A good fit
Michaels says. Cat bonds’ diversification benefits mean they are able to curry favour with the growing number of fund managers offering diversified growth funds, and thus give them a shoe in with a broader investor base.
The Baillie Gifford diversified growth fund, for example, invested 9.8% of its portfolio in insurance linked securities as of 31 March 2012 making it the fund’s fifth largest holding out of 12 asset classes. And by way of further example, the $26.5bn Danish Pensionskassernes Administration (PKA) fund appointed Twelve Capital to run a $150m balanced mandate which has the freedom to invest in insurance linked securities including cat bonds.
Michaels says: “Some of our clients have got exposure to cat bonds because they are billion pound schemes, but mainly investment is made indirectly. Cat bonds are the sort of thing one might have exposure to via a multi-asset vehicle.” Line Vestergaard, head of absolute return strategies at the PKA fund, says the diversification benefits have lived up to expectations so far, leading the fund to investigate further investment in diversified mandates with exposure to financial insurance contracts. While cat bonds may be uncorrelated with more traditional asset classes, in themselves they are heavily dominated by US disasters such as hurricanes and tornadoes. Consequently, should there be a significant number of these kinds of event experienced at any one time, investors could be left exposed.
Monnier says: “The US risks are still the largest amount of risks seeded and represent a large share of the market; there are probably around 50% of cat bond deals exposed to US risks.” However, Michaels says the cat bond market is still developing and while it is driven by the US, European bonds are available and pension funds can spread the risk.
“It takes a bit of care but one can build a more diversified approach and I’d see that increasing over time,” he says.
Cat bonds have so far proved attractive based on a lack of correlation to other asset classes, but how do they fare in the risk/return stakes? According to Christophe Fritsch, head of the ILS team at Axa Investment Managers, cat bonds offer a strong risk/ return profile, and he argues that current pricing is particularly attractive following the high number of natural disasters in 2011 and early 2012.
“Spreads have increased recently due to the losses incurred last year by reinsurers, so the return is attractive today,” Fritsch says.
For 2011, the cat bonds fared relatively well, although lagged the S&P500 considerably. For 2012, cat bonds look less profitable than their traditional bond peers.
Vestergaard says the returns from PKA’s balanced fund investment reduced at the start of this year thanks to widening spreads. Similarly, in a 2012 Clearpath Analysis report which looked at insurance linked securities for institutional investors, the £8bn BBC pension fund described its 1% allocation to cat bonds as proffering a “marginal positive return in 2011 which at a certain level was slightly disappointing”.
Michaels adds: “I don’t see cat bonds as generating the highest returns. You need to look at what cat bonds offer in their own right but it’s not going to be your highest returning asset class.”
Liquidity is another issue for investors when considering cat bonds. The investments are typically long-dated and relatively illiquid, which means institutions should expect to be in it for the long haul.
Monnier says this is less of a concern for pension funds since their investment time horizons far outstrip cat bonds’ typical durations, and he notes investors are rewarded an illiquidity premium. Further, investors can take advantage of the secondary cat bonds market should they need to disinvest before maturity, although this is still relatively small and immature. While there may be obvious benefits to including a cat bond investment in an institutional portfolio, it is worth bearing in mind the providers’ motivation in promoting these products.
Rules and regulations
The insurance industry is experiencing the double whammy of climate change, which is set to increase the number of natural disasters which will need insuring over the coming years, and increased regulatory scrutiny which is imposing higher levels of risk management in insurers’ portfolios.
Solvency II, for example, lays out stringent capital requirements meaning insurers will need to pass even more risk to the capital markets, which in turn will lead to higher numbers of cat bond issuers in search of investors. Fritsch says: “The cat bond market will develop on both the offer and demand sides of the transaction. Insurance and reinsurance firms have an increasing need to hedge their risks because of regulatory requirements, such as Solvency II. This will enable the cat bond market to grow, as firms hedge more risks.
“From the investor’s standpoint, with this asset class providing good risk/return and diversification, it makes sense to include cat bonds as part of strategic asset allocation.”
As track records extend, investment opportunities emerge and a growing number of pension funds take the plunge, the cat bond market could well reach the $30bn levels predicted within the next four years.
However, the relative risks and complexities associated with this asset class mean it is still very much a niche investment and, multiasset funds aside, there is some way to go before it becomes commonplace in a typical pension fund portfolio.
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