The life risk investment market ultimately comes down to two sides of the same coin: longevity risk and mortality risk. Holding both risks in a portfolio simultaneously are something of a natural hedge, like an equity hedge fund manager maintaining both long and short positions in public equity markets or a credit hedge fund taking long and short positions across the yield curve.
There aren’t many similarities between public equities, government bonds and life risk. However, managers of life risk strategies take similar approaches to portfolio construction as equity and credit hedge fund managers do – namely, additional layers of diversification within the portfolio.
“When we’re trying to buy policies from brokers, we look at what they have based on face value and age ranges. We want to ladder the portfolio based on life expectancies so that it matches the life of the fund and we look at different face values largely because we need to ensure that the capital we’re deploying can access a diversified range of ages,” said Anna Bailey, Managing Partner at Virginia-based Chestnut Capital Management, an OCIO for life settlement fund managers.
It’s a similar approach that the insurance linked strategies team at Credit Suisse applies. The firm invests in a range of biometric-focused transactions that are exposed to either longevity or mortality risk, and Olga Ho, Head Underwriting Life at Credit Suisse ILS in Zurich, Switzerland, says that considerations are made across transactions to achieve both hedging and diversification.
“We seek to build a balanced portfolio that includes various types of risks such as excess mortality, excess morbidity, longevity, or shock lapse. Within each risk class, we seek to invest in different transaction structures, regions, and different trigger and pay-out mechanisms to further limit tail risk of the portfolio.”
Life risk-related products are illiquid and over the counter, relying on relationships and networks to source deals and execute them, as opposed to the more easily accessible exchange-based nature of public equities. This makes product selection arguably more important to a life risk-based investment manager than stock selection in a public equity strategy because what goes into the portfolio is heavily dependent on supply and the fewer exit options make rigour a keyword in terms of portfolio construction.
“We don’t have a strong bias to either longevity risk or mortality risk – portfolio construction is primarily a matter of the alignment of available investment opportunities and the suitability of those to the risk/return profile for the portfolio,” said Ho. “Any investment we make is subject to a rigorous due diligence process that focuses not only on the ceding company and the underlying risk, but also on various external factors that may affect the long-term success of the business, such as the regulatory environment or market position. We also stress test these opportunities to obtain a clear perspective of the underlying risk.”
In life settlements, the risk is exclusively longevity, so there’s no hedging per se – diversification is the name of the game. And after Bailey’s initial age and policy price screen comes the hard work to ensure that risk is mitigated.
“We won’t buy any policies where the life expectancy is less than 36 months. That’s too much risk if the policy holder outlives the expectation,” she said. “But in terms of the details, you have to do a lot of the work yourself. You may get a life expectancy estimate from a supplier, but if your $400k policy is a 72-year-old lady in California who lives on a $5-million-acre plot, you might as well add five years to that estimate. Understanding socioeconomics is critical in life settlement and longevity risk investing.”
Longevity risk isn’t exclusive to life settlements and life ILS funds. Defined benefit pension funds are, by far, the largest company type that is exposed to this risk, and their entire investment program is designed to ensure that it delivers investment returns so they can meet the promises to their current and future pensioners. On the surface, therefore, adding additional longevity risk to their investment portfolio might seem counter intuitive, but that is considered by some to be a misconception.
“Pension fund investors often overestimate the correlation of a balanced life ILS portfolio’s longevity risk with their own longevity risk, especially considering that longevity risk constitutes only one risk type in an overall Life ILS portfolio,” said Ho. “Also, and more importantly, a pension fund’s longevity liabilities may be very different from the biometric risks to which a particular life ILS strategy is exposed to in terms of regions, health systems, and age groups.”
Diversification is the only free lunch in investing, according to a quote attributed to Nobel prize laureate Harry Markowitz. It’s as essential in life risk-based investing as it is anywhere else, but the understanding of the nuances of risk in this space is not as widespread as it is in more liquid markets. Consequently, investors looking to access the uncorrelated returns that longevity and mortality-based investment strategies provide should pay particular attention to a manager’s approach.
“In life settlements specifically, we look to diversify across age, gender, life insurance carrier, state of residence, impairments and net death benefit of the policies we buy,” said Bailey. “But there really isn’t a definitive way to construct a portfolio in this space; it’s more like a puzzle you have to fit together. Investors doing due diligence on longevity or mortality risk-based investment managers need to ask how a manager diversifies their portfolio and be sure they are understand and are comfortable with the answer.”