than an investment in an operating business which may yield a high profit, low profit or no profit at all. To address the issue of the issuing carrier investing in government bonds and crediting an interest rate to the cash value in the policy, a Shari’ah compliant life settlements fund could invest only in policies that have no cash value (term policies or term policies converted to universal life, for example).
In sum, creating a Shari’ah compliant life settlement investment vehicle would be challenging and require innovative structuring. However, if it can be done it would allow Islamic investors access to this attractive, non-correlated asset.
James W. Maxson is Of Counsel in the firm’s Insurance and Reinsurance Practice and co-chair’s the firm’s Life Settlement Practice. Mr. Maxson concentrates his practice in corporate and regulatory matters for the life settlement industry, as well as focusing on mergers and acquisitions and securities transactions. Jim received his bachelor’s degree from Denison University and law degree from the Ohio State University School of Law.