Advisors whose clients are looking to participate in the life settlements market will probably get another sniff at product in the first quarter. But with several regulatory challenges and unfavourable tax treatment relative to the U.S. market, it’s unclear how this industry will develop in Canada.

Hamilton, Ont.-based Wickham Investment Counsel Inc. is aiming to launch a pool of U.S. life settlements products that it will manage for what it calls a “major” brokerage registered with the Investment Dealers Association of Canada in the first quarter of 2008.

“We’re midway through the deal,” says Neil Wickham, Wickham IC’s president. “The first product is for accredited investors, as a private placement. In the third quarter, we will follow it up with a public prospectus, assuming the first one is successful. That would be a traditional closed-end fund.”

The investment dealer in question chose not to discuss the details, but Wickham IC is also teaming up with Sandor Capital Corp., a Burlington, Ont.-based tracker for the North American life settlements industry. Sandor is taking a consultative and educational role.

“Canadians have not warmed up to the idea of life settlements, and this will be the first nationwide introduction,” says Gil McGowan, Sandor’s chief operating officer.

Last summer, SCC Ltd. , a firm headed by McGowan that had an arm’s-length connection with Sandor, launched a similar pooled investment for accredited investors, SCC LP. But, McGowan says, the partnership wound up the pool after it failed to get shelf space at any IDA or Mutual Fund Dealers Association of Canada firms. Product-approval teams at the firms didn’t know Sandor, whose CEO is Jason Moos, nor did they grasp the life settlements industry, he adds.

Life settlements grew out of the viatical settlements industry that started about a decade ago in response to the needs of AIDS patients. Viaticals were designed for policyholders nearing the end of their lives and looking to cash in their life insurance policies. The deals varied by policy, but, generally, if the holder had no beneficiaries, he or she could sell the policy to an investor for more than the cash surrender value paid by the insurer but less than the full death benefit. The investor then received the amount payable on death when the policyholder died.

More common in today’s marketplace are life insurance settlements. If the policyholder is older and healthy, with a life expectancy of two to 15 years, he or she can sell the policy in the secondary market for cash. The buyer assumes premium payments and receives the death benefit when the policyholder dies.

The secondary market for trading in Canadian life insurance policies is virtually non-existent, however. The U.S. market, on the other hand, is mature. U.S.-based investment firm Bernstein Research says that more than 50 firms trade in life settlements in the U.S., selling them to both retail investors and to pension funds. According to studies by Conning Research and Consulting Inc. of Hartford, Conn., Bernstein and Lehman Brothers Equity Research of New York, the U.S. industry has grown to more than US$13 billion from virtually nothing and is expected to grow tenfold to more than US$125 billion over the next several years.

The main reason for the lag in the Canadian market is that insurance legislation in six provinces — but not Saskatchewan, Nova Scotia, New Brunswick and Quebec — prohibits “trafficking” in life insurance policies by individuals and institutions, with the exception of insurance companies.

Ontario has amended its Insur-ance Act to allow viatical settlements, but the change and supporting regulations have yet to be proclaimed. The provincial Min-istry of Finance has no plans to introduce such amendments to the legislature.

The upshot for investors in On-tario, Alberta and the other provinces that limit these investments to insurance companies is to participate in life settlement pools that gather U.S. policies, which they are technically allowed to buy and sell.

Life settlements managers, through advisors and brokerages, pool 200 to 400 policies with varying rates of maturity, based on actuarial studies on mortality rates. In other words, they invest in policies written for people expected to die at different times.

There is some investment risk related to policyholder longevity. But, arguably, the underlying assets of a pool have no market correlation to equities or fixed-income investments, although the original policies are underwritten with some assumptions about the performance of bond and equity markets.

@page_break@Several early entrants into this market in Canada have forced regulators to make rulings. Universal Settlements International Inc. of Waterloo, Ont., was among the first to enter untested waters more than five years ago, when it created pooled funds of life settlements. The Financial Services Commission of Ontario failed in 2001 to impose a “cease and desist” order on USI, when the regulator’s internal panel determined that the firm was not dealing in Ontario insurance policies. The Ontario Superior Court then gave the Ontario Securities Commission the right to investigate USI’s practices, and the regulator ruled that the pooled funds ought to be considered as securities in Ontario. (Toronto-based Kingsmill Capital Ventures Inc. , bought the life settlement assets of USI in August 2007.)

That has set the stage for the recent interest in life settlements.McGowan and Moos have been watching developments in the U.S. industry and have met with Canadian associations and potential investors. Last month Mc-Gowan spoke to a “study group” in Pickering, Ont., to describe the life settlement market and its potential in Canada.

Brian Shumak, a certified financial planner in Toronto who organized the event, says clients might like to participate in a secondary market for life insurance policies, either by selling their own or by buying into the market through managed products.

“Once it becomes legal,” Shumak says, “you’ll see it become part of the mutual fund industry, either indirectly or directly.”

However, the nascent industry here may face a battle from Canadian insurers. Moshe Milevsky, professor of finance at York University in Toronto, notes that lapsed policies — which happen when policyholders fail to make premium payments — figure heavily into life insurance carriers’ actuarial calculations and, eventually, into their earnings.

As many as 75% of policies lapse before maturity, which means the death benefit is never paid out. “Suddenly, if everybody can sell their policies,” he says, “those policies won’t be lapsing before the policyholders die; somebody else will pay for it. So, that scares the [insurance] companies.”

In the U.S., Milevsky adds, life insurance companies are actively lobbying against the settlements industry and competing against it by providing increasingly more attractive advance payments on death benefits for the terminally ill. In fact, many Canadian life insurance providers offer some form of advance payment already.

But life insurance policies are major assets that people should be able to sell, Milevsky argues, and he generally supports the idea of a transparent, regulated secondary market in Canada if such a market could exist.

A strike against it, says Moos: Canada has no central registry for deaths that would allow buyers of such policies to begin the process of collecting their benefits.

Finally, the industry here may never experience the same growth momentum as the U.S. because tax treatment for the investment is not likely to be as favourable as it is in the U.S. There, the net gains are treated as capital gains and taxed at 15%. Although the Canada Revenue Agency has yet to make a formal ruling on the matter, it has said it would potentially consider proceeds from life settlement investments as business income, says Ted Ballantyne, director of advanced tax policy at the Conference for Advanced Life Underwriting in Toronto. As well, the seller of the policy would probably have the proceeds taxed as income at his or her marginal rate.

In all, the tax treatment makes the deal less attractive to Canadians on both sides of the transaction. The seller will want a higher price for the policy, reducing the yield for investors. IE