Everybody complains about the weather, but no one notices the correlations – or rather their absence.
For institutional investors, taking on weather risk is what Graham Thouret, president of Diversified Global Asset Management in Toronto, calls an “alternative” alternative investment. He was speaking earlier this month at a seminar on catastrophe bonds – Cat bonds – sponsored by the Canadian chapter of the Chartered Alternative Investment Analyst Association.
Weather and associated catastrophe risks truly are uncorrelated with stocks, bonds and currencies. “What happens in the bond market or the equity market on a given day does not make the wind blow or the earth shake and it won’t make it rain,” says Barney Schauble, managing partner at Nephila Capital in Bermuda. (Nephila is a Bermudan spider with an uncanny ability to sense hurricanes.)
Nevertheless, earthquakes and hurricanes are part of financial markets: they give rise to reinsurance. In the reinsurance market, Cat bonds are perhaps the most prominent. They are special purpose vehicles in which investors buy a bond with a high-yield return. Should disaster strike, investors lose their capital and further interest payments. But such bonds are only the tip of a much larger iceberg of insurance-linked securities – or reinsurance.
There’s $3 billion to $4 billion in new issuance of Cat bonds every year, with about $11 billion outstanding. By far the biggest part of the $200 billion market – at about $150 billion – are over-counter reinsurance contracts. Then there are loss warranties – contracts that target industry-wide insurance losses — and retrocession – essentially reinsurance on reinsurance.
These vehicles have developed because catastrophe and weather risk are typically too large for a single insurer or reinsurer to handle.
“The basic idea of diversification obviously in insurance and reinsurance is to spread that risk as widely as possible,” says Schauble. “But there are places where, particularly in the United States, but anywhere where you have a large concentration of the physical value of buildings and natural hazards – that means earthquakes and hurricanes – there are places where that intersection is too large for the insurance industry to digest.”
There’s about $300 billion in capital for such disasters in the insurance and reinsurance industry. That may not be enough to absorb losses in a bad year – a three-hurricane year. Hurricane Katrina, for example, produced $60 billion in losses.
The absence of capital makes for an opportunity for institutional investors – although capital cycles vary. “Really what we’re talking about is peak risks that are too large for an individual balance sheet or an industry,” explains Schauble. “There are many places, most places around the world, where the property, aviation, crop insurance industry does a perfectly good job of covering that risk and as a matter of fact there’s often too much capital so they lose money underwriting that business.”
With peak risk securities, “the good news is that it’s illiquid, it’s opaque, it’s complicated, they’re hard to value, different people think about them in different ways. So as a manager, there’s all kinds of opportunity to be long in some of these sectors, short in some of these sectors, see mispricing or overvaluation – some of our investors have compared this to the early days of the high-yield market and the loan market where there’s lots of opportunities to be an active manager in this space.
Nor says Schauble, is it a zero-sum game. Rather, there is a positive structural return. “Catastrophe risk, weather risk, where you’re providing protection to someone against an outcome that impacts them negatively, it’s a non-zero-sum game. They don’t want these events to happen anymore than you do. So it’s a slightly different relationship and it leads to a slightly different investment profile.”
But it does require a lot of modelling. “What you do is you simply simulate 10,000 years of catastrophe events,” says Schauble. “That’s a complicated process and if you assume that we’re not worse at estimating probabilities than the credit market or the commodity market or the stock market you can get some comfort in the overall rates of returns or what an investment can look like.”
Still, such estimates do not produce a conventional bell curve distribution. It’s a flat distribution for the most part with a fat tail at each end. “We’re not assuming normality,” Schauble explains. “But we are taking a look at what the full range of outcomes can be for an investor and therefore as a potential investor in the asset class a pension fund can say well ‘what if I want to make more, or what if I want to take on more risk’ and adjust that risk profile until it comes to something that fits their specific risk preferences.”
One Canadian investor in the reinsurance arena is the Ontario Teachers Pension Plan. “It’s a totally different market,” says Bernard Van der Stichele, an oceanographer by education and an associate portfolio manager inside OTPP’s tactical asset allocation group. “So basically the strategy was to partner with a couple of external funds that are dedicated to the ILS [insurance-linked securities] space, select a few partners in the reinsurance industry and also start our own catastrophe fund internally.”
He uses the term “accordion capital” to recognize capital flow cycles. “We’re not there to compete with the reinsurance market and we would never want to be seen that way. We really want to be in the market when there is a need for this capital that we can supply and back out of the market if rates soften and there is an oversupply of risk capital.”
So far, the experience has worked well for Teachers’. But what about for other pension funds?
“If you’re actually looking at things that will truly diversify their portfolios,” says David Kaposi, a principal at Mercer Consulting in Toronto, “the nice thing about Cat bonds is that the risk factors that are important, which is capital supply in the insurance industry and weather patterns, are not things that investors are subject to anywhere else in their portfolios. So you really are adding something unique in the portfolio.”
But that doesn’t make them fixed income replacements. Rather, he argues, the risk reduction potential should be applied to the equity side. “After you have reduced the basic asset-liability mismatch, the asset-duration mismatch, the next biggest risk clients have in their portfolios is beta risk.”