In this series of interviews with investment managers from high-profile insurance-linked securities funds, collateralized reinsurance entities and reinsurance-linked investment firms, we hope to reveal a little more detail on the individual manager’s experience and the firm’s specific investment strategy. We begin this series with a chat with Michael Stahel, one of the four partners/portfolio managers of LGT Capital Management’s Insurance-Linked Strategies team.
Tell us a little about your backgrounds and how you got involved in ILS and reinsurance-linked investing?
LGT Insurance-Linked Strategies (LGT ILS) consists of four partners/portfolio managers: Hilary Paul, Christian Bruns, Pascal Koller and myself. We were all involved in the banking and reinsurance space in various positions for a number of years before joining forces back in 2006/2007 to setup our ILS practice. Personally, I started at Swiss Re back in 1998 as a property underwriter; in 2002, I joined Swiss Re’s Syndication team as structurer/trader for ILS (Insurance-Linked Securities/Cat Bonds), ILW (Industry Loss Warranties) and Retrocession. In 2006, I joined Clariden Leu to build up the Insurance-Linked Investments practice. At the same time, Hilary Paul joined as modelling expert from Converium (now Scor) where she was involved in the underwriting/risk modelling of natural catastrophe risks as well as for the global aggregate accumulation at company level – including involvement in the cat bond issuances of Converium in the early days of the market. Hilary established and still leads our cat modelling team. Simultaneously, Christian Bruns joined from the Boston Consulting Group’s Banking & Finance Practice where he specialised in capital efficiency for insurance companies and banking/asset management transactions. Christian leads our portfolio management team and was instrumental in the development of our proprietary portfolio management tool. Pascal Koller was a former colleague at Swiss Re Capital Markets in London, after which he worked for Pension Corporation in London before he became our fourth partner. Pascal’s valuable experience in deal structuring and his proficiency with regard to life investments complements our team perfectly.
In early 2012, LGT – a Swiss-based multi-alternatives asset manager with USD 40bn under management – partnered with the four of us to acquire the insurance-linked investments business from Clariden Leu Ltd. With this partnership, LGT was able to strengthen its investment competency and further enhance its offering; we on our end gained a highly reputable partner with an international presence, an impeccable franchise and a broad distribution network. Today, our core portfolio management team consists of 10 specialists, supported by an experienced senior staff within LGT for legal, structuring and distribution. With our ILS franchise, we count among the pioneers in insurance-linked investing, managing funds with track records reaching back as far as 2001. We currently place close to USD 2.5bn of capacity in the worldwide reinsurance market, underwriting both non-life and life transactions.
What is it in particular about the sector that you think makes it an attractive place to work?
The reinsurance industry is going through a fundamental change – and we are at the forefront of this change. We believe that by 2015, more than 30% of catastrophe risk capacity worldwide will be provided directly by investors in the form of insurance-linked investments. At LGT, we are helping to lead this change by constantly working on innovative new solutions – beginning with the launch of the first pure ILS fund in 2001, the first mixed ILS/FIC fund (mixing ILS/Cat Bonds with Financial Insurance Contracts – e.g. traditional reinsurance transacted in collateralised form) in 2005, the first UCITS ILS fund in 2010, “Cat Bond Lite” structures with an issue volume of over USD 120m to date, and most recently, by setting up our own fleet of Special Purpose Insurers in Bermuda. This is what makes it so interesting to work in this sector – being part of an industry that is going through a fundamental evolution of its business model, to be able to drive and support this evolution by providing insurers with the needed capital and capacity to protect their balance sheets against severe catastrophe events and simultaneously serving our institutional client base with diversified funds, offering uncorrelated returns within their strategic asset allocation.
What is it in particular about the sector that you feel makes it an attractive place to invest?
Our client base consists mainly of institutional investors such as banks, pension funds, sovereign wealth funds and large family offices. They in turn manage large pools of money on behalf of their clients (e.g., annuitants/pensioners); their key goal is on the one hand capital preservation and then to achieve a solid, steady return within a well-contained risk spectrum. In today’s market environment, it has become increasingly difficult to meet these targets by only accessing traditional financial market investments. The insurance-linked asset class presents our client base with a very interesting value proposition of returns that are exhibiting low correlation to financial market movements, that are not prone to interest rate fluctuation and that present minimal counterparty credit risk.
Is there anything about your approach or strategy to investing in the sector that you feel is unique?
The investment philosophy of LGT Insurance-Linked Strategies is based on our assessment that investing in insurance-linked assets can be highly profitable over the long term, as the risk premiums our counterparties pay for transferring insurance-linked risk to the capital markets consistently outweigh the long-term default probabilities. By combining diverse insurance-linked risks in a sophisticated manner within a portfolio, it is possible to generate stable, sustainable, absolute returns with controlled downside risk. The cornerstones of our investment strategy are therefore:
– Diversification by instrument, risk class, structure and geography
– Maintaining a constant risk approach
Diversification: Is key to the steady, long-term performance of an insurance-linked investments portfolio. On average, every one of our funds and mandates is spread across twenty independent risks and event classes. Additional diversification is achieved by further spreading the risk geographically, by trigger type, and by default probability.
Constant risk approach: LGT Insurance-Linked Strategies manages all of its products and mandates on a constant risk basis. Each product/mandate has a clearly defined risk budget expressed as the portfolio expected loss with maximum down-side limitations per single event. This implies that returns to investors will be higher as premiums rise and lower as premiums fall. Investors will, however, be exposed at all times to the same level of risk as defined within the risk budget of the product. By contrast, most of LGT’s peers manage their products on a constant return basis, exposing investors to higher risk levels in soft markets and times of reduced premium rates. LGT strongly believes that running products on a constant risk budget represents a competitive edge as it leads to a consistently higher risk-adjusted performance for investors and is considerably more transparent.
What do you believe gives your fund management operations an edge over competitors?
– LGT Insurance-linked Strategies is one of the three largest players in this industry with a track-record dating back to 2001. We count ourselves among the most experienced and well-connected teams in the industry having a reputation for transparency among investors.
– Our location allows to optimally accessing business: LGT is headquartered near Zurich, with offices in Dublin, London, New York, Singapore and Hong-Kong. Zurich has transformed into a global reinsurance hub and a key location for accessing worldwide reinsurance business. With the benefit of our location, LGT Insurance-Linked Strategies has direct access to a large number of primary insurance carriers, allowing for prime access to a large selection of attractive market placements and private reinsurance transactions.
– A constant risk approach – LGT Insurance-Linked Strategies strongly believes that running products at a constant risk level, as opposed to promising a fixed target return, represents a competitive edge as it delivers consistently higher risk-adjusted performance for investors.
– A boutique-style investment manager within a well-established and fully regulated organization – we are unique in offering a sophisticated investment infrastructure uniting a dedicated insurance-linked investment team with the risk management, legal and product management specialists of a fully-regulated asset management institution. Our optimal size also provides us with a competitive edge: big enough to be an important and influential player in the market, yet small enough to efficiently deploy capital without diluting returns.
Can you explain a little more about how you balance the risks within the investment fund to ensure good diversification and to minimise risk for investors?
Our portfolio construction process combines a top-down and a bottom-up approach in order to achieve the highest possible return for the lowest possible level of risk and optimal diversification of each individual portfolio:
Top-down approach for strategic allocation:
The top-down process determines the optimal asset allocation among individual insurance risk classes. This strategic asset allocation is derived from the overall profitability analysis of the current market conditions for each specific investment type. All risk classes are continuously analyzed for market prices and profitability. The analysis is then fed into a risk class optimization process that is conditioned by the fund/mandate’ objectives and the team’s outlook for specific markets. The investment objectives focus on stable attractive returns, low correlation to traditional market risks and controlled downside risk.
Bottom-up approach for tactical allocation:
Following the strategic asset allocation, a bottom-up tactical allocation process is used to price individual transactions and further optimise risk classes. This includes maximising diversification through different trigger levels, geographies and deal structures. The tactical or single-position allocation is followed by the marginal pricing concept that requires new positions to improve the profitability of the existing portfolio well above the tail risk they add. The clear goal is to achieve the highest possible return for a minimal risk level in an optimally diversified portfolio.
Our transparent and detailed monthly reporting to our institutional clients underlines our approach by including information components such as a full plot of the exceedance probability curves for the whole portfolio, and key risk indicators such as the expected loss, VaR, TVaR and draw-down estimates for a set of historical losses.
How do you see the sector developing over the next 5 or 10 years?
The participation of capital markets investors in our sector is growing rapidly. Investment managers are now essentially competing against traditional reinsurers, providing primary insurance carriers with catastrophe reinsurance for extreme (‘tail’) events. Over the last 24 months, insurance-linked investor’s allocation has grown to well over USD 10bn of capacity in the collateralised market alone – outside of the ILS/Cat Bond space. This is capacity which in the past was supplied by traditional reinsurers. This so-called “collateralized reinsurance” capacity is fundamentally superior to that provided by traditional reinsurers as the full limit is paid-in and guaranteed for the transaction term, ensuring that the cash is readily available to pay for potential insured losses – without any exposure to counterparty credit risk. We believe that the competition between traditional reinsurers and capital markets investors will further increase in the coming years. Primary insurance carriers are viewing us and our peers no longer as temporary niche players, but rather as valued partners for providing them with core capital and as strong participants on reinsurance placements.
Where do you see opportunities for the sector to grow?
Some growth will clearly come from the continued transition of the traditional reinsurance market to collateralised protection provided by the capital market. Yet more importantly, the required capital in the insurance industry for protection against catastrophe events is constantly increasing, mainly as a result of construction activity, increasing regulations and partly due to climate change (and more importantly as a result of the corresponding adjustments to the cat models). This leads to an almost natural growth of our sector. Further growth will most certainly come from the expansion to regions and perils which in past have not typically lent themselves to capital markets investors (e.g., perils such as flood and regions such as Asia, etc).
Do you see any issues facing the sector which it will need to overcome in order to grow?
Considerable growth could be achieved by transacting more business in the form of ILS/Cat Bonds as such positions are most easily handled from a regulatory and operational point of view enabling investment managers to attract a much broader group of institutional investors. Yet, ILS/Cat Bonds are still very expensive to transact. The fixed cost element for legal fees, structuring, modelling, rating and distribution which must be borne by the sponsor are considerable. Especially where ILS/Cat Bonds would fit best into the capital structure of a primary insurance company, providing capital against very severe events or aggregate structures with a very low attachment probability, the expected loss would be very low and the corresponding spread would be minimal. At these levels, the cost element is playing a major role. The industry has to find ways of transacting small issue volumes at more efficient cost levels in regulated security form (e.g., 144A) enabling smaller insurance companies to participate in the market; standardization is key to bringing this market forward.
Do you have any final words on your outlook for the space?
The acceptance of capital markets investors by primary insurance carriers has increased substantially over the last 24 months and we are definitely excited about the current market environment: As a large insurance-linked investment manager, we are able to allocate capacity to transactions of high quality and partner with reliable, well-established primary insurance companies to supply the market with our capital. We are very optimistic both with respect to the ILS deal pipeline as well as regarding our ability to allocate new capital and capacity to FIC in this market environment.
Our thanks go to Michael and his partners for his insight into the work of the LGT Insurance-Linked Strategies team.
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