Diversification across catastrophe risks between different territories and natural perils is essential, according to Anthony Harrington
At a glance
• Good diversification across natural perils is necessary but the public cat bond market is highly concentrated in US wind.
• Yields fell in 2013 and 2014 as capital flowed into cat bonds.
• Secondary market trading and the private placement market can improve diversification and yield.
Pension funds that have not yet investigated the catastrophe (cat) bond market might think it a strange idea to risk their fund’s capital against a loss that an insurance company is trying to avoid. After all, events that are likely to occur less than once every 50 years might be rare statistically but when they happen they can generate losses in the billions, more than enough to wipe out whatever principal the fund has put up.
As Aon Hewitt partner Daniel Peters notes, this is a mental hurdle that anyone new to the cat bond market has to get over before they can become comfortable with the concept. Yes, it is a binary asset class and if the bond triggers, your principal can vanish on the spot. However, a good cat bond fund manager will structure a portfolio across 60 to 70 bonds with different perils in different regions. If all those perils happened simultaneously across all regions, investors would probably have more to worry about than the loss of their principal.
There is evidence that diversification in the cat bond sector does work. The two really bad years so far for this asset class were 2005, when there was hurricane Katrina, and 2011, with the Japanese Tōhoku earthquake and the resulting tsunami that caused the meltdown of Japan’s Fukushima nuclear reactors.
“If we take 2011, which saw several disasters, even average ILS managers that we looked at came out of that year with a 3% positive return, despite all the losses, while the best showed an 11% positive return. Even lower-quartile managers were only down 5% on their portfolios that year,” Peters comments.
There are two main reasons for investing in this sector and both are simple to understand.
The first is yield, although there are caveats, since yields began falling in 2013 and continued to fall through 2014 – following the law of supply and demand – as additional billions poured into the asset class.
The second reason, as Peters explains, is that insurance-linked securities are largely uncorrelated to any other asset class. Hurricanes and earthquakes do not happen because stock or bond markets fall – although the reverse is not always true.
“There is no other asset class out there that is naturally as uncorrelated with the other main asset classes. The attraction is that this lack of correlation is not dependent on some hedge fund’s unique black box strategy or the skills of a particular manager. It is simply embedded in the asset class,” Peters says.
Investors vary as to which of these two attributes they prioritise. Roman Muraviev, executive director and head of catastrophe bonds at Twelve Capital, points out that although the firm’s clients are concerned with strong levels of alpha generation, many also prioritise access to balanced investment strategies, with funds allocated to several bonds across a diverse range of risk exposures among a variety of territories and perils.
However the firm is also able to accommodate clients that aim to maximise yield. “We offer clients access to a focused cat bond investment strategy as well, if yield is their primary objective and they want attractive yields on a risk-adjusted basis,” he explains. To achieve this, the firm selects 30 to 40 of the most attractive bonds in risk terms. “There are cat bonds in this space that may even offer double-digit returns,” he says.
Determining the right allocation to catastrophe risk is a complex one. Anecdotal evidence suggests that some pension funds are wary of allocating more than about 2% of their overall assets to cat bonds and are still testing the asset class. The probability is that they will commit to larger positions when they are comfortable with that idea.
“The growth of the cat bond market has actually been quite significant, as five or six years ago the market was dramatically smaller than it is today. However, the discipline coming from investors is very important in shaping the premiums on a risk-adjusted basis. Because of this, we do not envisage excess demand developing for cat bonds and, in fact, in our view, demand and supply are pretty evenly matched at the moment,” Muraviev comments.
Twelve Capital is also active in the private cat bond market, talking to possible cedents and originating and structuring bonds for clients. “We access the private cat bond market as well as the public market since, in our view, it offers better risk-adjusted returns, and provides access to risks that are difficult to achieve on the public cat bond market,” he says.
Most importantly, from an investor’s point of view, Muraviev points out in his view, simply going for alpha through buying and holding a high-yield cat bond to maturity is not likely to be the most productive strategy.
“A cat bond fund manager should offer more than just exposure to a high-yielding bond. You can improve yields by dynamic, active trading on the secondary market, especially by taking advantage of seasonal patterns, and by trading during and after catastrophes,” Muraviev says.
Niklaus Hilti, who heads the ILS business at Credit Suisse, says that while in 2015 there was a stabilisation in cat bond market spreads, yields are, nevertheless, about half of the levels they were in 2011.
“Right now, the average yield for a cat bond is around 4.4%,” says Hilti. “In 2011 the average was more like 9%.” At the same time, in 2011 the total outstanding issuance in the cat bond market stood at about $11bn (€9.9bn). By the start of 2016 it was around $23bn, but Hilti and other ILS managers do not believe there will be another massive influx of capital into cat bonds until yields increase.
Hilti points out that for investors who are seriously chasing yield, not only is 4.4% a doubtful return for the risk that is run, but since close to 70% of the public cat bond market is exposed to US wind perils, it is hard to get a properly diversified public cat bond portfolio. This, in turn, makes it difficult for fund managers to improve the risk-reward ratio unless they diversify into private placements and other perils.
“There is no other asset class out there that is naturally as uncorrelated with the other main asset classes. The attraction is that this lack of correlation is not dependent on some hedge fund’s unique black box strategy or the skills of a particular manager. It is simply embedded in the asset class”
The cat bond market itself has several private placements. Cory Anger, global head of ILS structuring at GC Securities, says her firm has played a leading role in building volume in the ILS private placement market for both catastrophe and non-cat (other) perils. “We structured the $50m bond for China Re’s first ever entry into the ILS market in July 2015, and did the $70m bond for the Swiss building insurer GVB that year, as well as a private cat bond for the Caribbean Catastrophe Risk Insurance Facility,” Anger says, pointing out that the firm raised $900m for sidecars and other similar vehicles in 2015 and in 2016 to date.
She points out that there are typically 100-150 investor organisations following the ILS market. Depending on the type of deal, the public market cat bond deals under the SEC’s rule 144A that GC Securities arranges will include between 15 and 45 parties to the transaction, while private placements will have anything from one to 10 participants. In a private placement, the sponsor typically faces an SPV and has no insight into the cells that are providing the funding to the SPV, which is usually funded via investors subscribing via preferred shares.
For Anger, although the total issuance outstanding in the cat bond space decreased slightly in 2015, it was still a remarkable year, given how much yields had shrunk. “We saw four new sponsors electing to utilise the 144A [public] cat bond market in 2015, while two corporate sponsors came to the market. The first was Kaiser, with its Acorn Re transaction, the other was Amtrak. Plus the China Re deal was the first time investors were offered Chinese earthquake risk. All in all, this was a very good year,” she concludes.
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