ILS investment manager interview: Dexion Capital (manager of DCG Iris)

In this series of interviews with investment managers from high-profile insurance-linked strategies (ILS) funds, collateralized reinsurance entities and reinsurance-linked investment firms, we hope to reveal details of the individual manager’s experience and the firm’s investment strategy. The latest in this series is Dexion Capital.

We spoke with Ana Haurie, Managing Director and Martin McCubbin, Research and Advisory at Dexion Capital. Dexion Capital operate the DCG IRIS ILS fund, which acts as a feeder into a Credit Suisse managed ILS fund. DCG IRIS currently has approximately £61m in assets and is closing its latest share placement early next week. The q&a transcript follows below.

How did you get involved in ILS and reinsurance-linked investing?

At Dexion Capital, we were looking around for alternative investment strategies that offered a lack of correlation with other investments, while at the same time offering a yield of some sort, because that’s what our clients were telling us they wanted. After some dedicated research, one of the areas we came across was ILS, and after exploring a range of options we approached Credit Suisse with the aim of bringing a product to market based on one of their existing open-ended ILS funds. And so we launched DCG IRIS  as a London listed closed-ended investment company, in June 2012, a feeder into the IRIS Low Volatility Plus fund managed by Credit Suisse.

What is it in particular about the sector that you feel makes it an attractive place to invest?

In terms of what they offer investors: low correlation and the potential for portfolio diversification, and yield. Furthermore, given a lack of large natural catastrophe events leading to significant insured losses, ILS investors can expect steady total returns with low volatility. However, it must be said that the frequency and magnitude of events leading to insured losses is, of course, unknowable in advance and can have a sizeable impact on performance.

ILS is an interesting sector as it aims to exploit inefficiencies in the insurance (reinsurance and retrocessional) markets, whereby it pays insurance (and reinsurance) companies to lay off some of the risk in their primary business, and at the same time pay attractive premiums, to the investor, for taking on that risk.

And from a non-investment perspective, researching and trying to understand ILS is intellectually stimulating as it forces you to think about topics you don’t normally confront when it comes to investments, for example the prevalence of US hurricanes, seismic activity and the nature of probability.

What do you believe gives your fund management operations an edge over competitors?

We feel that Credit Suisse, as the investment manager of the master fund in which DCG IRIS invests, has a number of advantages over competitors. First of all, Credit Suisse is a more institutional organisation compared to the managers of the other funds in the listed ILS sector, with AUM of $5.3bn in June this year, substantially higher than the third party capital managed by the others.

They also have been doing it longer – for example, Credit Suisse has a live track record managing essentially the same fund as the DCG IRIS master fund going back to 2007.  The others have no such track record managing third party assets within a current fund structure. Along with this comes their experience in being able to assess when investments are mis-priced and to rigorously estimate the risk/reward profile of each investment within the context of the portfolio.

The global reach of Credit Suisse allows the team to assess reinsurance risk right across the globe, bringing greater geographical diversification to its portfolios, should they be paid enough to take on that risk.

Furthermore, Credit Suisse applies active portfolio management in managing its funds, for example by establishing hedging positions while events are in progress – not all the competitors do this.

One final distinguishing feature that applies to Credit Suisse is that since it does not run its own (re)insurance book, there can be no conflicts of interest (real or supposed) associated with their management of third party capital within their range of ILS funds.

How do you see the sector developing over the next 5 or 10 years?

Five or ten years is quite a long time period, but we do expect, on that type of timescale, the ILS sector to continue to grow, with increased allocations to come from the capital markets. However, growth may be at a slower pace than has been the case since the first “outside” money came in more than ten years ago, when cat bonds were first issued, till now.

Future growth will be dependent on the continuing relative attractiveness of ILS compared to other asset classes. At present, with low interest rates and tight credit spreads, investors can clearly see the benefits of an investment in the sector. However, this may change in the years to come, and investors will make their investment decisions accordingly.

There is also the potential for the further “blurring of lines” between insurance companies and asset managers, with more and more asset management businesses, with a focus on ILS, being launched by insurance companies.

Where do you see opportunities for the sector to grow?

Natural catastrophe insurance is where the risk/reward profile is most skewed to the investor’s benefit at present, and so this is the segment in which capital markets have largely been focused to date. The next most important sector for insurance companies, in terms of their potential losses, is on the life insurance side, where they can be impacted by, for example, high mortality events and increased life expectancy. Some life bonds have been issued so far, and while this sector is still small it looks set for further growth.

There are currently sectors of the insurance market which have little or no exposure to the capital markets, simply because the associated risk/reward profiles are not attractive (and as a consequence, no investment products have been structured based on these risks). Such areas include terrorism and motor insurance. Any such development seems a long way off, but there may be possibilities for future expansion into these sectors.

Coming back to natural catastrophe risk, there are currently developed markets where returns are limited given the risks (for example, in New Zealand, which has experienced a number of devastating earthquakes in recent years), and there are emerging markets with very little or no insurance penetration. Here, historical data is scarce and the ability to carry out detailed modeling is restricted.

Again, this may change in the future, for example with increasing wealth in emerging markets, but at present the benefits of overly increasing the range of geographical exposures (without getting paid appropriately) for the purpose of the diversification within an ILS portfolio are limited.

Do you see any issues facing the sector which it will need to overcome in order to grow?

Generally, the “health” of the sector is affected by the premiums that can be earned by ILS investors in relation to the risks, and how these compare to what can be generated elsewhere, in other asset classes. The inflows from the capital markets over recent years, together with the relatively benign environment for natural catastrophes, has put pressure on these premiums, which could lead to investor out-flows when it is widely recognised that more attractive investments exist elsewhere.

One issue which is bound to happen at some point in the future is that we have not yet had a major disaster since capital market investments in ILS reached sizeable proportions. The last large scale event was Hurricane Katrina in 2005, but that was before the capital markets had developed to where they are now. When the major event occurs (an example of this would be an earthquake hitting San Fransisco), and ILS funds are down 10% or more, then it remains to be seen what the investor reaction will be – will they pull their money out or will they remain invested (or even double up)? We feel that investors understand the risks and that they will generally remain allocated to ILS.

With regard to future regulatory changes, there can only ever be more regulation. This is not expected to be a hindrance for ILS investors, but rather an opportunity, as there would be a greater need by insurance companies for the involvement of capital markets, perhaps in new sectors (other than the natural catastrophe segment, the focus at present), or more restrictions on the risks that insurance companies are exposed to.

Do you have any final words on your outlook for the space?

We believe that ILS has become recognised as an asset class in its own right, and is here to stay for the long term. It offers the potential for steady returns (barring major natural catastrophes), lack of correlation to other assets, and a yield – all supportive of further growth. However, it should be recognised that there are some risks to growth – for example, too many participants and too much capital, and a lack of major disasters, putting downward pressure on premiums. There are some potential growth sectors for ILS, in terms of the types of risks, increasing geographical diversification, and product innovation, all of which will have varying timeframes before they come to fruition. All in all, we believe that investors can look forward to many years of uncorrelated, high risk-adjusted returns from ILS investments (barring any large scale insured loss events).

End.

Our thanks go to Ana Haurie and Martin McCubbin for their insight into the work of the Dexion Capital team.

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