More pension funds are investing in insurance-linked securities. Daniel Grieger and Kristina Poliakova argue that recent natural catastrophes have made them even more attractive

The asset class of insurance-linked securities (ILS) has withstood the financial crisis well and more pension funds are beginning to realise that ILS can be a source of attractive returns with little correlation to other asset classes. The investment universe of ILS comprises catastrophe bonds (‘cat bonds’) as well as privately arranged reinsurance transactions.

The correlation of ILS to financial markets is low because ILS returns are influenced by prices paid for reinsurance risks. Reinsurance pricing depends, among other things, on the frequency and severity of natural catastrophes, but not on events in financial markets: a financial crisis does not trigger earthquakes. In addition, individual risks in an ILS portfolio can be diversified like in no other asset class - a hurricane does not trigger an earthquake or a pandemic.

The returns generated by ILS are composed of a fixed component compensating investors for the insurance risk, as well as a floating component which represents the collateral the investment proceeds are invested in. This floating-rate coupon turns ILS into an inflation-neutral investment which does not bear interest rate risk. As the collateral is invested in short-term government bills or supranational debt, the credit risk is kept as low as possible. Hence, the primary risk an investor faces is the occurrence of an insurance event that meets the trigger criteria of the transaction.

Investors worldwide have started using the asset class as an alternative to their fixed-income investments. Figure 1 shows the efficiency gains achieved by adding ILS to a generic pension fund portfolio. It also shows the volatility and returns of a portfolio without any allocation to ILS, as well as a gradual increase of ILS up to 20%. Naturally, the high value of 20% was selected for illustrative purposes only - typical allocations range between 3-5%.

For this analysis, a portfolio was constructed that is based on the 2010 Swiss pension fund survey of Swisscanto Asset Management. The initial portfolio consists of 29% equities (represented by GDDUWI), 20% real estate (RUGL), 5% hedge funds (HEDGENAV), 38% corporate bonds (G0BC) and 8% government bonds (JHDCGBIG). The analysis was performed in US dollars. Starting from a portfolio without allocation to ILS, an allocation to ILS (SRCATTRR) was gradually increased while all other asset classes were proportionately decreased.

Two results can be observed: an allocation to ILS slightly increases the total return of the portfolio and significantly reduces the volatility.

How to get invested
Most institutional investors allocate to dedicated ILS funds managed by specialists with the expertise to assess and price reinsurance risks and construct portfolios that meet pre-agreed risk-return targets. An important point to look at is the liquidity of the underlying ILS instruments a fund is invested in. While cat bonds can be traded over the counter (OTC) and have proven to be relatively liquid, even in times of distressed market conditions, privately arranged reinsurance transactions mostly run for a risk period of one year and can hardly be sold in between.

Pension funds investing in ILS should look for funds without liquidity mismatches. Such a liquidly mismatch occurs, for example, when a fund with quarterly liquidity invests in reinsurance contracts with fixed maturities of 12 months.

Liquidity mismatches create two issues: first, the portfolio structure can change in case of redemptions as only liquid positions can be sold.

Second, an equal treatment of subscribing and redeeming investors cannot be guaranteed, since reinsurance transactions cannot be marked to market.

A solution is to offer funds set-up in series, where the maturity of the fund matches the maturity of all underlying transactions. No additional investors are permitted until a new series is launched. Existing investors will only get their money back, once a transaction has expired without losses. An interesting alternative for larger pension funds is segregated mandates where portfolio structure can be mutually agreed and the single investor means that liquidity mismatches are no longer an issue.

Tohoku, Yasi, Queensland, Christchurch, Irene….
Is ILS more attractive today than one year ago? The magnitude 9.0 Tohoku earthquake of 11 March 2011 triggered a complete loss of one cat bond - ‘Muteki’, a special purpose vehicle issued by Munich Re and created for that transaction only. Muteki’s trigger mechanism was based on peak-ground acceleration measured at several stations across Japan. Each value was weighted by the insured values in the area of the measuring station. As a result of this trigger mechanism, and due to the intensity of the earthquake, investors had to suffer the complete loss of the bond - a risk that had been compensated with a coupon of LIBOR-plus 4.4% before it was triggered.

.…have made ILS even more attractive
The earthquake in Japan was not the only catastrophe this year. Together with cyclone Yasi (Australia), the floods in Queensland (Australia), this year’s earthquake in Christchurch (New Zealand), as well as the tornados and hurricane Irene in the US, there have been several catastrophes that should have a tightening effect on reinsurance capacity. It is a characteristic of the reinsurance market that premiums tend to increase after severe losses. Historically, times after severe events have been the best moments to invest in ILS.

Daniel Grieger is partner and portfolio manager and Kristina Poliakova investment analyst in ILS with Twelve Capital