Natural events like hurricanes can have severe financial repercussions for property owners and the insurers providing coverage to them. Yet events in financial markets don’t really have a noticeable impact on nature. This disconnect means that catastrophe strategies using insurance-linked securities can offer wholly uncorrelated returns to whatever price action takes place in financial markets.
The plunge in equities prices and the subsequent credit crunch that followed the collapse of Lehman saw unexpectedly high correlation among many hedge funds, despite nominally different investment strategies. In subsequent years, the correlation among many hedge fund strategies has been underscored by the ‘risk on’ and ‘risk off’ price swings in markets. In contrast, Nephila Capital has a long history of providing diversified returns and its correlation to the broader markets has been extremely low.
Returns from insurance-linked securities (ILS) are generated by charging an insurance premium for taking the risk of a large natural catastrophe. The aim for the seller of the premium is to have diversification of premium income and therefore of risk. Primary diversification is created by holding risk from different geographic regions, say, the US, Japan and Europe. Secondary diversification is obtained by spreading risk across a geographic region, e.g., with US hurricane exposure spread across Florida, Texas and New York. As well, tertiary diversification can be obtained by underwriting multiple strike prices on different levels of insurance industry losses.
No natural counterparty
“In financial markets there are natural clearing prices for dollar versus yen or fixed rate versus floating rate notes, but there is no natural counterparty for catastrophe risk,” says Greg Hagood, a founding partner of Nephila Capital. “The only place to pass this volatility is to the reinsurance market or funds such as Nephila and we believe insurers are willing to pay above the odds to transfer this risk. Therefore, over a longer period of time our investors should be left with a positive expected return for absorbing that volatility, but the trade-off is that in any given year that volatility can manifest itself, and you could have some claims.”
The behaviour of some investors is highly opportunistic. After hurricane Katrina in 2005, for example, insurance premiums rose. That made it more attractive to sell insurance and Nephila attracted around $1 billion in new allocations. Some of the money that came into the market was opportunistic and moved out 12-24 months later. But for most investors in reinsurance the allocation is more of a strategic asset allocation. This is particularly true for Nephila’s investor base. The firm has $7 billion under management (up from $5.5 billion at 31 December 2011) with 80% of the money from pension funds around the world. For such investors, there is a preference to have a 1-2% weighting to catastrophe insurance in the portfolio over time owing to its non-correlation. This strategic asset allocation would be part of the pension fund’s core position. It might be augmented with temporary additional allocations after an event like Katrina or the 2011 earthquake in Japan.
Building the business
Hagood and Frank Majors co-founded the business in 1997. It began after they pitched Willis Group, the London-based insurance firm, about setting up a new reinsurance strategy. The strategy operated within Willis, which was the majority shareholder, while also contributing seed capital and other services. As it grew, the fund hired its own staff and began to trade with other insurers. By 2003, it made sense for Hagood and Majors to buy out Willis and start an independent operation, which is Nephila Capital today. In 1999, the head office for the business was established in Bermuda. This wasn’t for tax reasons but rather because the island is the centre for the catastrophe insurance industry and the over the counter market where players like Aon and Marsh McLennan are trading exposures. In short, Bermuda is where the information flow and the relationships are based. Nephila has also opened an office in Marin County (outside San Francisco) and is developing an office in Nashville to be run by Hagood. In 2008, Man Group acquired a 25% stake in the firm, bringing in proven distribution muscle to an ever-broadening investor base.
The Nephila name roots the firm in Bermuda. Island folklore has it that the silk spider, ‘nephila clavipes’, is known for its ability to predict bad weather. It is thus called the ‘hurricane spider’ since it spins its strong, golden web close to the ground when a hurricane is approaching and high up in the shrubs and trees when the weather is clement.
The firm’s principals, for their part, rely on an analytical, proprietary framework honed and developed over 15 years. The value proposition is clear. Information is difficult to come by in this area since the prices of catastrophe products aren’t publically available. Nephila’s systems analyse individual risks and build portfolios based on internal research. The research is divided into three primary areas: risk assessment, market dynamics and portfolio construction. It is formalised in reports containing a statement of the problem, the data used in the analysis, the methodology employed and the conclusion. The reports are circulated internally and often made available to investors. The process allows peer review, builds institutional memory and provides a method for educating employees.
Nephila generates a return by charging an insurance premium to take on the risk of a large natural catastrophe. With a hurricane it would analyse the risk and might charge a $1 million premium to take on a $10 million liability. If destructive hurricane happens, it pays out the $10 million (less the $1m premium received) but if nothing happens it keeps the $1 million. The aim of the business model is to bridge a gap between two capital markets, creating attractive non-correlated assets for institutional investors by offering best-credit-quality coverage to buyers of reinsurance.
For Nephila, the key thing is that diversification can be created among geographic regions. For example, a US hurricane has nothing to do with a US earthquake, which has nothing to do with Japan earthquake, and which will have nothing to with a European wind-storm. This makes it possible in portfolio construction to disperse risk. Even within regions, additional secondary diversification can be obtained as different insurance companies whom Nephila will re-insure have different market-shares in different states or cities.
“You can understand how a storm in New York will impact some insurers, but clearly not all, many of whom would be more heavily concentrated in the south-east,” says Hagood. “So the risk diversification within a region is important as well.”
Each time an insurer sends Nephila information to get reinsurance they supply their market-shares by postal code. The result is that Nephila will know how much insured value an insurer has in one place compared to another. “It’s just like putting together a jigsaw puzzle,” says Hagood. “You want to have some companies that are heavy on, say, Houston and some that are light Houston or some that are heavy London and some that are light London, and so forth. Essentially it is a big data optimisation exercise.”
Nephila is able to access a broad range of instruments (see Fig.1). Each of the instruments used in the $250 billion catastrophe risk market is used by different types of insurance players and features different barriers to entry. They all trade differently and there is substantial fragmentation. Some players specialise in catastrophe bonds and others just do traditional reinsurance. Specialist expertise in different segments can mean that some players will offer better value than others.
However, a large part of the risk in the world is not being transferred to the reinsurance market. In the Japanese disaster last year, economic loss was estimated at $300 billion, but only about $30 billion was insured. In the US, there are state-based entities, the most notable being a company called Citizens in Florida, which are insurers of last resort because many commercial insurers withdrew from offering coverage after the severe losses incurred from Hurricane Andrew in 1992. The bottom line is that a lot of risk being held is not getting to the reinsurance market. For Nephila, this represents a long-term growth opportunity, matching new capital with new risk opportunities.
With $7 billion AUM, Nephila is an upper echelon catastrophe reinsurer. What also distinguishes Nephila as a counterparty is that it is collateralising its obligation. With a big traditional rated reinsurer, the buyer of the reinsurance is basically taking it on faith that coverage will be paid out when it is required. When Nephila gives an insurance contract, it posts three month T-bills as collateral for the trade in a trust account. This is a big credit enhancement compared to what traditional reinsurers do.
In 2005, when hurricanes Katrina, Rita and Wilma made landfall in the same season, Nephila paid out claims and suffered a negative return for the year. Yet Nephila’s investors were comfortable that the outcome was within expectations from such a series of events and the firm grew assets significantly the next year as premiums for the same risk were significantly higher.
“The whole market changed a lot; it was an incredibly active season,” says Hagood. “We made adjustments to some of our models and made some changes in our portfolio construction, but I wouldn’t say that they were material changes. We knew it wasn’t a matter of if we’d ever have a loss, it was a matter of when. We managed the risk appropriately and it was consistent with the risks that our investors thought they were bearing. No investor is happy about losing money, but relative to some of the losses you saw on capital markets in 2008, it’s held up pretty well.”
Nephila now offers five different commingled funds mixing varying levels of risk and expected performance. It also has a number of customised mandates managed on behalf of larger pension funds.
“There’s a large sub-set of investors, particularly in the UK, who start with a lower risk/return strategy,” says Hagood. “These funds are positioned out of the money and don’t have a lot of tail risk if a series of large catastrophes occur. So think of it as somewhat of a baby-step into the asset class. After a year or two, investors get additional comfort with the risk and realise that not every hurricane is going to ruin the portfolio. They often then begin to migrate to one of the other funds with higher return characteristics.”
Since 2005, Nephila’s research capabilities and analytical abilities have grown considerably and it has a team of 50 people today. It also has a sharply increased presence in certain types of private transactions. The firm is well positioned for growth in a sector that looks likely to see continuing capital inflows.
“Fourteen years brings a lot of experience and the team is pretty seasoned,” says Hagood. “We have some of the world’s most sophisticated investors as our clients and they drive us and demand we be thoughtful. We can grow materially and still deliver the returns our investors need. We are a $7 billion part of a $250 billion market, which could be a much bigger market in the future.”