When investors insure.
Investment strategies. More and more investors are using cat bonds to diversify their portfolios. These securities function similarly to an insurance policy against natural hazards and are intended to generate interesting long-term returns independent of the capital markets. In 2017, however, the large number of natural catastrophes put prices under pressure. A warning signal? Or a chance?
The business of insurance is pretty simple. Day after day, month after month, she collects premiums from those who seek protection from an emergency. If this one enters, she has to pay.
"The art is to spread the risk in such a way that the premiums exceed the payouts in the long run," explains Sandro Müller, cat bond expert at investment manager GAM.
The balance sheets of Allianz, Munich Re and Hannover Re show that this generally works. Year after year they generate high profits. Sometimes, however, the damage accumulates. When hurricanes Harvey, Irma and Maria swept across the Caribbean and the USA last year and wreaked havoc, the insurance professionals knew it would be expensive.
According to Munich Re, the global losses caused by storms, forest fires and earthquakes in 2017 actually amounted to 330bn dollars. According to estimates by Swiss Re, 136 billion dollars of these were insured, the third highest sum ever to fall due within one year.
Since then, fears have been spreading that insurers will face problems in the future as natural catastrophes accumulate due to global warming. "Exactly the opposite will be the case," contradicts Sandro Kriesch, investment expert at the Swiss company Twelve Capital AG in Zurich, which specializes in insurance investments.
"In the long run, difficult years are always positive for the industry. Firstly, the demand for insurance will increase in the future. Second, insurers can generally charge higher premiums for events that have caused massive damage. A difficult year is usually followed by several good ones."
This is also interesting for investors who deal with so-called cat bonds. These securities originate from reinsurers who outsource part of their payment obligations in the event of a catastrophe to a special purpose vehicle, which in turn passes them on to investors in the form of securitised securities.
In the event of a claim, the insurance company or reinsurer does not have to pay. Above a certain loss amount, this is then charged to the catastrophe bond concerned. "If the event occurs, the deductible takes effect first," explains Kriesch. "Only when this and the existing, very extensive insurance coverage through primary insurance and reinsurance has been exhausted does the investor have to bear losses. Cat bonds are therefore usually exposed to risk only in exceptional cases."
For example, if the deductible and the covered loss amount are each $100 million and the actual loss is $110 million, the deductible erodes and the price of the bond falls ten million or ten percent to 90 percent.
In addition to securities that hedge individual events, there are also securities with an aggregate structure. They cover several events in a row. The damage that has occurred is then totaled. Here, too, the deductible is consumed first. Any additional losses will then be borne by the investors. If loss events only affect the insurer's deductible, the bond, if stipulated in the conditions, will be as new again in the following year. "The risk buffer is then reset to the full amount," explains the expert.
Against this background, it is understandable that in the autumn of the hurricanes there was also a high level of nervousness in the market for cat bonds. In mid-September, the Swiss Re Cat Bond Price Return Index - which roughly reflects the entire market - collapsed by 16 percent within one trading day.
The conviction that the initial cost estimates were exaggerated then prevailed and the market calmed down somewhat. Overall, however, the index closed September 2017 with a minus of 6.5 percent - the sharpest decline in the market in its history.
What basically applies to insurers now also applies to investments in insurance risks. "After the difficult past year, there is now also the opportunity to get better conditions in the form of higher returns," explains Kriesch. "We have found that, as a result of such events, the premiums for investors rise by an average of five to 15 percent, in individual cases even by up to 25 percent. So if you invest now, you get more return for the same risk."
Achim Siller, Head of Portfolio Management at Pictet Wealth Management in Germany, is also convinced that it could be worthwhile for investors to take a look at this type of investment. "Investors in catastrophe bonds use two sources of income," he explains. "First, there is the premium of the respective bond, which reflects the remuneration for the underwritten insurance benefit. It averages four to 4.5 percentage points."
In order to have a solid calculation basis, investors should deduct the expected average loss from it. In the past, this was between two and 2.5 percent. Plus the base rate. The insurance premiums received are invested in interest-bearing securities with short maturities, mostly in safe AAA bonds such as US government bonds. "This could leave a total of three to 4.5 percent (in US dollars) in the future. That's interesting."
Added to this is the diversification effect. "The occurrence of natural catastrophes is in no way related to developments on the capital market. Unlike conventional investments on the capital market, returns are completely independent of the economic cycle and stock market performance," analyses Siller. "That's why these securities improve the portfolio structure."
Especially in the current market phase there is a further advantage. "Many investors fear a sustained rise in interest rates", explains Sandro Müller, "conventional bonds with longer maturities would then have to accept price losses. Catastrophe bonds, on the other hand, usually have variable interest rates and relatively short maturities of two to three years. Their yield therefore rises as interest rates rise. And since the capital is usually invested in first-class securities, cat bonds are also largely free of credit risks."
An attractive yield premium, capital market-independent development and a steady return - sounds like a good investment. What's the catch?
A first critical point is the issue of climate change. According to a Munich Re study, only around 250 loss events occurred worldwide in 1980. With the exception of a single year, this figure has always exceeded 400 since the beginning of this millennium, and more than 700 loss events were recorded in 2015 and 2016. If the losses were to rise sharply in the future, insurers and Cat Bond investors would probably still face problems. This is because the pricing of premiums is usually based on a "gradual" change.
One more point is worth noting: "Due to the concentrations of values in cyclone regions in recent decades, the loss amount for comparable events may be higher than in the past," Kriesch stated. "One reason for this is that wealth concentration is increasing in densely populated regions. As a result, more infrastructure is being created there and the sums insured are rising accordingly," explains Sandro Müller.
This can even be advantageous for investors in the long term. "One of the biggest challenges when investing in cat bonds is the lack of availability. Of these papers, only a volume of almost 30 billion dollars is in circulation. This corresponds roughly to Munich Re's market capitalisation," outlines Achim Siller. So far, little supply has been matched by high demand. "Papers from new issuers or bonds that insure against new risks such as pandemics are attractive from the perspective of a fund manager. This increases both the breadth and depth of the investment universe from which individual bonds can be selected," Müller explains.
This trend towards more investment opportunities is also driven by regulation. "The Solvency II Directive increases the capital requirements for insurers", explains Kriesch: "If they now outsource insurance risks to the capital market, this will relieve their own balance sheets and reduce the required equity capital. This is increasingly the case when reinsurance instruments such as cat bonds are used for risk transfer." In other words: In the coming years, the market for these bonds could grow further and perhaps much faster than previously assumed.
An essential aspect for the success of an investment is then the selection of the securities and thus the insured risks. After all, the seller side of the insurers is made up of professionals with many years of expertise and highly developed models who probably know exactly why they want to pass on certain risks in securitised securities to investors.
"Don't worry," says Kriesch, "we also have experts with the appropriate experience and equally good models on our side. We only invest when we have a precise understanding of the risks inherent in the securities. And only if we are sufficiently compensated for the risk we have taken."
But it is also clear that an investment in these securities should only be made with professional support. "The bonds themselves, but also the underlying risks, are far too complex for a private investor to assess," Achim Siller makes clear. "That's why specialized funds are always the first choice."
Investing through funds has another advantage. A successful investment in insurance risks generally requires sufficient diversification. If a loss occurs, it must not cause any considerable loss in the securities account. This can only be achieved by funds that take on a large number of positions and thus construct a broadly diversified portfolio.
"If these conditions are met, an admixture in the portfolio can be quite interesting," concludes Achim Siller. "The business model of the insurance industry has proven itself over many years. There is nothing to prevent investors from acting as reinsurers themselves and using this idea to their advantage."
How to invest: in Securities on insurance risks.
Basically, investors have two options for assuming insurance risks - cat bonds or private ILS transactions. Unlike catastrophe bonds, private ILS transactions are not publicly traded securities, but private transactions with a term of six to twelve months in which the conditions are negotiated bilaterally between an investor such as Twelve Capital AG and the insurer.
Both markets are primarily dominated by US risks. "Around two thirds of securitized insurance risks relate to storms in the USA," says Sandro Müller of GAM. "Although there is a dollar risk for euro investors, the funds hedge some foreign currency risks," adds Achim Siller, Pictet. Investors should therefore talk to their advisor about how they want to deal with currency risk.
When analysing the funds, it should be noted that they are difficult to compare on the basis of pure performance data because they assume different levels of risk. The maximum drawdown, which indicates the maximum cumulative loss since inception, and the expected loss give an indication of how sporty the funds are. Dieser corresponds to the expected loss im Portfolio weighted with mathematical probabilities. The higher the expected loss, the higher the insurance premium and the return potential of the fund.
// 01. Cat Bond Fund
In the past five years - there is hardly any fund traded here in Germany with data dating back some time - the yields of the most important funds fluctuated between just under 19 percent plus in 2014 and almost minus 14 percent in 2017. However, last year was the only year of losses in this period. According to the fund analysis firm Morningstar, the best funds yielded annual returns of up to 3.45 percent (as at 13 February 2018). The maximum drawdown over the next five years was between around four and seven percent.
Interesting Funds: GAM Star Cat Bond Fund (IE00B3Q8M574), Plenum CAT Bond Fund R EUR (LI0115208543), Solidum Cat Bond Fund EUR (LI0049587301), Twelve-Falcon Cat Bond Fund EUR (CH0019572566).
// 02. fund for private ILS
This strategy has been accessible to investors since around 2003. According to the Eurekahedge ILS Advisers Index, between January 2006 and January 2018 it generated around 88 percent. This corresponds to an annual return of around 5.5 percent.
What is important is that, unlike cat bonds, private ILSs cannot be traded on a stock exchange. "However, they are compensated for this disadvantage with an additional illiquidity premium. The return opportunity is therefore higher than with cat bonds," explains Sandro Kriesch, Twelve Capital.
Other differences: Compared to cat bonds, the maturity of six to twelve months is very short. "If the insured loss does not occur during this period, investors will get back the nominal value of the security and have earned the coupon. In addition, a broader spectrum can be covered, i.e. risks are also insured which are not covered by the cat bond market. They are therefore based not only on natural catastrophes such as earthquakes or hurricanes, but also on risks from the aviation and transport sectors," the expert continues.
Interesting funds: LGT (Lux) II ILO B2 USD (LU0908636490), LGT (Lux) III ILS Plus B USD (LU0950816578), SCOR ILS Fund - SICAF-SIF Atropos (LU0670876076), Twelve Capital PILS Fund I USD (LU1314785269).
Author: Gerd Hübner