Credit Suisse Insurance-Linked Strategies

Turning catastrophes into uncorrelated returns

SIMON KERR

The creation of crop futures, then forward metal markets, and later financial market futures enabled risk to be transferred from those who naturally have the risk as part of their regular commercial activities to speculators and traders. The insurance industry was running short of capacity for insuring certain sorts of risk after the impact of Hurricane Andrew in 1992, and turned to pass risk on to the capital markets in the form of insurance-linked bonds. The creation of new securities, the return of which is tied to insurable events, allowed different sources of capital to share in the risk of the insurance industry (see Box 1).

The introduction of new securities is a fertile time to make money as there are always neophytes unknowingly taking on risk at a price they shouldn’t. In newly traded markets the advantage lies with those who have expertise in the “underlying”. In the case of insurance-linked securities it was not just the insurance companies who necessarily started off with such an advantage so much as re-insurance companies, a sector dominated by a few, large companies.

So it is important that companies that now invest and trade in insurance-related securities, a growing area of alternative investing, truly understand the primary insurance and re-insurance markets. Credit Suisse’s Insurance Linked Strategies Group (ILS Group) is headed by Niklaus Hilti who was Head Actuary at Helvetica Reinsurance, as well as formerly being Head of Catastrophe Pricing Converium Ltd in Zurich, and a Pricing Actuary at Zurich Re.

Two catalytic years for insurance-linked securities
The earliest sort of insurance-linked securities were related to reinsurance of large-scale risk. These Super Catastrophe Bonds are widely known as Cat Bonds. Issuance of cat bonds grew slowly – only $8 billion worth were issued in the period up to 2002. In the time since, two periods became significant to how the market for insurance-linked securities developed. First, 2005 became a notorious year for large insurance losses because of hurricanes Katrina, Wilma and Rita landing on the continental United States. These losses compelled an accelerated issuance of insurance-related securities, and by the end of 2007 the liquid cat bond market jumped in size to about $14 billion in bonds outstanding. A good six billion of those bonds covered US hurricane risk alone.

The second period was more recent and wholly negative – Nicklaus Hilti explains. “The issuance of cat bonds and then the secondary market trading of them was handled by investment banks. The structure of the bonds meant that the counterparty was effectively the investment bank, which was okay until the credit rating of the investment banks began to be questioned by the financial markets.” This questioning started in 2007 after it became clear that Bear Stearns had a problem as the parent of hedge funds in the mortgage-backed area that had had significant losses. Hilti continues, “so from January 2008 we ourselves took a policy decision to back away from the credit risk associated with cat bonds (see Fig.1). The events of the second half of 2008 made the problem clear to everyone else.

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In terms of total market size, cat bonds have stalled – in late 2009 the total in issue was still only $15 billion, with about $5 billion in new issuance and $3 billion maturing in the year. It is indicative that a significant hurricane insurance bond issue came from the Mexican Government in 2009 – it was backed by the World Bank so that counterparty risk was not an issue for potential purchasers. “The thinking behind such supra-national backing is that a working insurance market will help recovery in affected places,” says Hilti.

The wider acceptance of the structural disadvantage of cat bonds fed into the growth of another form of transfer of insurance risk – that of (non-securitised) insurance-linked swaps. The market for insurance-linked swaps like most swap markets is over the counter, and principal-to-principal. The disadvantage of there being no secondary market for the swaps is more than balanced by the advantages. The market volume for insurance swaps is of the order of $350 billion underlying insured risk, so is much larger than the market for cat bonds. This large market has semi-standardised documentation like ISDA documentation for OTCs, and has lower transactions costs than that for cat bonds. The swap market covers natural catastrophe risk like the cat bond market, but in addition insurers and re-insurers can mitigate or take riskin many other insurance market segments such as aviation, marine, aerospace, oil rigs, energy infrastructure, crop failure and life risk, most of which are not covered via insurance-linked securities. The range of risks covered gives great scope for managers of insurance risk like the ILS Group to diversify their assumed risk.

Specific expertise required
To handle such a range of risks, each a form of risk with their own characteristics and history of loss, requires deep expertise. The ILS Group have more than 39 years of relevant experience with reinsurance, risk modelling and risk pricing backgrounds. The vagaries of the cycles of the insurance industry are familiar to the team of two actuaries, a meteorologist, an ILS fund manager, an insurance analyst, and a reinsurance analyst. Between the team members there is a variety of academic backgrounds (a theoretical physicist, a mathematician, a Ph.D. in Economics, and a Ph.D. in Law) to cope with the scientific and quantitative parts of the work. The members of the ILS Group get involved with cutting-edge scientific publications and have collaborations with universities and scientific institutes to keep their knowledge fresh.

Only a few years ago members of the ILS Group were deeply involved in primary research with Colorado State University and Tropical Storm Risk at University College, London. The relationship of the team to research has become more about consumption than active origination – to some extent this has been because of the successful application of forecasting software to hurricane and extreme weather patterns. The whole sphere of modelling/forecasting hurricanes was not taken seriously in the insurance industry before the 2005 hurricane season. However that year became a turning point, so when the 2006 extreme weather forecasts were a lot less cautious than 2004-2005 it was plausible to risk capital on them. So the academic aspects of the work of the ILS Group are now about applied rather more than pure research.

Segmenting risk and diversifying its source
The experienced ILS Group takes exposure to a range of risks in something like the form of the matrix simplified in Fig.2. The portfolio is diversified across regions for natural catastrophes.

So winter storm damage in Europe is insured as well as typhoons in Asia and hurricanes in North America. The risk types, such as aviation, marine, etc. and the different regional risks are such that the perils insured have little or no correlation to each other and allow efficient diversification of the portfolio. Better yet, each risk type or region is then further diversified by sub-region or trigger levels.

An example of a trigger level is the magnitude of an earthquake. A well-known earthquake risk is in Southern California. A single transaction structure could be cover for something like an earthquake with a magnitude of 7.0 or stronger. The insurance cover may be as specific as insuring losses for an earthquake of severity ranging only from 7.0 to 8.0, and will cover a specifically designated area of the state.

It is important to stress that the ILS Group’s products are not just about taking super-cat risk. Indeed Hilti maintains that he prefers to take a lot of smaller-sized risks covering flood damage in France or bush fires in Australia rather than underwriting chunks of hurricane risk in North America. This mind-set even applies to years when a weak El Niño wind is expected, which is strongly associated with a mild US hurricane season. The strong preference from a portfolio management perspective is to diversify first.

So through the application of triggers at varied levels and taking different tranches of risk (see Box 1) the specific risk assumed for the pool of capital can be varied according to the mandate. Table 1 shows the range of risk-return profiles offered by the ILS Group to institutional investors via the (ILS) platform Insurance Related Investment Solutions (IRIS).

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Out-performing through active management

Hilti and his team are not passive acceptors of risk – just like in equity or bond management sometimes insurance risk becomes under or overpriced in the market. So like an equity portfolio manager can trade on his variant perception of the equity market, or more likely his different valuation of a stock, Hilti will sell down some insurance risk already taken through reinsurance or ceding. If the risk has been taken through cat bonds, advantage can be taken of market mispricing by trading them out.

There are opportunities through the year associated with specific seasonal factors. Most of the information for the northern hemisphere extreme weather that is insured is in place between May and July. The ILS Group doesn’t utilise seasonal or long-range forecasts to take on huge outright risk on autumn or winter weather. Rather, as new shorter-term forecasts emerge in the six week window before the hurricane season or the European winter weather comes in then Hilti and colleagues will actively trade with the new information as it emerges, putting on offsetting insurance risk positions to manage their portfolio of risks as information hardens up the outlook.

Crop yield insurance is written by the ILS Group on a co-underwriting basis i.e. it partners with experienced underwriters in specialised markets.

“We work with the best underwriters there are,” says Hilti, “and access is very important in an area like this.” Insurance and reinsurance for crops is not securitised and traded in bond form like the cat market. It is very localised, and has often been covered by mutual insurance arrangements historically. However as the agri-business becomes more sophisticated third-party insurance and/or reinsurance will likely grow. The ILS Group expects crop (re-)insurance to be increasingly important to them over the long term.

The ILS Group does not aim to replicate the returns of the cat bond index or some other proxy for this alternative asset class. “We aim to out-perform the market through active management,” says Hilti. “It should be possible to outperform the insurance-linked investment universe through superior risk selection skills and the use of advanced technology,” he states. And he and his team have done so. Fig.3 illustrates that the IRIS product design and actual outcomes for the ILS Group have achieved useful returns in risk-return space.

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Looking at the performance of the ILS products on a time series basis (see Fig.4) it is clear that the performance of ILS balanced mandates have not swooned and rallied like hedge fund returns or equity markets. Also, over the four years covered the diversified ILS Balanced product beat both the Cat Bond Index and US Government Bonds.

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The performance comparison given in Fig.5 confirms that the Credit Suisse ILS product has held up well versus global equities over the last four or five years. As important, for Hilti and his team, is that their efforts to outperform through active management have delivered better returns to their investors than a representative cat bond index. “You have to be able to recognise what is attractively priced,” says Hilti.

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One of the fears of investors in hedge funds is that there may be low entry barriers for the strategy. That said, the ILS Group have been together for seven years, and as important as their scientific and quantitative background is the fact that they have built a broad network through transactions.

Through structuring nearly 500 transactions and dealing with more than 109 counterparties the team have a history of conducting ILS business – so they understand the termsof business and who the commercially-driven counterparties are. The combined experience of the team would be difficult to put together from scratch and the inter-relatedness of the different disciplines makes the trust element of team work impossible to replicate without lifting a whole equivalent team.

The introduction of insurance-linked securities opened up the possibility to transfer insurance risk to new participants in the market, mostly coming from finance and trading, rather than with a background in insurance risk. It has also allowed those with an insurance background to use their expertise in formats other than applying them to insurance company balance sheets. Given the demand for alternative forms of alpha, whether in the hedge fund format or not, it was inevitable then that we should see insurance-risk related funds launch.

The insurance linked strategies run under the Credit Suisse name are deliberately run by staff coming from the insurance side rather than by traders or fixed income investors looking for an up-lift in running yield. The stasis in growth in the cat bond markets rather plays into the hands of those coming at funds for insurance related risk from an insurance company background. The market growth opportunities have been and will continue to be in insurance-linked swaps. Even deep-pocketed and experienced traders of financial market products are at a distinct disadvantage and cannot readily disrupt this market for insurance specialists.

Current outlook for the strategies
A major factor in returns from the strategy is the change in premium levels for insurance of different kinds, but particularly catastrophe reinsurance. The investment returns generated by the investment activities of insurers and reinsurers is negatively correlated with changes to premium levels.

In times of poor investment returns like 2008 premiums increase (rates harden) because of an effective drop in insurance capacity – risk capital is highly leveraged in terms of the liabilities assumed versus risk capital, so small changes to available capital can change premium levels. Loss experience also impacts premiums in following periods. Again, 2008 was a bad year for natural catastrophes, so high loss ratios and capital depletion from financial market losses combined to harden rates over 2008/2009 as shown in Fig.6. January is an important renewal season in the insurance industry, and early evidence from quoted insurance brokers is for a small softening in rates for 2010.

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The ILS Group has the flexibility to change the balance of business written, in reaction to market pricing and their own analysis of potential for loss. According to Hilti, “This year a policy decision has been taken to shift a bit of the focus in our active trading from US hurricane risks to insurance of extreme weather in Europe. It is not just about pricing, but also about where we have the better information edge or risk assessment capability.”

Attractive return characteristics from inefficient markets
Markets for insured risk are inefficient, and in the absence of commoditised risk and dominance of idiosyncratic risk, insurance will remain an inefficient market ripe for exploitation by experienced professionals.

Investing on a primary basis in insurance risk provides investors with an alpha source with low correlation to the financial markets and so gives institutional investors ready diversification. Natural catastrophes are the type of insured risk that has been most commonly securitised since the insurance markets turned to capital markets for new capital. Catastrophes whether natural or man-made are uncorrelated to financial risk factors.

The ILS Group is one of the biggest managers of capital applied to the insurance market on behalf of external investors. The ILS products have attractive return characteristics such as portfolio stability, low tail-risk, and low volatility (the low volatility funds have exhibited a standard deviation of less than 2% for more than seven years). The products are managed by a team with a long and proven track-record in the insurance-linked investment industry. The team has outperformed the market and has managed to consistently generate alpha.

The market opportunity set for the ILS Group is likely to remain fertile as they expect an accelerated growth in the market for insurance linked securities because of regulatory pressure (Solvency II), and toughening accounting standards (US GAAP and IFRS). Better yet, the balance of supply and demand in the market is still tilted in favour of investors in 2010.