Longevity Re-Pricing Repercussions

Jonathan Sadowsky, Managing Director of Finance and Portfolio Manager at Browndorf Private Equity Management, answers STORM’s questions.

Newport Beach, Calif. June 26, 2009 - Interview from the June 26, 2009 edition (Issue #44) of STORM’s newsletter for the alternative risk transfer industry.

Q: Which sector of the synthetic transfer of risk markets are you/your firm primarily
involved with?

A: We are primarily involved in the synthetic longevity (synthetic life settlements) markets and invest in derivative instruments linked to senior life settlements. We seek to take longevity risk positions using synthetic swap instruments or notes issued by major financial institutions. These instruments seek to replicate the risks and economics of directly holding a customized portfolio of life insurance policies while mitigating many of the risks and costs of directly holding the physical policies (e.g., insurability, contestability, rescission, possible lapsing and carrier credit risk), which are hard to manage and hedge.

Q: When, how and why did you/your firm become involved in the sector?

A: During the past two years while we were working on building distressed loan, real estate and film co-financing strategies, we were constantly hearing from clients that they wanted assets to help mitigate the risks of their other investments. After researching the options, we came away with longevity – with its low price volatility and attractive return potential that historically were uncorrelated to other traditional markets – as an option. Within that due diligence, we discovered the overall benefits the asset class provides as a direct investment as well.

We also liked the fact that it was an emerging asset class and that we could be innovators and carve out a niche for ourselves by being one of the first US based buy-side firms to focus on investing in longevity in synthetic form.

Q: In your view, what has been the most significant development in the markets you cover in recent years?

A: Unlike traditional markets where information that can significantly alter the asset price can be disseminated on a daily basis, the underlying driver for pricing longevity assets is the life expectancy of the insured population. These expected mortality rates have historically changed very slowly over a matter of years if not decades. This historically slow rate of change has, in our view, resulted in low volatility of the asset class. Low volatility is very enticing to investors as it produces a very low standard deviation of returns over time, especially as compared to other traditional asset classes. This potentially results in a much higher risk adjusted return than most other investments.

During the past year, a new set of mortality tables based on intensive data from 2002-2004 analyzed by the Society of Actuaries came out, called the 2008 Valuation Basic Tables. This study showed a further lengthening of life expectancies compared with their previous 2001 study, which caused life expectancy providers to rework their assumptions and models and change how they analyzed individual lives in regard to their expected life spans. This resulted in a downward valuation adjustment to existing life settlement assets and lower IRRs (internal rate of return) to account for the need to fund premiums longer than previously expected, the additional exposure to carrier credit risk and lower net present value of the death benefit since proceeds are expected to be received further into the future.

This market re-pricing, coupled with the credit crisis, has caused many deals to fall through and liquidity to dry up temporarily. But we believe that once market participants adjust to the new pricing paradigm (which we have recently been seeing signs of), liquidity in the synthetic longevity market will improve and growth will accelerate. The market may also benefit from knowledge that further substantial life expectancy adjustments, and thus the need for more re-pricings, may not occur for a long time.

Q: How has this affected your business?

A: We have been holding a large percentage of our capital in cash waiting for these adjustments to work themselves through the market and the asset class to settle in at new pricing levels. With the major life expectancy providers having adjusted their models, we will increasingly focus on finding the correct pricing levels for these assets and anticipate increasing our buying. In addition to our synthetic focus, we also opportunistically seek to purchase portfolios from owners in financial distress, which due to the recent credit crisis has provided us with a buyer’s market we are taking advantage of. We also believe investors have become wary of managers who have delayed or avoided marking down asset values and are looking for managers that are clean, transparent and proactively adjust their asset values.

Q: What are your key areas of focus today?

A: On a macro level, we spend a lot of time educating investors on the myriad of benefits of the asset class and synthetics in particular, as well as using longevity to help address our client’s desires to increasingly diversify their portfolios, to improve their risk adjusted returns and for assets to mitigate their exposures to riskier assets and projects. As a portfolio manager, I am focused on better understanding and modelling both risk and return profiles of the assets we trade in. I spend a lot of time drilling down on the creation of proprietary mortality curves for each type of insured life, trying to define different risk classifications, as
that is the underlying driver for modelling and valuing the asset.

Q: What is your strategy going forward?

A: We are an integral part of the innovation occurring in longevity synthetics as an investible asset class and the use of such products to address investors’ investment objectives. There are benefits to adding longevity-linked assets to their portfolios and we are one of the leaders, both in quantitative as well as qualitative knowledge, in the asset class and expect to be one of the larger asset managers in that space in the future.

Q: What major developments do you need/expect from the market in the future?

A: Basically, due to the recent and prolonged volatility of traditional investment arenas such as equities, bonds, real estate and commodities, I expect investors to change how they define and structure risk within their portfolios. They will learn more about the risk-reward and diversification benefits of longevity-linked assets, especially when achieved through synthetics. While synthetics are subject to counterparty risks, among others, and potentially increased volatility due to the availability of embedded leverage in the instrument, they mitigate most unwanted and unhedgable risks and costs of direct policy ownership such as contestability, insurable interest, lapse and rescission risks, to name a few. I also expect the asset class as a whole to significantly grow in both the number of players and size of the market in the very near future.

About Browndorf PEM

Based in Newport Beach, Calif., Browndorf PEM (Private Equity Management) is a full-service financial services provider, investment banking services and fund manager offering asset management and structured products for the sophisticated institutional investor. The Browndorf PEM investment team is headed by Matthew Browndorf, Jonathan Sadowsky, Tyler Spring and Schad Brannon. For more information, visit www.BrowndorfPEM.com.

You can also view the article on STORM's web site: www.storminvestor.com