What is a TEP?

A Traded Endowment Policy (TEP) is a mid-term with-profit endowment no longer required by the original policyholder who has sold it on the open market at a price greater than the surrender value.

Whilst some endowment policies were simply regular premium savings plans the vast majority of endowment policies available in the TEP market were taken-out by the original policyholders as a means of repaying a mortgage. However, for various reasons such as divorce, or a change in mortgage arrangements many policyholders either surrender their policies to the issuing life company or sell them through the Traded Endowment market.

It is estimated that only around 30% of endowments are held to maturity by the original policyholders and about 30% are cancelled or surrendered in the very early years.

The remaining 40% are either surrendered or sold at a later stage. Not all policies can be sold, there is, for example, currently no market for unit-linked or unitised policies. However it is estimated that approximately £1.2 billion per annum of policies could be sold for more than the surrender value but only around £500 million reach the Traded Endowment market, the balance are surrendered to the issuing life offices.

The Traded Endowment market exists because the surrender values quoted by many life offices do not fully reflect the true value of the policy as a continuing contract and many investors are willing to buy policies for more than the surrender value because they recognise such policies represent a low to medium risk investment opportunity.

So why does buying an endowment mid-term present a good low to medium investment opportunity?

To answer this we must firstly explain the mechanics of with-profits endowments. Endowment policies are normally taken out for a specified term usually between 10 and 25 years (sometimes longer), they are taken out for an agreed amount the ‘basic sum assured’ which is the guaranteed figure the life office will pay out at maturity (that is when the policy ends) or on the earlier death of the life assured. The policyholder pays a regular premium to the life office, which is invested to provide the plan benefits. Life office with-profit funds are invested in a wide range of asset classes such as fixed interest securities, property and equities (both UK and overseas) and the investment managers are able to make long-term prudent investments, which has enabled them to produce competitive returns over the years. However this should not be taken as a guarantee of future returns.

In addition to the basic sum assured with-profit policies receive a share of the profits earned from the investments in the with-profit fund. There are two ways that life offices distribute these profits.

• An ‘annual or reversionary bonus’ normally added to the basic sum assured each year, which once added cannot be reduced or taken away.
• A ‘terminal’ bonus that is added at the end of the policy term, or on the earlier death of the life assured.

With-profit policies benefit from a technique known as ‘smoothing’ which basically means that in years of good investment performance not all of the investment growth achieved in the with-profit fund is paid out as bonuses, some is held back in reserve so that bonuses do not necessarily have to be reduced in years of poor investment performance. However smoothing can only go so far and in prolonged bear market phases such as 2000-2003 many insurance companies with-profit funds reserves have been depleted to the extent that most have prudently reduced bonuses. As investment conditions improve we expect to see the reserves replenished and subsequent increases in bonus rates.

Bonus rates obviously depend on the investment performance of the life offices, the strength of the life offices, which has a bearing on asset allocation of the with-profit fund, and the way they choose to allocate profits.

When an investor buys a traded endowment policy he is buying an investment with a number of important attractions:

• The vast majority of the charges inherent in the policy are incurred in the first few years and these have effectively been paid by the original owner.
• The policy will also have several years reversionary bonuses already attached to it (once added these cannot be reduced or taken away).
• The guaranteed basic sum assured together with the attaching bonuses represent the minimum guaranteed maturity value or ‘locked-in’ value and sometimes it is possible to purchase policies where the ‘locked-in’ value is higher than the purchase price and the remaining premiums – meaning the investment carries a guaranteed profit.
• The policy will also participate from future reversionary bonuses (increasing the guaranteed value) and normally a final terminal bonus.

Companies like ourselves who specialise in traded endowment policies have developed sophisticated valuation systems enabling investors to purchase TEPs at rates that provide the potential to achieve attractive returns from low risk and sometimes no-risk investments.

When an investor buys a policy it is legally assigned to the new owner who takes on the responsibility for future premiums.

The life assurance element of the policy remains on the original life assured. When the policy reaches maturity (or if the original life assured dies) all the benefits are paid to the new owner.

The following graph illustrates how a typical with-profit policy gradually increases in value over the period to maturity: