Our panel of experts looks at what this alternative asset class can do for pension fund portfolios today
Chair for day: Peter Nakada, Managing Director, RiskMarkets, RMS
Chris Atkin, Managing Director, Atkin & Co
Andrew Firth, Investment Principal, Aon Hewitt
David Palmer, Head of Investments, Performance and Research, The Pensions Trust
Lorenzo Volpi, Business Development Director, Leadenhall Capital Partners
Marta Abramska, Manager, RiskMarkets, RMS
Chair: We would like to introduce everybody to the asset class of catastrophe bonds. We at RMS are in the business of evaluating catastrophe risk, mostly for the insurance and re-insurance industry, but I run the group that helps transfer the risk to the capital markets. We’re an active participant in this marketplace and we know a lot about analysing this risk.
One of the things that we’ve started to do is reach out to investors who aren’t in the asset class: find out whether they have heard about it, what issues they have with it etc. We know that it’s viewed by many as a very esoteric alternative, and we think that a lot of the issues with it can be addressed with better information and better communication of how the risk is viewed. That’s the objective of today – to have an open discussion, discover what the issues are that pension funds have when they think about catastrophe bonds and find out whether there is a way we can educate each other on this.
Let me start off by saying why we think the capital markets are better placed for certain types of catastrophic risk than reinsurers or insurance companies. Catastrophe risk is extremely concentrated. Of all the catastrophes modelled for the P&C insurance market, US hurricane accounts for 72 per cent of the risk – making it possible to have a $100 billion industry loss with a fair amount of probability.
Furthermore, within the US hurricane sector, it is further concentrated with 33 per cent of all hurricane risk in Miami/Fort Lauderdale; 20 per cent in West Palm Beach/Boca Raton; and 7.5 per cent in the Tampa/St Petersburg area. The top ten zones add up to 80 per cent of all hurricane risk. Seven out of ten zones – apart from Houston, New York, and New Orleans – are in Florida. So, not only is hurricane risk 72 per cent of total cat risk, but Florida is 70-odd per cent of hurricane risk.
A concentration as such is very costly to take on. In the reinsurance industry you have a relatively small number of financial institutions, mostly in Bermuda, London and continental Europe, taking on a significant amount of that risk. If there were a $100 billion event in Florida, it would really create mayhem in the reinsurance markets. So number one: it’s not a very resilient business model to have all that risk concentrated there; and number two: it’s not a very cost-effective one, because you have to hold a lot of capital against that risk. We believe that it is more efficient for concentrated catastrophe risk to be transferred to pension funds, where it can represent a small portion of their total risk.
Firth: Can I just ask, does this mean that they’re asking pension funds to take the risks that they don’t want to take, they being the insurer?
Chair: It’s not that the insurers don’t want to take these risks – it’s that they have built up too much concentration in them. If you ask what types of risks are most likely to find their way into the capital markets, the answer is the most highly concentrated risk. You’re not going to find much Turkey earthquake in the capital markets because the regular insurers and reinsurers do a fine job in diversifying it, there’s not that much concentration there.
US hurricane, however, is a huge problem for reinsurers because they get so much of it on their balance sheet, so it’s hard to diversify away and they end up having to hold lots of capital against it.
Volpi: Reinsurance is part of their risk management and there is a strong co-alignment of interest among parties; (re)insurers are not just offloading what they don’t like. For risk management/capital reasons they need to offload certain perils. Traditional reinsurance has been around for a long time, and more recently capital market players are providing additional capacity to (re)insurance companies so that they can diversify their reinsurance capacity while diminishing their counterparty credit risk with the usual traditional re-insurance players.
Atkin: To what extent is the cat bond market mirroring the risk market here? Is the cat bond market much more diversified than this?
Chair: It pretty much mirrors it.
Volpi: That is the challenge really. The cat bond only market is still a small niche compared to the overall reinsurance market. Cat bonds are a great tool for liquidity but if you’re a pension fund, liquidity might not be your main concern and objective, it’s more about looking at an asset class that is lowly correlated to what else is out there, get the best deal irrespective of the type of instrument used, preserving the capital of your pensioners, and making sure that you decrease the volatility of your returns over time. And that’s probably one of the major features of the asset class – you can manage to have a portfolio which is well diversified or more concentrated whilst always looking at extracting the most value from each transaction, irrespective of the tool that you’re using, whether that’s a three year cat bond that is a liquid instrument or a private placement of reinsurance which is illiquid but has a shorter duration of one year and gives you access to other types of opportunities across all classes of (re)insurance. That allows the portfolio manager to diversify the portfolio, that’s an approach that works, and an approach investors also like.
Chair: If you were managing a $10 billion pension fund and you said I’m going to put 2 per cent of my assets in this asset class and let’s suppose 70 per cent is US hurricane, so you got 1.4 per cent in US hurricane, and you figure out a way that it’s not one event, that it might be a couple of different events that would make it, so you cut that in half, so in any one event you have 0.7 per cent of your assets. Is that too much to have or is a 0.7 per cent loss, a chance in 50 of having that, is that too much or are you still well diversified? That is the issue that is facing this market. The concept is, if you have even a concentrated risk, if you keep it small enough in your portfolio, it’s still diversified away. You don’t need as much diversification within the asset class.
Atkin: And what you also want is investments in construction in Florida to diversify further, so you’re invested in something the money will be spent on. That seems to be a good diversification or hedge. It’s a question of how much risk you are prepared to take and that depends on the scheme, the sponsor, etc.
Firth: You can turn the question around - with 1 to 2 per cent, we’re well aware of the portfolio construction benefits because of the lack of correlation, but what does it do in a $5 billion portfolio? How much do we need to invest to make a difference and can we afford to put that much in an asset class which is relatively new and untested? There are still questions going forward. In my view that’s a key point. How much should a scheme invest to make a difference?
Palmer: One of the issues we should look at is moral hazard – when investors are buying into something, they will ask, are there any hidden risks? Effectively are investors going to be left holding the risk that the insurance industry doesn’t want? Having been burned before, that’s an issue that investors need to feel comfortable with. To pick up on another point, as a diversifier you really want an investment that works for you, that really makes a difference when you look at your portfolio on a holistic basis.
Chair: When you say make a difference, do you mean on a diversification side or on a return side?
Palmer: Diversification, because there are many ways of seeking returns, but when you look at a number of growth assets out there, there seems to be a lot of correlation with equity markets. To find a true diversifier which performs well in stressed markets and doesn’t suffer from the contagion effect is a challenge.
Volpi: You should avoid some obvious correlation to the equity market. One of the questions we get from investors is: why should I invest in a specialised ILS manager and not just in the stocks of an insurance company? The big difference is if you invest in our funds you get access directly to the underlying insurance risk and you don’t get affected by anything that happens in the outside world. If there’s a major stock market crash, we won’t be affected at all. The reality is that we invest in pure insurance risk and the only thing that could affect that is a natural catastrophe. There’s no moral hazard there – we cannot create a hurricane.
Palmer: We saw an example in 2008 in relation to hedge funds, and while you say the financial crisis has no bearing on the ILS market, we found that because these hedge funds had liquidity issues, they had to withdraw, so there was a knock-on effect.
Volpi: That was a very small niche of investors. Those were hedge funds that were playing opportunistically in the space and had to deleverage.
Palmer: Is the new attitude we are seeing towards collateral led by regulation or is the industry cleaning up its own act? And what happens
once everyone has forgotten about the last crisis?
Volpi: That’s an interesting question. The impetus is not regulation but from the self interest of both ILS sponsors and investors, neither of which want exposure to credit. You have the counter-party that is ceding you the risk which is the first one who will tell you, “well if you are providing me with reinsurance capacity I want to make sure that if there is a loss I’m able to claim and collect the money”. So insurance companies want us to either invest the money which is segregated into a trust account in high quality money market funds or leave it in cash. Insurance Companies like collateralised capacity because it means no counterparty credit risk as opposed to traditional reinsurance cover.
Then there’s us saying “if you structure a cat bond in a certain way we don’t buy it”. We recently saw an example where one investment bank had to pull back and change the investment guidelines for the collateral so that all the investors were comfortable with it; we’re trying to keep any potential credit risk as low as possible as we want to give our investors access to ‘pure’ insurance risk investments only.
Chair: Both of you made good points around whether this asset class is too new and whether it is booby trapped somehow. To the first issue, it’s not that young anymore, it’s been around for 15 years now, so the asset class has been around for long enough. And to be honest, there were some booby traps in it. The investment grade collateral account with total return swap didn’t belong in this asset class, because it exposed the investors to credit risk. This was inappropriate because ILS were always marketed as pure catastrophe risk. However, there was enough credit risk in the asset class so that three out of the six bonds that have ever defaulted did so for absolutely the wrong reasons, which is Lehman Brothers’ default and risky collateral in the collateral account. That’s now cleaned up. It’s not regulatory, but the market now is happier with pure catastrophe risk.
On the moral hazard front, the industry tends to favour industry loss deals that don’t have that issuer specific moral hazard. Indemnity deals where you are actually triggering it off an insurer’s own losses you might worry that somehow they are going to push the riskier stuff onto investors. But even then there’s a risk sharing scheme where they’re on the hook for the same risk as you are. Industry loss is even better because you are basically getting a trigger that’s based on the losses in the total industry not in any particular company. Then there’s a third type of trigger, which is a parametric trigger, which is even more divorced from the potential for moral hazard, and that is it’s triggered off of windspeeds or ground motion and that’s even more objective.
And lastly the industry has settled down on a structure that’s very simple. Back in 2007, there was some experimentation with tranching, that looked like CDO kind of tranching, that never really caught on. The structure is very simple – the money goes into a collateral account, that’s by and large invested in treasuries, and there is an attachment point based on industry losses, say it attaches at a $15 billion industry loss and exhausts at a $70 billion industry loss and you lose your money proportionally in between there. It’s a very simple structure.
The other comment I’d make, the example of the hedge funds during the financial crisis is actually an example of how the asset class is not subject to the same liquidity contagion that other asset classes are. During the global financial crisis of 2008, the hedge funds that got into ILS after 2006 were getting margin called, because most of what they owned was dropping in value. While most asset classes were trading at steep discounts (30-40 per cent) from par, cat bond trades went off near par. This was because most of the investors in cat bonds were either “real money” unleveraged investors or reinsurers who were not heavily invested in the other risky asset classes – so these investors were able to continue to buy during that time. So there’s an argument for not only that the risk is fundamentally uncorrelated, because hurricanes are uncorrelated to the global economy, but also from a liquidity contagion perspective, it’s one of the better liquidity hedges.
Firth: I agree with all those points, but if 1 per cent of your assets have those benefits and 99 per cent don’t, correlation does go up in a bear market, liquidity falls, you would say, yes, 1 per cent of my portfolio is doing fine, but the rest is being shot. What good does that 1 per cent do for you?
Volpi: I hear from other consultants and pension funds that they’re thinking more about 3-6 per cent of their assets under management. What should the right angle be in terms of diversified versus concentrated portfolio? Different pension funds, depending on their size, portfolio strategy, level of sophistication, give us different feedback. So for the big sophisticated ones, $100 to 200m is a small allocation compared to all the other asset classes and they might prefer to concentrate their ILS portfolio into the “peak perils” such as US windstorm and quake, where you get the higher level of premium for the risk you take. At the other end of the spectrum, you have the less sophisticated and maybe smaller pension funds who are more worried in case the big event does happen and how much they would lose; they worry more about the tail risk for the portfolio.
A diversified portfolio with a lower target return/lower risk would better suit their needs. It’s interesting to see how different the perception is depending on the pension fund type.
Atkin: It’s the big losses that you have to explain to the sponsor - 1 per cent isn’t going to make a difference, so we have to ask whether it is really worthwhile going into something so sophisticated?
Firth: I agreed that 3 or 6 per cent would be the ideal. In practice initially pension funds will not put as much as that into a relatively new asset class. The BBC have said that they have a 1 per cent holding, no more.
Atkin: Well 1 per cent is better than nothing.
Volpi: But this is also a discovery process for them. Pension funds might start with a relatively small allocation and then might add little by little over time while they get more comfortable with the asset class.
Also, following the big event which might lose you 5-15 per cent, investors might consider adding more to this space because premiums might double. Investors don’t look at just its diversification benefit but also at the actual extra yield they could make and how attractive they are versus those that can be achieved in other asset classes.
Atkin: The concept is actually quite simple. It’s fairly easy to understand what’s going on here. You tackled a lot of the problems in terms of collateral risk. It isn’t a difficult concept to understand, which is one of the attractions. On the due diligence side, making sure you understand the risks, and are aware of particularly the tail risks, that’s the challenge for the trustee to understand and for you guys to explain. And now, after hearing what you are saying, conceptually I can understand what cat bonds are trying to do and how they work.
Volpi: There is another very interesting angle that we bring up when talking to pension funds. We always talk about diversification or concentration of your own book, but then you also need to look at where you are taking the risk within the risk tower of reinsurance. Diversification is good, but if you start to diversify your book and take certain layers of risk which are ‘closer to the money’, then you’re more exposed to frequency of losses (i.e. a higher number of smaller disasters could impact your returns) and that’s also something that could hit you hard.
The reinsurance sector faced multiple headwinds in 2011. Significant losses in Australia, New Zealand, Japan, the United States and Thailand resulted in (re)insurers paying out more than $100 billion in claims. Losses were second only to 2005 when (re)insurers paid out more than $120 billion following hurricanes Katrina, Rita and Wilma. So when you think about how many events you can have in one year, sometimes a well-diversified portfolio but with the wrong attachment points (i.e. when you start to lose money on a deal) could actually be worse than a concentrated portfolio. We would suggest either investing in a low risk low return well diversified portfolio with very remote layers of risk, so that the frequency doesn’t hit your performance, or in a medium or high risk, medium or high target return more concentrated portfolio with less remote layers of risks and a higher probability of attachments.
Atkin: It’s the downside risk you’re worried about, a lot of events happening at once. It’s the possibility of a series of events coming all at once.
Volpi: Yes then you need to think that, before we lose money, the counterparty that is ceding us the risk has to have lost $300 million, for example. So it’s not that obvious that for everything that happens you get a loss. It’s very intriguing; following an event you get an email from investors asking, what happened to the portfolio? But there are so many different characteristics and variables, the penetration of insurance in that particular country for example, which drives pricing. In the US you have the highest penetration of reinsurance, which is around 50-55 per cent, then you have Europe, around 30-35 per cent and then you have Japan with 10-15 per cent. Then you have the developing countries where penetration is very low, where maybe the economic loss is very high, but insurance loss is very low. It’s a very important differentiation. That’s why when you build your portfolio it’s not obvious whether or not you have certain exposures when you have an event.
Palmer: It’s generally about the patterns of returns – would you expect the returns to be generally positive and then to suffer sharp draw-downs at certain points in time?
Volpi: Yes, that’s spot on. The risk measure in our industry is the concept of expected loss, which is very different from the concept of expected loss in mortgage backed securities for example.
When we say that the portfolio targets an expected loss of 2.5 per cent, this means that on average over a very large number of years you would expect to lose 2.5 per cent per annum before income. However the reality is that nine out of ten years after taking into account income on the portfolio you would make money and only the remaining one year would a net loss be expected depending on the portfolio risk.
Chair: Coming back to the earlier point of is the market booby trapped, another nice feature of this market is that there are independent modelling firms that are retained by the issuers. These modelling firms provide an analytical complement to the rating agency analysis. In our modelling as of 2006 we have taken a view on hurricane activity rates that is different from the historical backward looking view.
There are other modelling firms that believe that the average activity rates over the last 100 years are the best predictor of the future. We say we’re in a period now of elevated sea surface temperatures and higher sea surface temperatures mean more frequent and more severe hurricanes so we’ve incorporated that into our risk metrics, and there are now two different views in the market and investors now can take a view. Ours has more of that built in.
Firth: Has no one copied you in that? You were criticised for that by some members of the community, but no one yet has followed you?
Chair: The other modelling firms have produced what they call warm sea surface catalogue results that are similar but not the same as our approach.
Abramska: Another point to make about climate change, it’s such a long-term process and we don’t know what’s going to happen in tens or hundreds of years, and with cat bonds being on average three to five years of duration we can be pretty sure that weather patterns won’t dramatically change between the inception and expiration date of a bond. Also, cat models get updated very frequently whenever new science is available.
Atkin: So earthquakes are safer, because they are not going to be affected by climate change?
Volpi: Well, when you think about climate change you tend to think about US hurricanes and European Windstorms, which is what could really have an impact in our industry. There are two elements. One is the modelling agencies, are they going to take that into account? The answer is yes, so this in theory should also move the pricing of risk. We also expect the pricing to be more sensitive in the short term before anyone realises what the actual impact of climate change is, so in theory it should be to the advantage of investors, so they should get more premium for what is expected to happen in the future.
Another point is that, for example, people thought last year would have been a very active US hurricane season. It was an active hurricane season but not as active as expected and there was relatively little damage. The frequency and severity of hurricanes are only important when combined with their location. A large number of big hurricanes out at sea in the North Atlantic are not a problem for us. The important point is that where the hurricane is going to make landfall, because the exposures that we take in our portfolios in theory should be well diversified across the US; we call this the mix factor, so we have certain exposure in Florida across different counties, other exposures across Louisiana etc. And until the hurricane makes landfall, you really don’t have a feel about what the real damage could be in your portfolio.
Atkin: Is pricing more governed by other things then, for example, climate change?
Volpi: It’s more governed by capacity.
Palmer: Is supply an issue? It strikes me that supply is driven by the insurance companies and what it wants to pass on to the capital markets. Do you think supply will dry up at some point?
Volpi: Not really. We are a capital market investor, the reality is that we can take risk through a cat bond but also through other types of securities, like vehicles that transform traditional reinsurance risk into capital market risk through private placement of reinsurance.
Chair: Let’s discuss pricing. There are industry rules of thumb on how to price cat bonds, and one that is common is two times expected loss, plus a constant. Usually the constant is around 5 per cent – it varies depending on where you are in the cycle.
Another thing to do is compare this to credit. Not only is this asset class low correlation compared to credit risk, but also outperforms it, even on a pure standalone basis, just looking at the spread you get paid relative to the expected loss on it.
A lot of that has to do with the fact that the people that are setting the price on this have huge amounts of concentration in this risk and have to price up for this. For the off-peak perils they don’t price anything like this, for the peak perils they have to, because they’re so concentrated. I think that’s really the opportunity here.
Coming back to your other point, is the supply there? If investors did feel comfortable with this asset class, odds are they would bid the spread tighter to the point that reinsurers would find it economical to transfer much more of the risk to the capital markets. Our estimate is that this could result in a market that is roughly ten times the size of what it is now.
Palmer: It depends on whether there is a smooth mechanism at work. When markets fail to work smoothly, pricing gets distorted.
Chair: We’ve been involved in a lot of discussion with new entrants to the marketplace because if a big pension fund decides it wants to come in, one of the things they do in their due diligence is to come in and talk to the modelling firms. So we have a window into that. We know that there are a number of giant pension funds that are now well on their way to getting significant allocations to the asset class, allocations that could meaningfully move the dial in terms of how much money is in the sector. So it feels like a point where now it is going more mainstream. It used to be more alternative, but now I feel more big pension funds are saying, maybe we’re missing out on something not being involved in, rather than this being something we want to stay away from.
So the thing that the industry needs to be careful about is managing the on-ramp into the marketplace. If you have $8 billion coming into a market that’s got $12 billion already, you need to make sure there’s not a shock that dislocates things.
Volpi: Well every time we have an investor who wants to invest more than $100 million, we say, OK, there are two key renewal seasons in our industry, the 1st January for Europe, 1st June/July for the US and we would like at a least a couple of months’ notice so that we can line up a number of investment opportunities to make sure that the money works as efficiently as possible.
Chair: One of the CIOs I spoke to during the due diligence phase said: “One of the worst things for a CIO is to be unconventionally wrong in a new asset class.” What are your thoughts on that? Is this still an asset class where people would lose their jobs if the wind blew hard and they lost their money on this? How does it compare to infrastructure and agriculture, also sort of unconventional?
Atkin: Invest 10 per cent and lose a lot, and you lose your job. But if we’re down to 1 per cent, it doesn’t make a difference either way.
Chair: Another point I wanted to make, regarding the 1 versus 3-6 per cent, another way to look at this, there are five significant perils that are securitised: US hurricane, US earthquake, Europe wind, Japan quake, Japan wind. And all are quite definitively not correlated with each other, so you could imagine this being a 2 per cent play in each one of five, which does add up to 10 per cent.
Firth: But the first two risks account for 82 per cent of total risk.
Chair: Yes, as far as what’s issued, but you could develop some diversification within it that would take you above a 2 per cent in any one peril.
Firth: You have got to also remember that these pension funds that are invested in cat bonds have about 60-70 per cent in equities against 1 per cent potentially in cat bonds, so the lack of correlation has no impact. They’re accustomed to taking equity risk.
Volpi: We talk about losing 5-25 per cent on a very infrequent basis depending on the risk profile of your portfolio. Equity markets can easily lose more than that and have done frequently in the last 25 years.
Palmer: Pension schemes are aware of that risk.
Volpi: In our industry, we usually need a big event to lose a huge amount of money, premiums would then go up as a consequence of that and we should recover over time as we do not expect such an event to happen every year.
Palmer: The great strength is also the great weakness. If that one event happens, that will affect the ILS market, whereas if you’re invested in another asset class and there is contagion, you can ask where else could we have gone. With this asset class, you’re going out on a limb with something that can move completely contrary to any other asset class.
Atkin: It makes trustees think about risk and diversification and here is an uncorrelated risk introduced to the conversation. It’s a relatively easy concept to get hold of and it makes trustees think about risk and reward and think about, if we’re going to commit money to this, what’s the risk, what’s the return and does it make a difference? It’s an interesting vehicle to consider.
Chair: As an educational catalyst?
Atkin: Yes, because it’s so different from anything else. It introduces the concepts of diversification and return.
Chair: Do pension funds run asset allocation models? In almost any scenario, you have to admit this has a very low correlation.
Firth: But there is theory and then there is practice. In theoretical asset portfolio construction, you’re absolutely right, this seems to make sense as the correlation is low. But then in practice to expect a pension scheme to put 15 per cent of its assets into this asset class, which is still relatively new and untried, is a very big ask. These three big, very sophisticated schemes, they are putting in 1-2 per cent.
Chair: But that’s their initial allocation.
Firth: Well, perhaps.
Palmer: I think a lot of trustees have seen pre-2008 models which didn’t work as they should have, so post-2008 there is a certain lack of trust in models, rightly or wrongly. There’s an intuitive argument that people can understand modelling based on historic data, but it is a harder sell than it used to be. People will just go with their most recent experience of capital markets.
This brings us back to whether there a booby trap here that investors are unaware of. I’m not suggesting there is but there were problems in the past with other asset classes given that there wasn’t a proper understanding of the tail risk involved.
Now people are more aware of tail risk and therefore realise they can’t take these models at face value. So there is still a process of education to go through.
Chair: In the insurance and reinsurance world there is a recognition that you have to own your understanding of the risk. The models are valuable tools, we take the best science available, we make it useful for investors, but at the end of the day it’s your money, not ours. You need to understand the assumptions that go into the models, we don’t want to oversell that 1 per cent of expected loss is some sort of truth, it’s our best estimate of this and you do need to dedicate enough understanding to get comfortable with that.
Insurance linked securities - an opportunity for pension funds?
Our panel of experts looks at what this alternative asset class can do for pension fund portfolios today