This interview with Michael Stahel, Partner at LGT Insurance-Linked Strategies, looks at ILS portfolio construction and the relative merits of diversified and concentrated insurance or reinsurance-linked asset portfolios.
This interview, fully titled ‘Diversified vs. concentrated portfolios: exploring a catastrophe bond and collateralised securities blend‘ is taken from a report published earlier this year by specialist financial services, pensions and investments publisher Clear Path Analysis, titled ‘Insurance-Linked Securities for Institutional Investors 2014.’ Clear Path Analysis have kindly allowed Artemis to republish it here in full.
– Michael Stahel, Partner, LGT Insurance-Linked Strategies.
– Sarah Mortimer, Account Director, rein4ce.
Sarah Mortimer: What are the advantages of diversified portfolios over concentrated portfolios and vice versa?
Michael Stahel: Insurance-linked securities (ILS) has been in the market for some time already but this year, discussions amongst our client base have really taken off again. We follow suit with other European investors in that we are very much concerned with running a diversified portfolio and not a concentrated portfolio. Whilst you give up some of the returns in comparison with a concentrated portfolio that is heavily geared towards U.S. wind storm, by running a diversified portfolio you are able to equally have European, Australian and Japanese exposures. The benefits are clear in that in running a diversified portfolio the loss potential is much lower than for a concentrated portfolio.
You may give up return potentials but realistically these are minimal at roughly 1 or 2% on an annualised basis and simultaneously you may improve the downside potential by 20% to 30%. This means that instead of running a 95% tail wind minus 40%, you end up running at minus 15% to 20%. We hence strongly advise clients to give up 1% to 2% in short-term annual gain to save on a 20% additional loss potential – in our view the only sensible way to invest in insurance-linked strategies. The approach of U.S. and Bermuda managers is different because they go for more ‘bang for your buck’, as they say, and are heavily geared towards U.S. wind storm risks. 70% to 90% of the overall ILS allocation would typically be allocated to this peril.
Our clients are typically pension funds who are looking for a diversified allocation within their portfolio and so accordingly allocate between 1% and 3% of total assets to ILS. We typically hear this portion doesn’t need to be diversified because it’s the diversifying bit in the overall asset allocation. We strongly disagree: if you do not diversify that ILS proportion as a pension fund manager, you could be in danger of losing as much as 50% of your ILS allocation with one single US wind storm event. Pension funds must ask themselves if they allocate 2 % to ILS would they want 1% of their overall asset base to be lost in one single wind event? The answer is typically no and as a fund manager we also do not want this within our portfolios.
Sarah: What do you think has prompted discussion on ILS again?
Michael: The rate environment has come under pressure for two reasons. Firstly, the increased capital flowing into this market from institutional investors which has boosted investor demand and secondly, there haven’t been many severe catastrophes in the last couple of years. 2013 was a quiet year and as a result, there was less demand from capacity buyers which enabled insurance and reinsurance companies to build up their reserves. The pressure that we see on pricing is already having a very strong effect on the U.S. wind rates. The U.S. wind allocation has always had a bit of an opportunistic characteristic but since pricing has decreased for this region, more investors are starting to really question this U.S. way of investing; the promised excess returns are no longer being generated, yet clients still sit on the higher loss potential. Today, running a concentrated portfolio over a diversified portfolio does not yield much of an excess return anymore and so finally institutional investors are paying attention to the downside risk potential.
Sarah: Have any of your investors and sponsors been talking about securitising new diversifiers?
Michael: This is an interesting question. We don’t really believe in new diversifiers but feel that ILS investors should rather focus on the peak regions where the traditional reinsurance market is no longer able to provide the capacity and where counterparty credit risk really matters. We at LGT do not believe ILS investors should engage in “diversifying” risks such as Chilean earthquake.
Re-insurance companies are much better suited to provide this capacity as it does not bind much capital and reinsurers can make best use of their balance sheet and apply a leverage factor. However, it is still very much possible to structure diversifiers within the peak regions, e.g. in U.S. windstorm; such transactions would then not cover the big single event, it can be structured as a sideways transaction which addresses multiple events but still focuses on U.S. wind. Such a transaction is not exposed to first event risk and thereby offers an interesting diversification to an ILS portfolio.
Sarah: Pension funds are increasingly seeking to capture the premiums available for investing in less liquid assets- how do collateralised securities support this?
Michael: LGT has a very big franchise on private equity investments and so aside from the fact that we are one of the largest ILS investors we are also one of the largest private equity investors and across both businesses there are similarities. There is an illiquidity premium in investing in collateralised reinsurance transactions; pension funds are looking to capture this illiquidity premium and allocate into less liquid ILS investments, though it has taken time after the financial market crisis to come to terms with such less liquid assets.
Right after the crisis there was a big strive for liquidity and transparency, triggered by the low yield environment. Today, pension funds are seeking to recover that lost yield and are consequently becoming increasingly comfortable with illiquid positions. Whilst collateralised reinsurance contracts are less liquid, it is important to note that they are only illiquid for 12 months. At expiration, the investors get their money back.
It’s different from looking at, say, a 10 year allocation of private equity because collateralised reinsurance is a very short-term illiquid instrument that equally brings many upsides. It helps to lower correlation and owed to the short-termed illiquidity, there is no market to market fluctuation around pricing. Pension funds are increasingly looking at this illiquidity as a means of providing even lower correlation and an improved pricing element.
Sarah: How can collateralised reinsurance contracts enhance the diversification benefits that CAT bonds already provide pension funds with?
Michael: Our most recent analysis shows that the current CAT bond market is heavily geared towards first event U.S. windstorm. In fact; 73% of all CAT bonds issued today are geared towards U.S. wind. The question therefore is: how can you diversify away from that? Collateralised reinsurance provides such an opportunity because it enables investors to allocate to sideway structures, for example – something you cannot do in the current CAT bond market. You do not see enough CAT bonds in European wind, flood and earthquakes or Japanese wind and earthquakes, and finally even in Australian and New Zealand catastrophes. It is fair to say that in these regions the CAT bond market is not providing sufficient supply. To counter this we use the collateralised markets to source additional risk. It’s important to note that CAT bonds still provide an important foundation but the difference is that today, in a perfect ILS portfolio, CAT bonds form only a third of our portfolio offering, the remaining two-thirds are allocated to collateralised reinsurance with a blend of U.S. wind, sideways, other U.S. natural perils and a strong allocation to European and Australasian perils.
Sarah: Why would you not advise investors to opt for a pure collateralised reinsurance approach?
Michael: The answer lies in the liquidity and utilisation of market opportunities. If you tie everything up in illiquid positions you will be unable to make best use of market environments because you won’t be in a position to capitalise on market shifts and other short-termed interesting investment opportunities. Even an investor with a very long-term target may still want to shift the allocation during the year to change the portion of CAT bonds in order to potentially generate liquidity. There will be opportunistic transactions around an event; this might allow to buy bonds which are under pressure, allocating to new risks or enabling your client to increase or decrease their allocation by up to a third because if the portfolio is one third CAT and two-thirds illiquid then you can sell positions and generate the cash for a shift.
Sarah: Are investors concerned that this market hasn’t been properly tested?
Michael: There are several elements here and it can be approached from different angles. From the pension fund manager’s view, the key concern raised is ‘how much money can I lose?’ This is easy to answer because ILS managers can be very transparent with their clients as to how much money they would lose should a severe event such as a CAT 4 or 5 hurricane hit Miami; for example they could risk losing 15% of their allocation.
Protection buyers typically ask how the collateralised markets will react to such a situation and whether the market will be sustainable. We have seen the wall between the capital market and reinsurance market torn down which has subsequently resulted in increased capacity and movement between the capital and reinsurance market. However, if rates drop further, liquidity and capacity will be reduced and pension fund investors will begin to look elsewhere for other opportunities – which is when the market has reached a form of equilibrium.
On the other hand, if an event occurs and rates rise, cash will flow in much quicker than we have experienced in the past. To a prime insurance company who fears that post event capital market investors will flee I would say actually the opposite will occur as people expect rates to rise. We’ve had discussions with several European pension fund managers who have opened up to ILS as an asset class, have had it approved by their trustee boards but have not yet allocated. Instead, they are waiting on the sideline until the opportune moment, right after a natural catastrophe. They will shift in money so easily that in essence the reinsurance cycle as we’ve known them will become much less pronounced going forward.
We see many investment managers, including ourselves, already lined up with new investment vehicles set up ready to be pulled out of the drawer immediately after an event. On one hand, there is a long lock-up on existing money which prevents money from disappearing and enables us to bring additional capacity right after the event. Going forwards we will increasingly see more strategies that include capital already been committed, but not called up. Investment managers have lined up contractual agreements with pension funds to provide us with money right after an event, enabling us to enact the cash call and commit to signing contracts. In effect, our institutional clients would be saying we’ve had a CAT 3 hurricane hitting Florida, so let’s move in and allocate.
Michael: A last point is around what type of investment manager is best suited to this change in market environment. There is a different skillset required for allocating into collateralised reinsurance as opposed to CAT bonds, and it’s very much driven by the sourcing capability. CAT bonds are offered to you as an investment manager whereas collateralised reinsurance is hard work; you have to go out and source these transactions. We do a lot of travelling and for us location is key, although being based in Zurich does help when seeking parties to line up potential future transactions with. Going forward, being successful as an insurance-linked investments manager rally comes down to sourcing capability!
Sarah: Thank you Michael for sharing your insights.
Read our other articles and transcripts taken from this report:
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