Adam Balinsky, president of Stamford, Connecticut-based life settlement investment specialist Caldwell Life Strategies, says the key to his firm’s success in an asset class full of traps for the unwary is making underwriting the cornerstone of its investment process at Caldwell and focusing closely on the underlying mortality assumptions that are the fundamental drivers of performance of a life settlement portfolio.
GFM: What is the background to your company and products?
AB: Caldwell Life Strategies Corporation, based in Stamford, Connecticut, is an asset manager providing life settlement and related life insurance investment solutions to investors. A life settlement is a transaction in which an in-force insurance policy is sold by the policy owner for an amount above the policy surrender value, but lower than the full death benefit, of the policy.
Traded policies are generally those issued to insured individuals aged 70 or older. Caldwell has a 33-month track record in managing a portfolio of more than 400 individual life policies with a notional face value in excess of USD2.5bn. The portfolios that Caldwell currently manages are effectively held in a managed account structure for the benefit of a single investor.
Caldwell’s management philosophy differs from many in the life settlement business in that it entails a fully integrated, vertical approach with in-house capabilities to originate, underwrite, document, service and track mortality. Additionally, the firm focuses on the underlying mortality assumptions that are the fundamental drivers of performance of a life settlement portfolio.
Its team has expertise in assessing and determining appropriate baseline for older aged mortality. In particular, Caldwell’s chief underwriting officer is an actuary and mortality expert with extensive experience in setting and applying mortality assumptions for older age populations. This has allowed Caldwell to develop innovative investment strategies that focus on key mortality assumptions, life insurance product features and opportunities based on actuarial cells that provide increased expected returns and reduced risk.
Consumer awareness of life settlements is growing, and the settlement option is increasingly seen as a consumer-friendly alternative to the surrender of an insurance policy. Caldwell uses investment strategies that provide risk-adjusted exposure to a non-correlated asset class with superior credit quality. With a statistically credibly-sized portfolio of policies, life settlement investors can expect stable long-term returns with predicable mortality, low volatility and virtually none of the overnight “gap risk” that occurs in other asset classes.
Caldwell commenced operations in the fourth quarter of 2006, financed by a single investor. It deploys multiple life settlement investment strategies including both lending and acquisition, focusing on niche strategies that provide excess returns compared with the general life settlement market. These identify specific purchase opportunities for life insurance products with features that provide returns not currently recognised by the broader market or that the market is not currently taking advantage of.
Caldwell is managed by myself as president and a senior staff of seven individuals with more than 40 years of combined experience in insurance and life settlements investing. I joined Caldwell from Baker & McKenzie where I led the firm’s life settlements practice. Our senior actuary, Edward Hui, was a pricing officer with General Reinsurance responsible for setting pricing policy, mortality research, product development and managing an USD8bn notional portfolio.
The entire staff at Caldwell comprises 19 professionals and current assets under management exceed USD350m in a portfolio with policy death benefits in excess of USD2.5bn. The firm marks performance on a mark-to-model basis and is up 34.9 per cent since launch. The mortality performance of Caldwell’s pool, although not yet statistically significant, has been in line with expectations having experienced 17 policy maturities across all strategies.
GFM: Who are your key service providers?
AB: Caldwell is audited by JH Cohn and its legal advisers including Arent Fox and Greenberg Traurig. The firm uses Wells Fargo Bank and Christiana Bank as trustees of certain portions of the policy portfolio it manages. Caldwell verifies its pricing assumptions annually with an independent actuarial consultant.
GFM: Have there been any significant developments within the firm?
AB: Caldwell is currently engaged in structuring an unrated debt offering of USD100m in principal with a ten-year final maturity and double-digit current coupon, heavily over-collateralised by a significant amount of equity that will be largely kept in the underlying portfolio and released only subject to specific mortality and performance hurdles. Most of the debt offering proceeds will remain in the structure to provide premium funding on the policy portfolio and to service the current coupon on the debt.
GFM: What is the profile of your current and targeted client base?
AB: Caldwell is actively engaged in soliciting managed account investors interested in assets with very low correlation to traditional investment influences including interest rates, stocks, bonds, real estate, currencies, commodities and international unrest, and who seek middle-and longer-term stable and predictable cash flows with very high credit quality underlying collateral.
Expectations are best achieved by long term investors who are able to commit to a ten to 15-year investment horizon. The asset is best suited to US onshore investors or those who can benefit from a treaty-advantaged offshore structure for tax purposes. All assets currently managed by Caldwell are held in our single managed account structure for the benefit of our institutional client.
GFM: What is your investment process?
AB: Caldwell seeks to capitalise on its in-depth knowledge of insurance products and advanced understanding of mortality. The firm has a targeted list of insurance policy forms with specific product features which, when managed properly, can provide increased yields compared with market assumptions.
This arbitrage is based on Caldwell’s ability to price complicated policy features using a proprietary pricing model. The firm has developed other purchase strategies that focus on actuarial cells where it has identified advantageous pricing and increased returns.
The investment process begins with identifying a client’s risk profile, time horizon and investment needs. From there, the firm works with clients to set appropriate purchase parameters and an expected portfolio composition. It then uses its origination arm (Caldwell Funding Corporation) and industry relationships to source policies that satisfy the purchase parameters.
Policies undergo an extensive underwriting process and are selected on the basis of age, sex, health status, estimated life expectancy of the insured, premium pattern, carrier rating and other critical factors. We take numerous other factors into account including the conditions of putting the policy into force and the persons involved in writing the policy and brokering the trade, the number of years since the policy issue date, the claims paying rating of the issuing carrier, the legal structure in which the policy is held, and the expected premium stream. Factored together, the data is used to derive a net present value, bid price or loan to value for the policy. As a passive investment strategy, policies are purchased or lent against with an eye toward long-term ownership and management of a static pool.
When acquiring policies, Caldwell strives to reduce intermediary fees by purchasing policies through its own licensed provider entity, enabling it to purchase on a wholesale basis in contrast to other investors who sustain significant mark-up fees. This approach also means Caldwell is responsible for the extensive due diligence review for each policy purchase.
Even where the firm purchases through third-party providers, it uses internal due diligence procedures and guidelines to ensure that policy acquisitions are uniformly vetted and reviewed to mitigate origination, fraud and legal risk that can be associated with life settlement investing.
GFM: How do you generate ideas for your funds?
AB: Caldwell’s new product and investment ideas are developed internally as well as through exposure to concepts from third parties. The firm’s chief underwriter and underwriting team analyse new and existing life insurance products issued by carriers and identify opportunities based on product features, riders and pricing mechanics.
Caldwell also develops strategies internally that take advantage of general industry approaches to life expectancy and mortality, and focuses on situations where there is a sound basis for differing views and pricing approaches.
Additionally, the firm provides financing to innovative transaction concepts and structures and is routinely approached by third-party groups seeking equity and debt financing to bring new concepts to market. Caldwell’s management team reviews these opportunities, evaluates them and where warranted, structures transactions to deploy funds into these strategies. Over the years, this pipeline has been a fruitful source of innovative transactions.
Caldwell’s preference is to work with groups who recognise that this is a long-only investment with selective opportunities for short-term trading of individual policies. There have been attempts to develop a synthetic market to offer exposure to life settlements but the underlying cash market isn’t yet large enough to support a synthetic market, and long-term counterparty risks are a significant obstacle.
GFM: What is your approach to managing risk?
AB: This is a buy and hold strategy with limited opportunistic exits. The most critical risk components for long-term investment success are judging the mortality performance of the asset and optimising cash flows by paying the minimum premiums required to keep policies in force.
Caldwell focuses on correctly assessing and setting baseline mortality assumptions and optimising premiums. Having an in-house actuary with specific expertise in setting, evaluating and verifying old age mortality is unique in the industry, and having a statistically significant portfolio is a key component to achieving expectations.
Market knowledge is a critical factor in mitigating risk. The life settlements market is an insider’s game and novices can pay a heavy entry fee. Understanding the evolution of the market and knowing the participants first-hand is an invaluable asset. The experience of Caldwell’s team provides an important guide to the decision process.
Understanding the counterparty exposure to each carrier and the impact of changes to features within their policy products requires constant diligence. At a macro level, litigation brought by carriers in any state jurisdiction can have an immediate economic impact on specific policies within the pool. Legal due diligence and capabilities are critical success factors because different types of policy origination can introduce risk into transactions. Caldwell’s internal legal capabilities ensure that appropriate review and analysis are undertaken on each case.
GFM: How has your recent performance compared with your expectations and track record?
AB: Caldwell’s investment performance to date has been in line with expectations. Investment returns in life settlements are generally back-end loaded. Since returns are driven by mortality performance and mortality accelerates as a pool ages, the receipt of death benefits occurs with the aging process and will peak for a pool with an average life expectancy of ten years in years seven to 12 and then drop down as the number of remaining lives in the pool is reduced through to final maturity of the last policy.
Consequently, Caldwell’s mortality performance and related track record only provides insight into the early durations, but management’s expectation is that performance will continue to track its mortality assumptions and the underlying actuarial tables as adjusted by Caldwell to reflect the life settlement population. A critical factor to consistent returns is the number of individual lives in the policy pool. Caldwell’s current pool contains more than 400 policies, large enough to correlate with the expected mortality of industry mortality tables as adjusted by Caldwell.
The performance of a statistically significant static pool should have a bell curve-shaped mortality distribution. That is the situation with Caldwell’s portfolio, and as a result the largest expected returns are in the years ahead. The firm expects to reach the point where death benefits exceed premium payments in late 2011 or early 2012 (although cash flows in early durations can be lumpy and early year cash flow break-even is not a certainty). From that point forward, expected annual returns should grow over time as the pool ages and insured reach or exceed their life expectancy predictions.
GFM: What opportunities are you looking at right now?
AB: Current market conditions have never been more favourable for new buyers entering the market. There is a market for aggregated portfolios of policies but trading portfolios tends to add additional layers of complication and executed pool trades are a relatively rare event. At the moment, competition between buyers of individual policies is slight and there are abundant opportunities to aggregate single policy assets with expected internal rates of return in the mid- to high teens on an unlevered basis.
Caldwell is focused on new policy acquisitions and raising capital against its current portfolio. A portion of the proceeds of the debt offering will be used to purchase new policies to increase the size of the existing portfolio and take advantage of current buying opportunities.
For new investors, Caldwell has a number of conservative, predictable strategies that can be designed to meet specific cash flow needs, both in terms of investment outflow and the timing of future cash inflows. Targeted acquisitions will be focused on specific products and policies that offer additional value that the market is currently mispricing as well as actuarial cells where niche opportunities exist.
GFM: What events do you expect to see in your sector in the coming year?
AB: The life settlements market is in the early stages of recovery. New institutional investors are still in the exploratory phase and capital has yet to return in meaningful amounts to the market since its exit in 2008. By mid-year, it’s reasonable to expect that new buyers will be entering the market and that there should be some corresponding price movement as capital flows come back.
The current buyer’s market should be mitigated and liquidity should improve – consequently those who deploy funds early are likely to be the beneficiaries of current market conditions with latecomers realising more market-level returns. However, Caldwell’s niche strategies are designed to be layered on top of market pricing, so in the medium term we expect to be in a position to implement strategies that beat market returns by material amounts.
Additionally, life settlements are beginning to be recognized as a viable asset class for investors seeking exposure to liability-driven investments. The long-dated, high return, low volatility, back end-loaded return profile of a well-developed life settlement portfolio matches the LDI return profile better than virtually any other asset class. Life settlements significantly outperform current long-dated fixed-income returns while offering better counterparty risk and delayed cash flows that seem almost custom-made for LDI investors.
GFM: How will these developments affect your portfolio?
AB: Caldwell expects a valuation improvement in the current portfolio as the overall market recovers and its pool seasons. The portfolio has been written down and conservatively priced to reflect the pricing downturn that started in 2008 due to life expectancy extensions as well as reduced availability of capital, which caused the tertiary markets to seize-up. At current levels, it seems conceivable that the market could see a rapid recovery back to internal rates of return in high single-digits or low double digits.
GFM: How do you assess investors’ current expectations?
AB: The investment environment for life settlements has improved significantly over the past six months and there’s currently renewed interest in the asset class. As markets recovered from the financial meltdown of 2008, there were abundant opportunities in other asset classes to purchase investment grade assets at distressed prices. As the recovery has progressed, fewer of those opportunities exist and investors are now investigating which assets have been left behind.
In the case of life settlements, the illiquidity of the asset class caused it to be overlooked until in the first quarter of 2010. Prices for life settlements are just beginning to recover and market volume is still running significantly behind the peak levels of 2006 and 2007. Investors who understand the risk-reward profile of life settlements, have appropriate time durations and value the positive features of properly structured life settlement investments – non-correlation to other markets, high credit quality and predictable stable cash flows – should be well positioned to take advantage of the current buying environment.
GFM: What differentiates you from other managers in your sector?
AB: A number of funds and asset managers currently in the market are attempting to ramp up their investment operations, but we see very few with working experience in the asset class or with specific expertise in mortality pricing. Most are outsourcing critical steps in the investment process and virtually none have a fully operational platform on the scale that Caldwell has developed.
Many investors fail to appreciate the risks of mortality-based investing and overlook the significance of direct expertise in assessing mortality assumptions. Underwriting has always been the cornerstone of the investment process at Caldwell. Other investors have failed to recognize the true risks of mortality assessment and the range of resources available to mitigate those risks.
GFM: How do you view the environment for fundraising over the coming 12 months?
AB: Caldwell is currently in detailed conversations with major institutions considering investment in life settlements. The calibre of potential investors and overall market conditions have never been better. Investors seem driven to allocate some portion of their capital to truly non-correlated investments. The merits of life settlements investing are just beginning to be recognised by sophisticated investors and we expect a number of new entrants to deploy money in the coming year.
GFM: Do you have any firm plans for further product launches?
AB: If Caldwell is successful in bringing its unrated note offering to market, there are plans to follow up with additional similar offerings. Life settlement fund structures have presented problems in the past due to lack of liquidity and reliable exit strategies. The development of a structured note market could provide the much-needed exit that short-term investors have been missing. As a result, Caldwell is considering development of a “warehouse facility” fund to aggregate individual policies over the short term that are to be used as collateral for future structured note products.