tag:blogger.com,1999:blog-1065621989140573374.post7118006769548489715..comments2023-05-27T02:40:36.933-04:00Comments on Risk R-Squared: Diversification Deja VuMarc Rostonhttp://www.blogger.com/profile/05891121575193072176noreply@blogger.comBlogger1125tag:blogger.com,1999:blog-1065621989140573374.post-27465285426798911022011-02-10T23:44:54.583-05:002011-02-10T23:44:54.583-05:00I'd have to disagree, actually -- suppose that...I'd have to disagree, actually -- suppose that you have ten-year LE's on a pure constant hazard rate model, working out to a 1% hazard rate per month (or thereabouts). If all the lives in a portfolio are genuinely independent, you only need about 400 lives to have a chance of only 1% of going any particular month without a maturity. I'd say at that point you're pretty well diversified, no?<br /><br />The real problem is correlation -- when your model is wrong, it tends to be wrong for everybody at once. The portfolios originated in the 90's were mostly for short-LE AIDS patients; when the triple cocktail was discovered and AIDS became survivable, the industry tanked hard. For the more recent spate of origination it looks to me like the moral hazard risk associated with secondary sales was just not modeled remotely adequately and that the entire industry (which depended on a small number of actuarial firms to compute LE's) got hit by it. Admittedly the guy who owns six policies is underdiversified, but even 100 is plenty for the law of large numbers to kick in.<br /><br />Relative to the equity markets, there's a confusion between (1) "get close to the market return, whatever that is" and (2) "have a portfolio that will return close to modeled expectations." In life settlements we're mostly interested in (2), in equities (1). Ironically, the reason you can get such a big chunk of the diversification in the stock market from 30 stocks is that there is a huge amount of correlation between equities -- there's just less diversification benefit to be had, which of course prevents you from being able to hold an equity portfolio that meets (2).Dennisnoreply@blogger.com