Insurance – it’s everywhere. We all use it. Someone makes money from it, and it might as well be institutional investors and their clients, writes KATE WILKIE, a product specialist in Credit Suisse Asset Management’s alternatives solutions business..

Risk transfer is an age old process. The popular book titled “The Richest Man in Babylon”, set in ancient times, described a form of life insurance via the use of rudimentary pooling techniques.

Private individuals are certainly prepared to pay good money for protection from life’s daily risks, in the form of theft, liability and life insurance. Insurance companies assume risks that affect individuals as well as those affecting the aviation or oil industries. For this, they receive premiums.

However, reinsurers and insurers alike have been faced with higher capital requirements in recent years. Today they require more equity capital to cover their risks than used to be the case. This is the result of stricter guidelines on the part of the regulatory authorities (Solvency II), new accounting rules (IFRS, US GAAP) and more rigorous requirements on the part of the rating agencies. As a result of these developments, the risk capacity of insurers has declined overall.

If insurers or reinsurers want to assume a greater level of risk once again, there are now two paths open to them. Either they have to obtain new equity capital from their shareholders, or they can elect to pass on part of their risk portfolio to other parties. As equity capital is the most expensive type of corporate financing, an increasing number of insurers are finding it cheaper to sell certain risks on to investors instead. This then frees up equity capital, which can be used to tap into new areas of business that are more lucrative for the insurance companies.

The idea behind insurance linked strategy (ILS) investments is strikingly simple: investors and insurance companies simply exchange their roles. Investors assume the role of insurance companies by taking on insurance risks, for which they receive a premium. The insurance companies take on the role of the insured, passing on risks to investors and compensating them for those risks with attractive premiums. This enables ILS investors to benefit from a unique mix that has low correlation with other asset classes, and to earn attractive returns.

As an example of the strategy in practice, if an aircraft was not insured, it would be grounded, since most airports would refuse to grant it an operating license. As such, airlines are obliged to insure their fleets with primary insurers. Each aircraft is insured for around US$2.5 billion. This is too great a liability for many primary insurers, which is why they turn to reinsurance companies. Reinsurance limits the maximum potential loss to primary insurers. The reinsurers then pass on part of their risks to the capital markets. Investors assume these risks in exchange for a premium.

There are two ways in which insurance companies pass on risks to the market: on the one hand, via securitised instruments (‘catastrophe bonds’) that can be obtained by capital market investors in standardised form, and, on the other, by means of non-securitised instruments – so-called individual agreements that are negotiated between investors and insurance companies. By using these two instruments, reinsurers and insurers can hedge themselves against risks arising from natural disasters, as well as risks in the areas of air travel, space travel, shipping and energy infrastructure, to name but a few examples. For their part, investors can participate in insurance risks through these instruments and are compensated in return with attractive premiums. ILS investors benefit from a return profile that is relatively independent of financial risk factors.

Attractive returns can be achieved through intelligent selection and diversification of risks, with conservative assumptions applied to the pricing of risk, which will often see opportunities rejected.

A diversity of experience in a team managing ILS is an advantage – for instance Credit Suisse’s ILS team have backgrounds in actuarial studies, mathematical modelling, meteorology and physics.

The task of an ILS portfolio manager is to find an attractive premium for the selected risks and to construct a diversified portfolio, seeking to limit tail risk. The prospect for diversification is clear with independent risks: the occurrence of a hurricane in Florida has no connection with an earthquake in Japan, the breakdown of a satellite in outer space or the growth cycle of the global economy.

The key to investment success with ILS is extensive specialist knowledge in the areas of meteorology and insurance studies, together with the use of state-of-the-art insurance models and databases.

A true alternative asset class, ILS offers virtually no correlation to financial markets or other alternative investment strategies.

Investment consultant Mercer says the insurance-linked securities market is complex, heavily intermediated and probably suitable only for the most sophisticated institutional investors.

Speaking from Bermuda last month on a research trip focused on ILS managers, Mercer investment consultant Ryan Bisch said there were a growing number of options available to institutions interested in assuming some risk from reinsurance companies in return for premium income.

For example an investor whom, through a broker, enters a structured contract assuming risk on a one-in-five year event (for example Hurricane Gustav) can expect income of as much as 35 per cent per annum, but must be prepared for the “fat tail risk” of said hurricane potentially wiping out the position.

Assuming risk against a one-in-fifty year severity of hurricane, such as Katrina, will generate lower income levels, Bisch suggests perhaps 12.5 per cent, but the likelihood of a 100 per cent loss in any one year of the investment is much lower.

The consultant said there were several ways for institutional investors to access ILS. The could do so by entering a contract direct with a reinsurer, which may cover single or multiple perils across various time horizons and trigger points, however Bisch suggested a specialist ILS manager could construct a more diversified portfolio and ‘narrow’ the fat tails so inherent in individual insurance securities.

Other avenues to ILS are fixed income managers such as PIMCO, which might take a small exposure to securitised cat bonds as “spice” for their traditional bond portfolios, or large hedge funds which have in some cases developed internal capabilities to value reinsurance opportunities and even write the contracts themselves.

Bisch points out the catastrophe bond market has “held up” throughout the financial crisis and as such has become an increasingly important source of liquidity for the hedge funds, even as the reinsurance industry generally has a “huge need” for capital and is willing to handsomely reward those institutions willing to invest.

Bisch said ILS remained a highly uncorrelated asset class, even if the Lehman Brothers collapse spelled trouble for four catastrophe bonds which used Lehmans’ ‘special financing’ unit as a total return swap counterparty.

The volume of cat bond issuance dropped off in 2008 with US$2.7b issued, after ramping up from US$7b of capital outstanding in 2006 to US$15b in 2007 on the back of a need for capital post Hurricanes Katrina, Rita and Wilma.

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