Understanding the Dynamics of the Longevity Asset Class and How It Relates to Portfolio Asset Allocation

By Jonathan T. Sadowsky, Portfolio Manager and Craig M. Taggart, Managing Director of Marketing Browndorf Financial Services Group, LLC.

In discussing sector allocation within an active investment management model, there are many strategies and asset classes to choose from. An emerging asset class, longevity, more commonly known as senior life settlements, is an investment area that is growing rapidly on Wall Street as well as Main Street and can no longer be overlooked by the global financial markets. As many firms look to implement more control over portfolio risk and volatility when it comes to generating a sustained return in asset allocation strategies, many institutional investors are turning to longevity-linked investments that can provide both capital appreciation and portfolio stability. This asset class is becoming more common in properly diversified institutional portfolios as it has been shown to have low price volatility and be very minimally correlated to traditional investment arenas such as the equity, bond, commodity and real estate markets.

Similar to zero coupon bonds, senior life settlements are purchased at a discount to face value, and when the investment matures, the investor receives the full face value of the policy. The only drawback is negative coupons in the form of insurance premiums that are required to keep the policy “in force” and the investment active. An investor can either use cash to pay for said premiums, which will cause a cash drag on performance or borrow the money from some premium finance facility, which will increase the investors overall cost of capital basis of the investment.

One solution to such negative cash issues is to structure the life settlements portfolio in synthetic form instead of buying physical policies. One of the many benefits of a synthetic life settlements instrument is that premium financing is built into the structure at a very advantageous cost of capital as compared to third party financing options for physical policies. As for portfolio construction, the synthetic portfolio return distribution profile can be customized depending on the investors' objectives such that it either emulates the economics and cash flows of a physical portfolio of policies, or acts as a pure longevity-linked note whereby no cash flows occur until the note’s maturity, as it is based on the actual observed mortality experience of the pool over the investment time horizon.

Most investors, as they look to allocate their capital, will inquire about the similarities and differences of an investment in longevity linked assets as compared to equities. There is a strong relationship between portfolio construction methodologies when investing in either life settlements or equities. Most institutional investors who practice active portfolio management strive to minimize specific risk by structuring a large diversified portfolio to track the beta of a particular asset class or subset of that asset class, and use their specific skill sets to find their competitive advantage by investing in only those areas where they can add alpha. Equities are more easily understood so I will use that as my example; most active S&P 500 managers buy the entire index (either through the holding of all 500 physical stocks or through a total return swap depending on their ability to hold derivative instruments) and then try to outperform that index by taking incremental risks where they have feel th ey have an analytical advantage by going more or less long (versus the index weights) certain stocks or industries.

Life settlement portfolio construction is similar in that diversification of at least 350 distinct lives is very important for achieving the beta of the asset class which can be defined as the expected modeled mortalities over a specific holding period and for minimizing the dispersion of the standard deviation of life expectancy possibilities, reducing potential volatility. Within that portfolio, specific policy selection of those lives that have a higher probability of maturing earlier than the market based model expects is where alpha can be created. Synthetic instruments make the creation of a diversified portfolio much more efficient as not only can the entire portfolio be created in one trade, eliminating ramp up risk, but they can be structured to have equal notionals across all lives, eliminating lumpiness risk and minimizing actual to expected mortality basis risk. Neither is possible when building portfolios of physical life settlements.

The differences between asset classes are very striking and yet basic, which is why they are a perfect complement to one another within a diversified portfolio. Equities are based on the pure equity ownership of corporations and inherently have a lot of specific credit risk as well as industry and macroeconomic risk. Life settlements are based primarily on the expected mortalities of a specific subset of the population and are not dependent on the fortunes of a specific company, industry or economy. Insurance carrier credit risk is present as well, but that can be mitigated through the use of a synthetic instrument. It has been shown that historical returns of life settlements are independent of global macroeconomic events such as recessions, capital liquidity events, extreme market volatility and crises of investor confidence. This provides the basis of the argument that life settlements are not correlated to equities.

Equities are a very popular asset class that due in part to the advent of mutual funds, hedge funds and more recently ETFs (exchange traded funds), as well as electronic trading platforms, have become more volatile as the ability to move money in and out of the market as a whole as well as between sectors are much easier. It is this increased volatility and overall risk perception in the equity markets and well as the credit, commodity and real estate markets that asset allocation strategies are now coming under review and alternative asset classes such as longevity are being closely looked as a portfolio addition.

For the modern portfolio theorist, adding longevity linked assets to a diversified portfolio of equities, bonds, real estate and commodities, due to its relatively low price volatility and high yields, serves to further optimize the portfolio by shifting the efficient frontier (also known as the Markowitz frontier) up and to the left. To step back, every possible asset combination for a portfolio can be plotted in risk-return space, and the collection of all such possible portfolios defines the investible universe. The line along the upper edge of these possible portfolios is known as the efficient frontier, representing the greatest expected return for any given level of risk. Adding an asset with a higher Sharpe ratio (the measure of excess risk per unit of risk) to such a portfolio will shift the efficient frontier up and to the left, providing for a higher return for any given level of risk versus the original portfolio.

Despite all of historical data and qualitative analysis that shows longevity is not correlated to traditional markets like equities and credit, there are unquantifiable factors that have been at work the past year or two that have caused a “phantom correlation” among all markets around the globe. As we saw after the fall of Lehman Brothers and the subsequent shutting down of the credit markets, all markets, except for the flight-to-safety assets like US Treasuries, moved in tandem on the way down as a global selloff of all assets took place with little regard to technical or fundamental reasoning. This phantom correlation to the downside seemed to break all the diversification rules of portfolio management theory and threw a big monkey wrench into asset allocation models that aim to mitigate portfolio volatility by diversifying among many asset classes and investment models. While many factors were at play, the overriding modus operandi of many investors at the time was to “raise cash at all costs” to fulfill margin requests, pay back credit lines that were pulled or satisfy investor redemption requests. This caused not only all asset classes to see a wave of selling, but the most liquid assets get hit the hardest as access to capital trumped getting value. When the tsunami of selling subsided, the value hunters came back into the market and bought those assets which, either fundamentally or technically, were severely underpriced, with the most analytically followed and understood assets rising first. Now that the dust in the market place as a whole has seemingly settled, historical correlations are expected to trend back to normal, especially as more asset class diversification occurs to prevent such an event from happening to investors’ portfolios again, which bodes well for alternative asset classes such as longevity.

*Jonathan T. Sadowsky is the Managing Director of Finance and Portfolio Manager for Browndorf FSG, LLC, and manages, through Browndorf PEM, LLC, the Browndorf Life Settlement Fund, LP which does participate in the physical and synthetic life settlements markets. Matthew C. Browndorf, Esq., is the Chief Investment Officer and Founder of Browndorf FSG, LLC. Browndorf FSG (Financial Services Group), LLC, is a California Limited Liability Company and the parent affiliate company of all Browndorf companies. Browndorf PEM (Private Equity Management), LLC is a Pennsylvania Limited Liability Company, a California Registered Investment Advisor and the United States advisor to our institutional clients, funds and securitization vehicles; CRD#146484.

Disclaimer: this material is for your private information and Browndorf FSG, 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 FSG, 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.