By
Jonathan T. Sadowsky, Managing Director of Finance / Portfolio Manager
Matthew C. Browndorf, Esq., Chief Investment Officer / Founder
As published in “Life Markets: Trading Mortality and Longevity Risk with Life Settlements and Linked Securities”;
The first treatise written by industry experts that is a complete analysis of the mortality and longevity risk markets.
By Senior Editor Vishaal B. Bhuyan and published by John Wiley & Sons (Wiley Finance) in July 2009
“But in this world nothing can be said to be certain, except death and taxes.”
Benjamin Franklin in a letter to Jean Baptiste Le Roy (1789) US author, diplomat, inventor, physicist, politician and printer (1706-1790)
Any investor schooled in the life settlements space is fluent in the inherent specific risks and costs associated with investing in physical policies, such as STOLI (stranger originated life insurance), rescission, insurable interest, contestability, underwriting fraud and carrier credit risks to name a few. The advent of synthetics serves to mitigate all of these risks and physical policy costs for the investor in exchange for swap counterparty risk, which is easier to quantify, manage and hedge, in addition to allowing the investor to target his risk characteristic profile more accurately and efficiently.
In general, a derivative is a financial contract or security whose value is derived from an underlying asset, in this case a life settlement policy. The two main functions of a derivative are for risk transfer, for example in hedging strategies, and to obtain the economics of a physical asset without having to hold said asset, such as in speculation and arbitrage strategies.
Specifically, a synthetic longevity asset is a bilateral financial contract that isolates longevity risk of a specified portfolio of policies and transfers that risk from one party to another. In doing so,
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synthetic longevity instruments separate the ownership and management of longevity risk from
other qualitative aspects of ownership of the physical life settlement asset, such as legal and other policy specific risks and costs. Such risk transfer mechanisms serve to both increase the efficiency and liquidity of the longevity asset markets as a whole.
There are many ways to obtain longevity risk through synthetics, from swaps to notes to indexes. The beauty of synthetics is the investor is not constrained by the limits of the current physical policy supply in the marketplace, only by the creativity, modeling capacity and risk appetites of the parties involved. The underlying risk structure can be anything from the mortality of an entire nation, which would reflect the systematic mortality trend of a population (beta or macro longevity risk), to that of an index with 46,000 lives, to a customized portfolio of lives selected by the investor (specific, micro or alpha longevity risk). The synthetic can be structured such that it emulates the economics and cash flows of a physical portfolio of policies, or as a pure longevity-linked note whereby no cash flows occur until the note’s maturity as it is based on the observed mortality experience of the pool over the investment time horizon.
The first main type of synthetic product is the swap, where two counterparties agree to exchange streams of cash flows based on a prearranged set of information or formulas, be they set fixed amounts or variable amounts based on certain conditions, like underlying life insurance policies and maturing lives.
The most basic longevity swap acts like a pass-through instrument where the swap buyer is obligated to pay to the swap seller a predetermined set of premium payments based on the agreed upon underlying portfolio of policies and active lives and the swap seller pays the buyer the death benefits as they occur. Upfront leverage and built-in premium financing are available depending on investor objectives, market conditions and the swap counterparty’s appetite for offering such products. This product is ideal for those investors who want to replicate the cash flow stream of a physical portfolio and collect income if death benefits outpace premiums in a given period.
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For those investors who do not want or need interim cash flows during the life of the investment,
they can buy a longevity-linked note whose underlying portfolio acts like an index product decreasing in value as premiums are owed and increasing upon constituent maturities. The initial index value is usually set at par and the final index value at the note’s maturity, which usually ranges from one to ten years depending on the investor’s objectives, determines the final payout amount.
Hybrid structures are also available such as notes whose returns and cash flows are based on actual mortality experience as opposed to policy cash flow based. These generally pay a fixed amount per mortality, subject to a cap and floor on the number of mortalities, and provide the investor with a smoother return profile. The fixed amount paid per life maturity takes into account the expected mortality models, premiums, financing and death benefit sizes. Other structures such as longevity options and swaptions can also be created.
In addition, unlike physical policies, the return distribution structure can be customized using synthetics depending on the investor’s needs, in formats such as total return, fixed coupon, fixed tenor or principal protection structures.
The table on the following two pages discusses in detail a number of the many advantages synthetics have over investing in physical policies from efficiency of capital deployment to risk mitigation to portfolio construction flexibility and customizable diversification. While this is a pretty comprehensive list, the main theme is that the synthetic product has the ability to target exactly the risks and economics that a longevity investor wants and avoid the ones he doesn’t. The ability to tailor the product exactly to the investors’ needs and objectives in an efficient manner is the biggest benefit synthetics provide over physicals.
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| DESCRIPTION | PHYSICALS | SYNTHETICS |
|---|---|---|
| Portfolio selection and construction | Purchase of individual policies on the open market: very time consuming, expensive and inefficient. Difficult to construct a portfolio with the exact desired risk characteristics. | Negotiated deal between buyer and seller where lives and all risk characteristics are highly customizable and trade is done quickly and efficiently. Longevity risk and desired cash flows can be targeted and constructed to suit the investor’s objectives. |
| Diversification of lives | Usually 20 to 100 per portfolio but depends on portfolio size and current market supply. The more lives, the harder it is to find and analyze. | Regardless of portfolio size, diversification is highly customizable from 100 to 46,000 lives. Most portfolios will have about 500 to 1000 lives depending on risk characteristics desired. |
| Ramp-up risk for $100MM | Could take 3-9 months. Larger amounts harder to put to work and still get quality assets. | Synthetic deals take days depending on complexity of term sheet. Unlimited scalability and deal size while still obtaining quality assets. |
| Portfolio lumpiness risk | Can be large as it is dependent on the current supply of policies in the marketplace. Very difficult to build a physical portfolio with equal notionals. | Can be completely mitigated by structuring the synthetics with equal notional amounts per life. |
| Negative selection risk | Can be large as it is dependent on the current supply of policies in the marketplace. | Small due to huge portfolio diversification available with synthetics on day one. |
| Carrier credit risk | Physicals are directly exposed to carrier credit risk. Very difficult and expensive to hedge the exact entity and part of the capital structure policy claims fall in. | Synthetic buyers have the option to take on carrier credit risk for higher yields but are not obligated to. |
| Other non-longevity risks | Physicals have all the well known risks, including: legal, rescission, insurable interest, contestability, documentation, underwriting fraud, settlement, administrative, regulatory, reputational, tracking and cross border tax risks. | Synthetics have swap counterparty risk only, which is more easily quantified, managed and hedged than physical policy risks. All other policy risks are held by the swap counterparty. |
| Unwind liquidity | Very low due to large amount of due diligence needed to sell a portfolio of policies. But there are numerous sources to go to, which is a positive. | Very high. As with most derivative instruments, the swap seller will almost always show an unwind price. The discount to full market value will |
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| DESCRIPTION | PHYSICALS | SYNTHETICS |
|---|---|---|
| A decent size portfolio could take | depend on portfolio construction as | |
| three to six months to find a buyer, | they have to replace that risk and will | |
| which is not ideal if the seller needs | pass that cost along. Due to deal | |
| to raise capital or stop the negative | customization, the swap is difficult to | |
| cash flow due to premiums. | assign to another party, thus the original seller is usually the only unwind option. | |
| Premium financing | Currently capital for premium financing is very hard to find and if found is extremely expensive, if not cost prohibitive. Also, due to current market conditions, future death benefits alone are not sufficient collateral, thus requiring additional assets to be pledged. | Premium financing can be built into the synthetic structure. Due to the lower internal cost of capital of the swap counterparties, the premium financing cost is usually lower than traditional hard money sources of funds. |
| Pricing risk for investors | Due to the illiquid nature of the physical asset and the current lack of marked-to-market rules, investors in funds that only hold physical assets are subject to extreme uncertainty about the true value of their assets. | Like all OTC derivatives, they are required to be marked-to-market at regular intervals (at least monthly) based on the latest models and market information. Swap counterparties valuation models are very sophisticated. |
| Leverage | Very difficult to obtain leverage in physical policies. Would require lenders accepting these assets as collateral for a loan which is not common in today’s markets. | Upfront leverage is available in the synthetic instrument depending on certain factors including market conditions and swap buyer counterparty risk. |
| Risk directionality | A physical only investor can only go short longevity risk (benefitting when constituents mature sooner than expected). | A synthetic investor can go both long and short longevity risk on any portfolio from a customized portfolio to a large index to a nation’s mortality. |
| Policy costs | Large. The operational, servicing, and administrative costs as well as legal and underwriting due diligence are very costly and can eat into returns very quickly and are usually not factored in when buying, so high initial IRRs are not realized. | None. The initial IRR calculated when the swap purchased will come to fruition as long as the realized mortalities equal the expected mortalities. |
| Policy purchase fees | Brokerage and settlement fees that can get onerous. | None. |
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Physical policy purchasers are restricted to the policies sold in the life settlements market, which severely limits their ability to construct a portfolio having the exact risk profiles they desire. The life settlement market is a subset of the insurable population who for whatever reason chose to sell their policies. The insurable population is a subset of the entire population.
Synthetic instruments are flexible in that they can be written with the underlying being an entire nation’s population, a large index of policy holders, a customized portfolio of lives or even “reference lives,” people who have given the swap seller permission to underwrite them medically and track their lives without having an actual life insurance policy written on them. The dynamics and risk characteristics of each population subset are very different and need to be analyzed and modeled differently. But the ability of synthetics to target any of the above subsets gives the investor a very powerful tool to target his longevity risk where he has a need or sees value.
This ability to customize the pool of lives is also very valuable to hedgers as they can minimize the basis risk associated with reference pool mismatches. For example, a pension fund that is trying to hedge its longevity risk needs to structure the synthetic hedge to as closely match its constituent’s profile as possible. Hedging the possibility of pension liability extension with a swap based on either the mortality of the entire United States population or a pool of only 100 lives doesn’t make much sense.
The basic skeleton to valuing a synthetic is exactly the same as valuing the underlying asset, a life settlement policy. For this description, which will be brief because it is covered elsewhere in this book, I will assume we are discussing a synthetic swap that replicates the economics of a physical portfolio of policies. While death itself is a certainty, the mortality rate is anything but. For all synthetic longevity instruments, the foundation of asset valuation is the modeling of the underlying
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mortality curves and the resulting expected probability of mortality for a life (or portfolio) over
time.
With the maturation of life settlements markets, more advanced pricing models have been developed. Most sophisticated investors utilize some version of the Probalistic Pricing Model, which uses different inputs like age, gender, smoking, net worth, impairments and other medical information, policy vintage and the appropriate mortality table to create an actual expected mortality curve over time. Depending on the age of the insured, the mortality table being used may have to be tweaked to reflect the fact that less life settlement specific data was used in the older age results. Additional long term mortality adjustments also need to be made for expected longevity drift over time for that insured’s age group as the trend is people are living longer the later they were born as factors such as health and nutrition information and medical advances serve to increase average longevity over time. This adjustment is very subjective as some people think the mortality improvements will seek to reverse due to the reemergence of infection diseases and antibiotic-resistant strains of previously controlled viruses, the increased pollution of the world’s air and water supplies and the recent increase in obesity, especially in the United States as well as the future strains on the Social Security and health care systems as the percentage of elderly increases relative to the total population.
As discussed in Chapter 16, the published life expectancy value is an average of the expected mortality distribution for the insured based on the mathematical probabilities of survival to each possible age, and is of faint usefulness without other information about the mortality curve such as standard deviation, kurtosis and skewness, which would define the exact shape of the insured’s mortality curve. Absent this curve shape information, investors would be prudent to value the asset under different shock scenarios that not only cover a parallel shift of the expected mortality curve but also shape shifts of the curve to account for different standard deviations, kurtosis and skewness values. For a large diversified portfolio with equal notional amounts per life, the blended mortality curves might mitigate most of the curve shape issue. For the curve shape risk to be minimized, the portfolio needs to be diversified not only by having many lives (at least 350 to minimize the dispersion of the standard deviation of life expectancy probabilities), but also by impairment, geographic region, socioeconomic group and life expectancy, among others. Synthetic longevity instruments allow an investor to do this very easily and efficiently, unlike in trying to aggregate a
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physical portfolio. In addition, for a whole portfolio, the more diversification there is among risk characteristic factors, the less expected volatility there will be in expected returns and thus a higher degree of confidence in the models.
Once the underlying mortality curve is defined, two sets of cash flows will be generated based on the calculated probability of mortality curve for each period from today to the policy maturity. The probability of mortality curve, which can also be looked at as a probability of survival curve, will quantify the expected probability the insured will achieve mortality in each time period, or looked at another way, will survive to that point in time. This curve construction theory is similar to the probability of default curves seen in credit default swap models. It is possible for some of the mortality curve to extend past the policy maturity date, which will require an adjustment so that those remaining modeled death benefits don’t get missed.
The first set of cash flows will be the expected premium outflows to maturity, or cost of insurance of the policy, and the second will be the expected death benefits received, both of which are proportionally related to the probability of mortality curve. Those cash flows are then discounted back to the present at the investors’ required internal rate of return (IRR) to obtain a net present value (NPV) for the asset.
In addition to the valuation of the actual policy cash flows, an additional step must be taken to account for the premium financing built into the swap structure, whose need and cash flows will also be tied to the probability of mortality curve. The cost of financing for premiums will have a surprisingly large impact on the final NPV of the asset, so LIBOR curve modeling will have to be done to estimate future funding rates as most funding sources from swap counterparties tend to be spread over one month LIBOR (sometimes three-month LIBOR depending on the swap terms).
One further comment about synthetic valuation is the initial calculated IRR upon trade execution will come to fruition if the actual mortalities over the life of the swap equal the expected (modeled) mortalities. There are no hidden costs like physical policies have that are usually not factored in by the purchaser when the initial IRR is calculated. These cause the realized return to be much less than expected. These costs include the legal and underwriting due diligence required when purchasing the policies as well as the annual servicing, administrative and operations costs. In addition, the risk of rescission or lapse can crush returns if even a small percentage of the portfolio experiences them, which is not a risk present in synthetics.
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For the sophisticated longevity investor, synthetics represent an opening of the proverbial sea into
new avenues from which to obtain customized longevity risk and economics. They also provide the
ability to go short as well as long, the flexibility to pick the investment time horizon, and the ability
to mitigate the dangerous physical-policy specific risks and costs that are difficult to hedge against,
all things not possible in the physical market. Also because there are no hidden costs in synthetics
like there are in physicals, there is a higher degree of confidence in the expected returns which is a
huge benefit to investors deciding where to deploy capital. Looking forward, innovation in
synthetics structures driven by speculators’ and hedgers’ needs will continue for the foreseeable
future and serve to further add efficiency and liquidity to an asset class that is experiencing
tremendous growth as a whole.
*Jonathan T. Sadowsky is the Managing Director of Finance and Portfolio Manager for Browndorf PEM, LLC, a registered investment advisor in the State of California, and manages the Browndorf Life Settlement Fund, LP which does participate in the physical and synthetic longevity markets. Matthew C. Browndorf, Esq., is the Chief Investment Officer and Founder of Browndorf PEM, LLC.
Disclaimer: this material is for your private information and Browndorf PEM, LLC is not soliciting any action based upon it or making an endorsement, recommendation, solicitation, or sponsorship of or in connection with any security, information or the data. We do not represent that the information is accurate or complete, and it should not be relied upon as such. Opinions expressed are our current opinions as of the date appearing on this material only. Browndorf PEM, LLC and its affiliates, officers, directors, partners and employees, including persons involved in the preparation or issuance of this material may, from time to time, have long or short positions in, and buy or sell, any of the commodities, futures, securities, or other instruments and investments mentioned herein, or derivatives (including options) on any of the same. Investments in longevity contain multiple assumptions that should be reviewed along with an official Offering Memorandum prior to making an investment decision. Past performance is no guarantee of future results.
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