Volatility In Valuation Inputs Is The Biggest Test
The big story, this year, has been the updates in mortality estimates. So, what impact do these mortality estimates updates have on unrealised returns? This article will help you break down what role mortality estimates play. Our history in the market gives us a unique experience to comment.
The evolution of life expectancy estimates is a long story and not within the confines of this article. However, the market is feeling the effects of recent updates. With two major players, ITM TwentyFirst and AVS Underwriting, announcing extensions to their older age mortality tables.
The inherent risk of life settlements is the uncertainty of the timing of that final positive cash flow (the benefit payable). In turn, the duration of the intervening negative cash flow (premium payments). The mortality estimates assist in modelling a range of likely outcomes but do not predict actual outcomes. Nevertheless, they play a big role in establishing current Net Present Value, and unrealised returns to date.
The nature of the asset means that more attention is sometimes placed on the unrealised state of play, rather than the realised outcome. There are many dynamics which affect unrealised returns. Unrealized income comes from such sources as a positive actuarial value accretion from aging of insureds, estimated future premiums to keep policies in force; changes in third-party life expectancy estimates; changes in the discount rate used to discount cash flows expected from policies.
Ultimately, these many dynamics need to be mindfully managed but let’s focus on LE’s and mortality tables.
The Mortality Estimate Updates
If you are investing in the asset class and are yet to hear about these updates, then you may need to pay closer attention to this post.
Because of the higher market share of ITM and AVS their mortality changes usually cause a large impact. This is not the first time the asset class has gone through mortality updates. In 2008 changes in Valuation Basics Tables (VBT) and subsequent changes from ITM TwentyFirst rocked the market.
One significant difference, compared to the 2008 environment, is that there are more life expectancy companies in the market besides the top three: AVS, TwentyFirst and Fasano. This has created competition in the market but also given investors greater flexibility in how to calculate LE’s. This competition has improved the accuracy of the estimation over the years.
Life Expectancy providers will continue to combine data and experience more observations. As such, they will continue to have more opportunities to improve life expectancy models. It’s a good thing for new investors coming into the market.
So, it makes sense that there will be a lengthening of LEs as statistically significant comparisons of actual to expected data become available. In turn, it gives more assurance in the accuracy of LE.
What is Life Expectancy (LE)?
LE’s generated by underwriters who estimate the length of time an insured is anticipated to live. They are used to project how long investors must pay premiums before the death benefit is collected. Short LE’s translate into higher offers to sellers, while long LE’s typically result in lower offers. The timing of maturities directly affects the value of the portfolio by affecting the timing and size of cash flows.
Notably, the important thing to understand about Life Expectancy (LE) reports is that they are estimates. The LE number popularly quoted is just the statistical median (50th percentile point) along with a range of possible outcomes.
The curve represented by this range of outcomes is not a “Normal” distribution rather a “Poisson Curve”. Each insured Life has its own idiosyncratic health and lifestyle characteristics. The modelling, by underwriters, attempts to match this against their historical experience of similar but not identical lives.
Life Settlements underwriters all employ varying evaluation processes. Consequently, underwriters rarely agree on LE estimates, leading to valuation disparities. When trying to gauge the accuracy of LE estimates, no unbiased methodologies exist.
Underwriters defend their methodologies, but the differences in LE calculations confuse both sellers and investors. The experience of the asset manager is crucial in determining how to best use the information provided by LE underwriters. One way to understand the impact of the mortality table, on the value of a portfolio of life settlements, is to stress test it.
How do you calculate mortality estimates?
The underwriters typically use methodologies including but not limited to
- Historical Data Tables: Mortality data accumulated over many years. These are based on normal Age, Gender and Smoker/ Non-smoker status. This is matched to the case being considered. Ie It is important to accumulate data on specifically Life Settlement Cases as these cases display different mortality experience to both the general population and even the general insured population.
- A “Multiplier”. Used to attempt to “quantify” the net effect on an individual’s case of the debits and credits associated with health and lifestyle. This is a complex interaction between conflicting benefits and deficits potentially influencing longevity.
- A model to consider the effect of the phenomenon called “Anti-selection bias. People willing to sell their policy have higher morale (therefore potential healthier outlook) than those who don’t. This effect appears to degrade over time after the initial sale of the life policy.
- A model that will attempt to quantify the potential effect of continued medical improvements over time.
To determine the LE’s it is essential to understand the underlying mortality assumptions and underwriting process. Importantly, a manger with historical experience in life settlements transactions and portfolio construction can help you decipher the noise in mortality calculations.
The Technical Bits
Anyone familiar with the secondary life insurance market would be aware that it involves the purchase of the fixed benefit amount of an unwanted, permanent life insurance contract, at a discounted price. The physical return only actually occurs when the benefit pays out at the uncertain future date. Meanwhile, the new owner assumes the burden to continue to pay the premiums until such time as the benefit pays out.
In the secondary life insurance market, most mainstream players, use a probabilistic valuation methodology uses known inputs. These inputs are the benefit amount and forward premium quotations from the issuing insurance company. Additionally, it uses life expectancy estimates. These are a range of possible outcomes based on previous experience of similar, but not identical insured lives, usually supplied but independent third-party l underwriters. Furthermore, a discount rate is applied based on a “risk” estimate based on the idiosyncratic characteristics of the case. The risk component is an outcome of several unrelated considerations. This includes the quality of the origination circumstances, policy size, policy issuer to name a few. These last group of inputs is usually proprietary to the investor. Unless it is intentionally disclosed, it is difficult to determine the underlying methodology
The Accounting Standards
The trick, for the new owner, is to value it on a regular basis. Naturally, this is subject to the regulatory requirements and perhaps accounting standards of their particular jurisdiction. Different jurisdictions have different requirements both accounting and regulatory. Assuming, the jurisdiction or entity actually elects to subscribe to any recognised standards at all, say, for instance, the International Accounting Standards.
International Accounting Standards are written to allow relatively standard comparisons to be made of financial statements of entities and assets commonplace in all jurisdictions. However, they struggle to allow valid comparisons between differing assets unique to only one or more jurisdictions and with non-standard structural or market characteristics. It’s fair to say that, secondary life insurance falls into this category.
A number of industry participants appear to hold the view that the latest round of updates by ITM 21st and AVS appear to represent a significant lurch to the conservative side of mortality estimates particularly in the very elderly age groups. These cohorts have seen the largest percentage moves in increased life expectancy predicted. This is interesting as previous underwriting changes in past years have seen the very elderly categories either decline or show little improvement.
We comment at this point that the willingness of the investment manager to be transparent about these processes to the underlying investor. At times this is rare but is nevertheless one of the most reassuring things in a manager/ client relationship.
Time will tell if these apparently conservative new estimates will prove effective. However, they may represent the best buying opportunity presenting to new capital that the industry has seen for some time.
Disclaimer: This information is intended for qualifying investors only. It was correct at the time of preparation. It has been prepared to provide general information only and should not be considered as a “securities recommendation” or an “invitation to invest” in any jurisdiction. Potential investors should consider the relevance of this information to their particular circumstances. Before proceeding, investors must obtain the prospectus and take their own legal and taxation advice. If you acquire or hold one of our products we will receive fees and other benefits as disclosed in the prospectus and relevant offering documents.