The Wave Report

The Benefits of Synthetics Far Outweighs the Risks

By Jonathan Sadowsky

Portfolio Manager, Browndorf PEM, LLC

Any investor schooled in the life settlements space is fluent in the inherent specific risks and costs associated with investing in physical life insurance 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 synthetic longevity products by

Wall Street 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, they allow the investor to target his risk characteristic profile more accurately and efficiently.

Most people associate derivatives and the resulting counterparty credit risk with being a partial cause of the credit crisis and taking down firms such as Bear Stearns, Lehman Brothers and AIG. The real cause was the misuse and abuse of derivatives to such an extent that the firms and other investors in the securitized products overextended their risk capabilities and did not have a firm grasp on how to model and mange such large portfolios of diverse risks. Also, mistakenly, no one ever thought a AAA-rated instrument could lose value, and when they did and were downgraded, both the asset values plummeted and their needed collateral reserves were increased, hitting them with a double barreled shotgun.

Despite the massive amount of recent negative press, the world of derivatives has many positive attributes, especially for the seasoned investor who understands their risk profiles and how to manage them. 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 or portfolio of policies. 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, along with the economics of that portfolio, from one party to another. In doing so, 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.

In addition to longevity risk, the main risk a synthetic buyer has is counterparty risk. In most cases it would be one of the global financial firms that trade in the synthetic longevity space. Since you are holding a derivative contract, you are basically holding an unsecured senior obligation of that firm, whose claims in any default or bankruptcy event would be pari-passu with all other senior unsecured debt holders. Your default risk is the same as if you bought a senior unsecured corporate bond from that firm. The difference is the asset’s performance is based on the underlying longevity assets and has quantifiable upside, with the default scenario sprinkled on top, whereas a corporate bond is pure default risk with limited upside potential, as your assumed yield to maturity is known at time of trade.

The benefits a synthetic longevity instrument provides the investor as well as the market far outweighs the probability of a worst case default scenario. A number of the many advantages synthetics have for the individual investor over investing in physical policies range from efficiency of capital deployment to risk mitigation to portfolio construction flexibility and customizable diversification. Aside from the myriad of legal and underwriting risks, some

other more specific physical policy risks that can be mitigated and managed by synthetics include ramp up risk, notional lumpiness risk, negative selection risk, liquidity risk, and carrier credit risk.

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. For the market as a whole, having alternative means of which to obtain longevity risk, both on the long and short side, serve to increase the liquidity of the physical market as well, since the swap usually needs physical assets underlying the contract.

Despite the risk mitigation and portfolio construction benefits of obtaining longevity risk through a synthetic medium, counterparty default risk is still a very scary scenario. It is, however, a much less remote possibility than the media would have us believe. With the parade of stories about write-downs and increased asset-backed default rates, one should be more vigilant about whom they do business with, but hedging again a counterparty defaulting starts at the trade. You should only trade, and maintain trades, with counterparties you feel comfortable with as a credit risk.

I do think such global bank credit risks are overblown as both balance sheet structure is improving, write-downs are slowing down due to both a stabilizing market and possible mark-to-market rule changes, and the world’s governments are becoming increasingly vigilant about credit risks within the financial system and providing stimulus that will serve to protect and preserve the bank’s balance sheets, while allowing them to grow again. In so much as the investor is concerned about counterparty credit risk, these risks can easily and efficiently be hedged in the credit default swap market, as all of these credits are widely traded. Compare that to a portfolio of physical policies and their respective carrier credit risks. These are much harder to manage and hedge because of the number of credits that will have to be analyzed and hedged, and the extreme difficulty in buying default protection on the exact entity and part of the capital structure that is responsible for policy claims. As wel l, most of the carriers do not even have CDS trading on their names, and if they do, the liquidity is very minimal, driving up the relative cost.

One such government program aimed at helping reduce systematic issues is US Treasury Secretary Timothy Geithner’s plan to address key liquidity and transparency risks of the credit default swap market. Trades would be reported either via clearinghouses for standardized swaps (such as most vanilla credit default swaps), thus alleviating the counterparty credit risk issue, or via trade repositories for non-standardized swaps. The key is to balance the need for greater oversight and control of the systematic risks such instruments can create in the market place, while preserving the risk transfer benefits they provide to investors.

The other numerous programs governments around the globe are trotting out that address issues from housing to mark-to-market to toxic assets on balance sheets to new regulation should serve to alleviate the pressure on both financial institutions balance sheets and the global economy as a whole. This vigilance and investment should give the

synthetic buyer comfort that the benefits he receives and risks he is exposed to from investing in a synthetic portfolio versus a physical portfolio far outweigh the credit risk inherent in a synthetic longevity transaction.

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.

Reposted on Browndorfpem.com with permission.

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, William Lundy, Melvin Browndorf and Schad Brannon. For more information, visit www.BrowndorfPEM.com.