Alternative Asset Opportunities (TLI:LN) recently released their Final Results – I thought readers might appreciate a new post. To some extent, I’m reminded of my original TLI post (wow, almost a full year ago now!) – the insured, those merry little blighters, are still trying their bloody living best to live forever! But Chronos waits for no man, or woman… Here are the policy maturities TLI has enjoyed to date:
7 maturities last year was in line with TLI’s 3 year average, and represents an accelerating mortality rate (as the total number of policies held has been steadily declining). However, proceeds of $5.7 million (mio/m) – just $0.8 mio per policy maturity – was an unexpected disappointment. But we have to chalk it up to bad luck (for us, and for them – the insured!):
Because (as of year-end) the $1.6 mio average face value (FV) of outstanding policies ($159.9 mio FV, 102 policies, 90 individual lives insured) was actually double the average policy maturity last year. And, as you can see above, at least 66% of the insured have policies which exceed $0.8 m. In fact, over 90% of the total portfolio is invested in $1.0 m+ policies. And the company has experienced a very welcome step-up in maturities since – in the first 3 months (of the new fiscal year), there’s already been 4 maturities, for a greater than expected $6.8 m (albeit with assistance from a single $5 m maturity). A pretty good harvest, and now winter’s just around the corner…
There was also a step-change in TLI’s valuation process at year-end. The company’s traditionally relied on 21st Services & AVS, the two major industry providers, for Life Expectancy (LE) estimates. However, the mortality rate (i.e. the ratio of actual to expected deaths) experienced to date has been less than 50% – which clearly suggests assumed LEs were too short (though TLI’s small portfolio/sample size should be noted). Two remedies have been applied. First, another programme of LE/medical assessments has commenced, to cover well over half the face value of the portfolio. As of year-end, over 40% of the portfolio’s now been assessed, and results actually re-confirmed the company’s latest valuation assumptions. Second, LE estimates have been obtained from a third provider (Fasano), who typically provides longer/more conservative LEs. [In fact, they actually provided LEs which were, on average, 24 months longer than the other two providers]. An average of all 3 providers’ LE estimates was incorporated into the assessments/valuations performed to date, and has also been applied to the remainder of the (unassessed) portfolio.
[Management also debated raising their 12% discount rate – but in light of the new assessments & a more conservative LE estimate, a higher rate might prove to be a form of double-counting. The obvious ability & intention to hold policies ’til maturity also suggests 12% is more than adequate. Personally, I note dramatically lower yield alternatives everywhere I look, plus increasing confidence & liquidity in the US market – I find it hard to believe 12%+ discount rates can persist much longer in the life settlement industry (at least for clean policies)].
The net impact was a 12.8% retrospective revision of the end-June NAV, from GBP 55.6p down to GBP 48.5p. [I was surprised to see TLI drop over 5% on the news – the company already flagged this back in July & provided a table indicating a likely 10-15% reduction in NAV]. It also grants the insured, who are now 89.6 years old on average, another 5.1 yrs to enjoy – an improvement on last year’s 4.9 yrs of average LE. [NB: Averages can be misleading – in this instance, it’s encouraging to note the minimum age in the portfolio should now be at least 85 yrs]. With a 64.5%-35.5% male-female ratio, this implies the new average LE assumption is about 9.5 months longer than that implied by the CDC’s 2008 tables. Might not sound like much, but I suspect it’s an eternity when you’re teetering on the edge of life & death at the age of 95!
OK, so what’s all this imply in terms of prospective investor returns?
Well fortunately, management been providing an increasing level of disclosure in the past year (to be commended). One of the most valuable tables provided is this new distribution of policy death benefits by LE band:
In reality, this is not a cash flow forecast – actual maturities will, of course, still be randomly/probabilistically distributed around each LE band. Arguably, a more refined approach might be a marriage of the CDC’s probability distributions (essentially my analytical approach last year) with this maturity table. But frankly, however much I fine-tune my analysis, the key driver’s always going to be estimated & actual LEs in the portfolio. And you can’t forget TLI’s sample size (just 90 lives) is ridiculously small compared to the population(s) the CDC & LE experts work with – so there’s a significant & inescapable level of random LE risk here. [But this works both ways – the table above predicts no maturities for the next year & a half, and three months later we’ve already had 4 early maturities! One can but hope most of the random risk will tend to cancel out]. A simpler analytic approach is obviously called for – based on the distribution above, with some obvious tweaks.
First we need to strip out the subsequent policy maturities (2 male, 2 female), worth $6.8 million. These maturities can’t (likely) come from certain LE bands – but lacking further info, we have to otherwise adjust maturities across the board, as follows:
In the right-most columns, I’ve adjusted the maturity schedule by 3 months (to end-Sep), and re-organized the maturities into discrete yearly buckets for simplicity. [I’ve assumed the two 8+ yr policies mature within a year]. We also need to allow for the fact some policies may expire worthless, usually when the insured reaches their 100th birthday. [Yes, the mind boggles at the legality of an insurance company offering a contract where you potentially pay premiums for a major portion of your life & then the policy benefit simply evaporates..!? That’s quite the 100th birthday gift, eh?] Presumably this is captured in TLI’s valuation process, but it obviously isn’t reflected in the tables above. Here’s a breakdown:
Fortunately, the odds are pretty low: Consulting the CDC (non-Hispanic white male & female) tables, we see 89.9 yr olds have a 4.8% (male) & 7.8% (female) chance of surviving to 100+ yrs. But only 46% of policies suffer expiry risk (49 no extension policies, and assuming a 50% payout for 3 reduced death benefit policies). Therefore, just 2.7% of policies will expire worthless, so we’ll haircut our policy maturities accordingly (across the board). Next, we need to factor in rising premiums – unfortunately, management provides little explanation, so let’s consider recent history:
While premiums paid has remained relatively static in absolute terms, it’s been steadily rising as a % of the average FV of the portfolio. However, there’s no particular pattern to the rate of increase, so let’s assume an average 8.8% increase going forward – which would, for example, peg premiums paid at 5.9% of average FV for the year ending Jun-15. Finally, we need to estimate current NAV:
[Table includes appropriate GBP/USD FX rates from Jun-Sep, expenses are estimated, policy gains are equivalent to the 2.1p & 0.8p TLI already reported, and the policy valuation adjustment’s a reconciling item. NB: At the current FX rate, estimated NAV’s now GBP 47.8p]. Right, let’s plug all this into our new model:
Now, let’s add another perspective – annual returns, cumulative returns & internal rates of return (IRRs):
Don’t forget TLI’s current GBP 39.25p share price is trading at a 17% discount to the end-Sep NAV. I still believe it’s entirely reasonable to expect this NAV discount to be eliminated in due course – as investors anticipate lower discount rates on policy valuations, as the average LE reduces & policy maturities accelerate, and as we see management repurchase shares and/or return capital. Therefore, I’ve shown two scenarios above, which assume discount elimination within 2 & 4 yrs respectively. You’ll note the sweet spot now falls somewhere between 3 & 4 yrs, as prospective annual returns are still well into double digits & IRRs are between 16-18% pa. [Duhhh!? Talk about re-inventing the wheel… TLI’s valuation process is based on a 12% discount rate, plus you earn another 5%+ pa from the NAV discount elimination – so a 16-18% pa IRR is exactly what you’d expect to see!]
We should obviously add a couple of provisos at this point. There’s a feeling of deja vu to this post – we’ve almost come full circle year-on-year, with the share price essentially unchanged, net cash/debt still near zero, and significant upside potential still on offer. If you already hold TLI since last year – as I do (with a current 8.8% portfolio holding) – the returns shown above will be diluted by your longer holding period. But is that really such a tragedy? You’re still going to enjoy an excellent IRR for holding what’s essentially an uncorrelated & investment grade** fixed income investment. [**95% of the life insurers are rated A or better, by A.M. Best – the other 5% is rated A-].
Plus you don’t have any leverage or interest rate risk. OK, admittedly you may have currency risk – TLI’s portfolio is in dollars. But I’ve always been OK with (multi) currency risk (or should I say, diversification) in my portfolio. And if the dollar isn’t your home currency, it’s generally served as a decent portfolio hedge in the risk on/risk off environment of the past few years: For example, when the market’s risk off, your portfolio suffers – but dollar strength usually benefits your TLI holding (& vice versa). Anyway, a share price retracement can often be a great opportunity to add to (or initiate) your position – and also an excellent opportunity for companies with an active share repurchase programme.
Ultimately, your only real risk is longevity – if these golden tickets manage to live a little longer, that obviously ratchets down your IRR. You can certainly model in advance the consequences of some extra months added to the average LE (because months, even weeks, are quite an achievement when you’re closing in on 100 yrs of age!). Or simply wait & see how the dice fall – maybe a little better, maybe a little worse – you know, I can live with that. Hopefully, they can’t…
And we can ideally hope the odds can be tilted a little more in our favour. The NAV/IRR model above is actually somewhat misleading – deliberately so, I wanted to illustrate a common problem investors face: You’ll note annual returns & IRRs begin to suffer after the 3-4 yr sweet spot I highlighted. This reflects zero interest earned on increasing amounts of cash on TLI’s balance sheet – an issue investors experience all too often in the real world, as they cope with the current ZIRP environment & management teams who refuse to return surplus capital. But prospects for TLI shareholders should actually be better than the model suggests – management’s now made a specific commitment to repurchase shares (and/or return capital). An aggressive repurchase programme, coupled with some prudent leverage, can really enhance shareholder returns – while the progressive return of capital could also make TLI a much more attractive longer-term investment (as back-end IRRs improve).
TLI’s $15 million facility with AIB expires at the end of Mar-14 – I still think management should be actively seeking a new lender. I’d consider (say) a 35-40% leverage limit (i.e. net debt vs. portfolio fair value) an attractive proposition for both lender & investors. Next end-March, we should be looking at something like a $60 mio portfolio fair value. Against this, a $21-24 mio loan facility would ensure a substantial margin of safety for a new lender. Additionally, the collateral will steadily appreciate in value, plus it’s a pretty palatable asset to bring on-balance sheet (if that ever proved necessary). With net cash (inc. receipt of $1.8 mio in policy maturities) currently around $1.6 mio, and net debt expected to peak around $16 mio in 2015, the company actually now has ample scope to begin repurchasing shares. Front-loading those share repurchases would offer the most bang for the buck, in terms of NAV enhancement & returns – but on the other hand, we can’t forget those relentless premium demands…
There’s a happy medium here – I’m obviously not suggesting TLI max out its debt capacity up-front! By initiating an active/systematic repurchase programme now – to ultimately result in a full utilization of TLI’s credit facility, by 2015 – management can return capital & enhance NAV, while still preserving financial flexibility. Of course, in this context, any further (unexpected) policy maturities are likely to represent a cash windfall – which can clearly be used for additional share repurchase!
Meanwhile, let’s maintain our bedside vigil & ready a fond ‘Bon Voyage…’
- Alternative Asset Opportunities PCC Ltd. (TLI:LN): GBP 39.25p
- Market Cap: GBP 28.3 mio
- Net Cash: $1.6 mio (inc. $1.8 mio of recent maturities)
- Current NAV: GBP 47.8p (at current 1.5972 GBP/USD rate)
- Price/Book: 0.82
- Tgt Mkt Cap: GBP 50.9 mio
- Tgt NAV/Share Price: GBP 70.7p (in 4 yrs time)
- Upside Potential: 80%