Opportunities for investors in catastrophe risks (now including retail investors)

Another week, another article in the press discussing the growing interest in catastrophe bonds and insurance-linked securities amongst the investment community. eFinancialNews.com (a Dow Jones franchise) carries an article (titled ‘Investors see opportunity in devastation risk’) today discussing the merits of cat bonds and other ILS and the growing interest in them from investors who see an opportunity to acquire attractive, non-correlated returns from investments linked to peak perils and reinsurance risk.

The article discusses how the non-correlated nature of ILS and cat bonds have become more apparent in recent years, particularly since the financial crisis. That has certainly helped to expand the profile of the ILS market, but of course those involved in the asset class for longer than that have been aware of the diversification opportunity they offer for much longer.

The article cites Christophe Fritsch, Head of ILS, AXA Investment Managers, who says that while the wider financial markets were in crisis this summer and spreads in most assets were widening, insurance-linked securities spreads were doing just the opposite and tightening.

The article goes on to point out that cat bond and ILS returns have again outperformed most other financial assets this year, this despite a turbulent market environment for ILS assets due to losses, bonds at risk of loss and uncertainty caused by the updated RMS U.S. hurricane model.

On the subject of losses the article discusses the loss of Muteki as the first full loss to a cat bond, now swiftly being followed by one of the Mariah Re tranches which is also expected to be a complete loss. eFinancialNews.com spoke to Ryan Bisch, Principal and Director of Exotic Alternatives at Mercer in Australia about the risk of loss, to which he said; “When you invest in this you are taking extreme tail risks so the potential drawdowns can be significant. Investors have to be aware that next year could be the year that the big event happens.”

We felt this deserved expanding on so we spoke to Ryan to glean some further insight on Mercer’s position on ILS and cat bond investing. He said; “Mercer continues to monitor this complex asset class – having commenced formal research coverage in early 2007. We are aware of growing investor demand and the potential implications of increased fund flows into the asset class.

As is the case for most alternative asset classes, access to high quality managers and deal flow is of paramount importance. Mercer suggests that for investors able to tolerate the tail-risk associated with exposure to catastrophe reinsurance, this uncorrelated alternative asset strategy is worth further consideration.

Investors in catastrophe insurance are taking rare but extreme risks. Therefore the investor has to be able to withstand rare, but possibly significant losses, on the catastrophe reinsurance portfolio. These loses may, indeed should, be quite small in a total portfolio context. However, this strategy may not suit the particularly loss-adverse investor.”

This is a really important point and one that tends to worry some investment managers now that retail investors are becoming more easily able to access the market (for example by the GAM cat bond funds we announced today). To date the majority of ILS investors have been sophisticated institutional outfits with years of experience and a full understanding of the risks they are taking on. Now that catastrophe risk has become available to retail investors it is the fund managers and financial advisers responsibilities to ensure that the risks of these assets are fully understood and that, as the GAM cat bond funds are, any opportunity is well-balanced and diversified to minimise risk of loss. If all managers and advisers work responsibly on opening the asset class to retail investors then there is no reason that they cannot profit from ILS and cat bond investment in the same way that institutional investors have.