JANA Investment Advisers Pty Ltd

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Subject: Insurance Linked Strategies

The following Note is an abridged version of a recent JANA Research Paper 1. Introduction
For many years, investors have been in pursuit of alternative sources of return in order to increase the diversification of their portfolios. The desire to identify uncorrelated return drivers has been heightened in recent times, given the Global Financial Crisis, where traditional asset classes and some other strategies exhibited unexpected and unprecedented correlation. The purpose of this Note (condensed for website publication) is to introduce the concept of Insurance Linked Strategies, which are a growing alternative asset class (we use the term asset class loosely, predominantly to identify the exposure to insurance risk as being the relative uniqueness). This Note will outline the thesis of insurance linked strategies, along with providing the backdrop in relation to how the asset class has evolved over time. The various types of exposures within insurance linked strategies have a common thread of exposing investors to insurance risk as a driver of return, but the types of those risks and the way in which they are accessed varies quite broadly. Our discussion in this Note focuses on two sub-sectors of the asset class which have attracted the most interest from institutional investors of late for discrete allocations (as distinct from being embedded within multi-strategy hedge funds), being catastrophe bonds and life settlements.

2. Thesis of Insurance Linked Strategies

The rationale for investing in insurance linked strategies is to access a return stream with a low correlation to traditional asset classes. The returns from traditional asset classes are linked to risks such as equity risk, interest rate risk, currency risk and credit risk. For example, the returns from the Equities, Bonds and Property asset classes are dependent upon factors such as economic growth and interest rates. In contrast, insurance linked strategies have little, or no direct link to these conventional sources of risk. Instead, these strategies provide investors with access to returns which are linked to insurance related risks, such as property risk, casualty risk, mortality risk and longevity risk.

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In the past, the primary way to access some exposure to insurance risk has been to invest in the traditional securities (i.e. equities, or bonds) of an insurance or re-insurance company. These investments typically have a reasonably high correlation with traditional asset classes, at least partly due to the corporate outcomes being a function of a wide variety of insurance and noninsurance factors (investment returns, operational performance, corporate activity, etc). Therefore, instead of gaining access to the pure or direct form of insurance risk which has a low correlation with traditional asset classes, investors have also been exposed to risks such as market risk, credit risk and operational risk. Some multi-strategy hedge funds have included insurance linked exposures within their portfolios for some time, but this has typically been a relatively minor allocation. Increasing sophistication and liberalisation in capital markets over the last two decades (at least) has enabled insurance companies to transfer the risks that are too big for their balance sheets to the capital markets. This has provided insurance companies with greater flexibility to manage risk and use their capital in the most efficient way. For investors, this has opened up a niche investment market of insurance linked securities, allowing them to access the underlying, or pure form of insurance risk. Insurance linked securities are defined as financial instruments, other than traditional equity and debt securities that are issued by insurance companies, and which carry insurance risk. For example, securities which contain property/catastrophe risk, mortality risk or longevity risk. Insurance Linked Strategies involve investment approaches that utilise both insurance linked securities and other avenues of obtaining exposure to insurance risks (e.g. secondary purchase of life insurance policies, direct reinsurance contracts, etc). The investment opportunity in relation to insurance linked strategies predominantly lies in accessing the beta of the asset class (exposure to insurance risk). There are clear areas for managers in this asset class to add value (e.g. actuarial expertise with regards to pricing and valuation models, underwriting expertise, and portfolio construction skill). In seeking to add value from active management, investors need to be aware that the managers in this space require specialised skills, many of which will be quite foreign to investors.

3. Types of Strategies
Insurance linked strategies can be categorised into asset class sub-sectors, according to the specific type of insurance risk that they are accessing. Some sub-sectors can be further broken down based on the nature of the securities or investment strategies utilised. Our discussion will focus on two sub-sectors of the asset class which have gained the most interest as of late, being Catastrophe Bonds and Life Settlements. A summary of these instruments is as follows: Catastrophe Bonds provide investors with access to catastrophe risk (e.g. the risk of an occurrence of a natural disaster such as a hurricane which leads to substantial insured losses). These securities have a similar structure to a bond, as they pay coupons and return the principal to investors at maturity. The risk is that the security will default, and as a result, not return the full expected payments to the investor. In the case of a catastrophe bond, the default is triggered by the occurrence of a natural catastrophe, as defined in the bond covenant. The principal natural catastrophes risks covered are wind storms (hurricanes, typhoons, etc) and earthquakes. The market for catastrophe bonds

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exists because insurance and reinsurance companies are limited in the amount of catastrophe risk that they can retain. Life Settlements provide investors with exposure to longevity risk through exposure to life policies. The life settlement market provides policy holders (in the United States) with a market to cash in their existing life insurance policies when they are no longer needed. A policy holder may sell a life policy because the policy is no longer relevant or required, the policy holder cannot afford to pay the premium, or the benefit of receiving the payment today outweighs the benefit of keeping the policy in force. The buyer of the policy makes a payment to the policy holder at attractive valuations, which is generally greater than the cash surrender value offered by the insurance provider, but less than the death benefit. The buyer of the policy then becomes the owner and beneficiary of the policy. The buyer is responsible for the premium payments, and collects the death benefit once the insured dies and the policy matures. The other type of insurance linked exposure which investors are offered as an investment approach is Diversified Strategies, which provide access to a range of insurance-related risks. These approaches may include exposure to property risk, natural and man-made catastrophe risk (man-made includes say a satellite launch), longevity risk and mortality risk within one investment portfolio. This Note does not focus on diversified insurance linked strategies. It is JANAs view that whilst these strategies add to the diversification of an overall insurance-linked portfolio, they also add significantly to the complexity. Managers of diversified strategies need to possess expertise in a variety of underlying sub-sectors, as well as having the necessary skills to combine these strategies in an optimal way. Performance measurement of these strategies may also be challenging.

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4. Key Features
A high level summary of the key features of Insurance Linked Strategies (categorised as in section 3 above) are contained in the table below.
Catastrophe Bonds Principal driver of return Pricing of natural catastrophe risk relative to actual losses. Life Settlements Actual mortality relative to initial assessment of expected mortality, for a pool of lives. Since the mid 1990s; secondary market was established to address the problem of low surrender values on life policies and provides an exit option to policy holders; US centric. Mid-single digit returns (approx. 8% p.a.), low single digit volatility (approx 2.0% p.a.) Pooled funds Direct ownership of policies Synthetic exposure Diversified Strategies A variety of insurance risks, where the pricing differential between the anticipated losses and actual losses determines the investor outcome. A response to the capital constraints of the balance sheets insurance companies.

Historical development

Experience in Returns/Risk

Principal access avenues

Dominant market players (investors) Fees

Since 1997; market was established following changing regulation and claims from disasters such as Hurricane Andrew in 1992 and the Northridge Earthquake in 1994. Mid- to high single digit returns (Libor +3-5% p.a.), low single digit volatility (approx 1.5% - 3.0% p.a.) Direct ownership in discrete mandate Co-mingled/pooled catastrophe bond funds, often in hedge fund structure Part of a diversified bond portfolio Part of a diversified insurance strategies portfolio Specialist managers Select bond managers 0.5% p.a. to 1.5%p.a. + performance fee Strong secondary market, relatively liquid.

Range of objectives. Generally seek to enhance risk adjusted return (via increasing portfolio diversification). Generally co-mingled/pooled funds, most often in hedge fund structure

Specialist managers Approx. 1.0% p.a. (dependent on investment vehicle) Secondary market, but semi-liquid.

Liquidity

Specialist managers Hedge funds Dependent on underlying strategies. Can be as high as 2%p.a. plus performance fee Dependent on underlying strategies. Generally less liquid in aggregate.

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5. Catastrophe Bonds
Catastrophe bonds typically refer to a special subset of securities issued into capital markets. In addition to these securities, there is a broader array of structured or over-the-counter (OTC) securities in the spectrum of ILS which serve a similar purpose of transferring insurance risk to investors. Catastrophe bonds were designed to facilitate the direct transfer of catastrophe insurance risk (natural events leading to catastrophic insurance losses) from insurers, reinsurers and corporations to investors. The insurers, reinsurers and corporations are the sponsors of the catastrophe bonds. Catastrophe bonds were designed to protect sponsoring organisations from financial losses caused by large natural catastrophes by providing an alternative or supplement to traditional reinsurance. The majority of catastrophe bonds relate to catastrophe insurance of the following events or perils: hurricane activity in the North Atlantic and Gulf of Mexico impacting the eastern coast and Gulf coast of the USA; typhoon activity in the North Pacific impacting Japan; earthquake activity in North America, principally the west coast of the USA; earthquake activity in Japan; and severe storm damage in Europe. Catastrophe bonds are also known as cat bonds.

Source: Aon Benfield Securities

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5.1

Arguments for investment

There is rational support for the prospect of returns of cat bonds being largely uncorrelated with returns on other investments. The circumstances leading to default on cat bonds are markedly different to those which apply to other corporate securities. Yields on cat bonds generally offer a premium over similarly rated corporate bonds, but the drivers of yield premium are generally unrelated to pricing for capital in corporate bonds. Used as part of a broader portfolio of marketable securities, cat bonds offer the prospect of strong diversification. Diversification obviously requires a suitable spread of exposures to different perils within the cat bond holdings, particularly to mitigate the big one event and its potential to lead to substantial losses. The experience of investors in cat bonds to date supports the fundamental observations on potential for diversification. Starting with correlations, the correlation of monthly returns over 2002 to 2009 of the Swiss Re Cat Bond Total Return Index with MSCI World Index is 0.28 and with US Government Bonds is 0.06.

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5.2

Risks to take into consideration

Cat bonds by their very nature impart risk the risk of an event which triggers the bond (and when this occurs principal can be lost rapidly). However, it is not simply insurance risk which an investor needs to bear in mind. The following are some of the other risks to take into account: Liquidity Risk Both the volume of secondary trading, and the transparency of pricing for secondary trades where they do occur, present risk in that they are both quite limited. Modelling Risk Many aspects of pricing and rating of cat bonds rely almost exclusively on complex modelling techniques. Whilst there is a small number of recognised modelling providers, the sensitivity of each to the data used as input to their model means that extreme care must be taken when utilising their analysis. Counterparty Risk Cat bond issuers commonly enter into swap agreements with third parties that guarantee interest and principal repayments to investors, in the absence of a trigger event. There is counterparty risk with the third party. Unregistered Investments these bonds are not subject to the level of oversight and disclosure typical of mainstream, registered investments.

5.3

The Cat Bond Market

The value of securities on issue in the cat bond market in 2010 amounts to approximately U$13B. This is projected to rise to between U$28B and U$56B by 2019 (according to Swiss Re). The magnitude of the market in derivative securities covering natural catastrophe insurance are more difficult to quantify due to the volume of OTC contracts comprising this segment of the market. Practitioners estimate that the market in derivatives is at least as large again as the physical bond market, and probably multiples of that market. The composition of sponsors in the cat bond markets is roughly: 40% reinsurance companies (e.g. Munich Re) 40% primary insurance companies (e.g. Allianz, Zurich Financial Services) 10% government entities (e.g. State of Florida) 10% large corporate (e.g. Disney Japan) Berkshire Hathaway is a dominant player in the areas of catastrophe reinsurance other than cat bonds (Berkshire considers cat bonds a relatively inefficient use of its capital given the bonds are fully collateralised). One of the potential concerns of investors in the cat bond market is that the presence of a dominant player such as Berkshire Hathaway in the broader market for catastrophe insurance risk may mean that pricing of the cat bond market is indirectly influenced by the actions of the dominant player(s). Significant investors in cat bonds include Fermat and Nephila (cat bond managers) and PIMCO (as part of broader based fixed interest portfolios), to mention a few. Industry participants JANA has consulted are of the view that the ability of a single market participant to unduly influence the market are not supported by market dynamics, other than perhaps in times of extreme market dislocation. Such an example might include the security pricing following a significant event such as Hurricane Katrina. However, the actions of
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Berkshire Hathaway in the market post-Katrina was to exploit the very attractive pricing for insurance capacity in that environment and probably contributed to establishing attractive benchmark pricing.

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6. Life Settlements 6.1 Growth of the sector

The life settlements market in the US began in the mid 1990s, and has experienced very strong growth. This growth has been driven by the increased awareness of the secondary market for life policies, along with favourable demographic trends. The market acts as a means for policyholders to sell their life policy because the policy is no longer relevant or required, the policy holder cannot afford to pay the premium, or the benefit of receiving the payment today outweighs the benefit of keeping the policy in force. The growth in the volume of US Life Settlements can be seen in the chart below.

Source: Coventry Capital

The market is expected to grow to $160bn in the next five years, based on the growth in the part of the population aged over 65. This is expected to provide a continuous supply of life insurance policies for the life settlements market. The chart below demonstrates the forecast potential of the US Life Settlements Market.

Source: Coventry Capital

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In addition, the remaining market potential for life settlements volume is significant. The chart below shows that $31bn policies are currently in force, leaving market potential of $514bn, or 94% of the market.

Source: Coventry Capital

6.2

Influences on Return

There are sound reasons to expect an element of excess return from life settlements due to: liquidity premium whilst a tertiary market for policies exists, they are at best semi-liquid, and information asymmetry premium a seller of a policy has little capacity to judge the value of the policy other than the alternative of a surrender value offered by the issuing insurer, leading to meaningful inefficiencies in pricing. Once purchased, the actual return achieved on life settlements will be influenced by: Longevity Improvements Improvements in longevity will have a negative impact on returns. Longevity improvements refer to the risk that the actual life expectancy of policyholders improves. For example, the development of medication for the treatment of HIV/AIDS has led to unexpected longevity improvements. Medical improvements are expected to contribute to longevity improvements in the future (although the rise of obesity may counter some of these effects). Underestimation of Life Expectancy If overly optimistic mortality assumptions are used to price policies, this will have the effect of inflating the cash sums that are paid to policyholders, and reduce the expected return to investors. Medical Underwriting Sensitivity Life Settlement returns are highly sensitive to the level and quality of the medical underwriting that has been undertaken. The dominant underwriters in the market are 21 Services, AVS, EMSI and Fasano & Associates. In the past, the use of different underwriters has provided different valuations for investors.

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Poor Administration Inefficient administration of life policies will also have an impact on net returns, primarily by delaying receipt of the policy proceeds.

6.3

Arguments for Investment

It can be argued that investments in Life Settlements provide an attractive risk-adjusted return stream which has a lower correlation with traditional asset classes. Based on simulated data, the asset class is expected to deliver mid single digit returns (approx. 8% p.a.). The chart below highlights the low correlation that the asset class has with the traditional asset classes. Whilst delivering low correlation, the asset class also exhibits low volatility.

Source: Coventry Capital

6.5

Issues for Consideration

The following issues need to be considered in relation to an investment in the Life Settlements industry: Regulatory risk: Investments are exposed to US regulatory risk. The Life Settlements industry is becoming increasingly regulated, and regulations are not uniform across jurisdictions. Quality of data and assumptions used: Returns are impacted by the actuarial valuation tables and pricing models used. Market participants have criticised that mortality tables do not properly reflect longevity risk. This is at least partly due to the volume of lives needed to make reliable estimates, and the relative immaturity of the market not yet offering that ability. Underwriting cycle: The underwriting cycle has an impact on investments in secondary policies, as a cohort of policies may have originated in the industry in a period of particularly strong (or weak) underwriting.

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Market distortions: Market distortions exist in response to stranger originated life insurance. Seniors have been persuaded to take out insurance through a premium financing arrangement, with the investor providing a loan or cash to the policy holder, with the intention of buying back the policy in the future. Market participants: There are a large number of participants in the life settlements value chain, which may erode the return received by the end investor.

6.4

Investing In Life Settlements

Providers Whilst the Life Settlements market is based in the United States, Australian investors can gain access to these strategies via managers such as Credit Suisse, Bentley, Coventry and Opus Life. Fund Structure There are a variety of ways to access life settlements, depending on the amount of money being invested, as well as liquidity requirements. A summary of ways to access the asset class is as follows: Pooled vehicle: The most common way to access the life settlements asset class is via a pooled structure. Pooled vehicles are appropriate for small to mid size investors. Providers of pooled vehicles undertake portfolio construction and diversify the pool of policies by factors such as face value, age, gender, life expectancy and carrier rating. Direct ownership of policies: For larger investors, direct ownership of life policies may be a suitable investment structure. This method of accessing the asset class provides greater control over the life policies; however it may not be as liquid as in investment in a pooled vehicle or a synthetic exposure. Synthetic exposure: As the market has evolved, so has the sophistication of access to life settlements. Synthetic instruments, such as longevity-linked swaps and notes, provide access to the life expectancy of the life settlement policies, or lives, within a reference pool. They also aim to reduce the cost of investing. Active versus Passive exposure An investment in the Life Settlements sub-sector of the market is reliant on manager skill and expertise, particularly in the following areas: Actuarial expertise with regards to pricing and valuation models, Portfolio construction and tail risk analysis, and Identification of market distortions. As a result, an active approach to investing is the favoured approach.

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