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Thomas Miller: A fund to help diversify away from bonds and equities

28 June 2016

Georgios Nikolaou, investment analyst at Thomas Miller Investment, highlights an investment strategy he and his team are using to protect their clients against equity and bond market risk.

By Georgios Nikolaou,

Thomas Miller Investment

The insurance-linked securities (ILS) market is an alternative asset class that has seen significant growth in recent years, increasing in size from nearly $14 billion of outstanding market capacity in 2008 to more than $26 billion in March 2016.

Whilst the value of traditional investments typically depends on factors such as GDP growth, interest rates and corporate profitability, the performance of insurance-linked securities is predominantly determined by the occurrence of pre-specified and low frequency catastrophic events such as hurricanes, earthquakes and tornadoes.

The return is therefore driven by the premium earned for insuring against these catastrophic events.

In terms of how the market operates, in a nutshell, a reinsurance company insures insurance companies. Property can be insured against natural and man-made disasters through traditional insurers.

These insurers can in turn buy reinsurance from a reinsurer to diversify their risk. The reinsurer fulfils an important role in risk transfer; if this was not available then, for example, the capital of a local Floridian insurance company could be wiped out by a single hurricane.

This would make home insurance for a local residence prohibitively expensive or, more likely, not available at all. As such, the ILS market provides a bridge between the reinsurance and capital markets and consequently an additional layer of risk transfer, ultimately providing a benefit to society

Although undeniably a niche asset class, the ILS market provides a wide offering of securities, structures, strategies and even perils. Managers specialising in ILS strategies can diversify their portfolio across different risk drivers.

Catastrophe (CAT) Bonds are the most well-known ILS structure.

CAT Bonds typically provide a defined level of protection and can be designed to cover any natural disaster. Some popular issuances cover US hurricanes, European windstorms and Japanese earthquakes. They have even been issued to cover non-natural catastrophes.

For example, FIFA issued CAT bonds worth $260 million to provide protection against the possibility of the 2006 FIFA World Cup being cancelled. However, a key risk is that the pricing models for CAT Bonds could mispecify the sponsor’s losses for an insurance event (similarly to what happened with certain issuances related to Hurricane Katrina).

Insurance-linked warranties (ILWs) are issued by reinsurers in relation to a specific industry event (e.g. a hurricane in Florida). The trigger point for losses is determined by an index of industry losses, rather than an insurer’s own losses.

Another category, which we believe offers better risk protection, is retrocessional (Retro) collateralised reinsurance.

Within a Retro insurance structure, a reinsurance premium is received in exchange for reimbursement payments made to another reinsurer for actual losses suffered, also known as ultimate net loss (UNL).

Performance of indices since January 2006

 

Source: Bloomberg/eVestment

The ILS sector has a number of potential benefits for investors. Since the inception of the asset class, ILS returns have been attractive compared to equities and other major asset classes.

They have also been much less volatile compared to other asset classes, although it is important to remember that ILS returns tend to be very ‘non-normal’ (i.e. exhibiting infrequent but severe losses).

The return profile is related to factors such as climate, geology or engineering and is unrelated to the economic cycle.

Whilst a financial collapse might cause equity and bond values to crash; it won't cause a hailstorm, earthquake or tsunami. This can be observed in the very low correlation that ILS strategies exhibit to other asset classes.

In the portfolio context, ILS are characterised by a high level of cross-peril diversification.

As an illustration, one can build an ILS portfolio by combining assets linked to independent risk factors such as Japanese earthquakes, UK flooding, Aviation Risk, Florida hurricanes, European wind and Asian Cyclones. If each of the six events described has a 1 per cent probability to occur, the probability of a total portfolio loss is 0.000000000001, or once in a trillion years.

From a market perspective, ILS pricing has experienced downward pressures recently as a result of less frequent catastrophe losses and the influx of capital from asset management firms, hedge funds and pension plans. However, a trend of gradual price stabilisation has been evident during the last year.

Generally, the pricing of products such as ILWs and CAT bonds has tended to be less favourable compared to the Retro space, as both are focused on standardised industry triggers. In contrast, reinsurers prefer to acquire cover against their actual incurred losses (i.e. Retro). Therefore, Retro investing commands a premium relative to commoditised products, such as CAT bonds or ILWs.

Within our alternative allocations, we favour the London-listed CATCo Reinsurance Opportunities Fund (CATCo) as a vehicle to access the insurance-linked sector, which offers an attractive potential return and diversification of risk. CATCo’s multi-pillar Retro approach enables it to have considerable flexibility to exploit market conditions.

Performance of trust versus indices since launch

 

Source: FE Analytics  

Overall we regard the characteristics of ILS to be highly valuable in the challenge of return generation against a backdrop of low-interest rates and volatile equity markets.

However, investors considering an allocation to ILS should consider the likely trade-off between return and diversification potential on the one hand, and tail risk on the other.

 

Georgios Nikolaou is an investment analyst at Thomas Miller Investment. All the views expressed above are his own and shouldn’t be taken as investment advice. 
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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.