- The Insurance Linked Securities industry continues to see growth and is increasingly being seen as a diversified source of alpha in investment portfolios. Could you please share with our readers a bit of background to Credit Suisse’s ILS business, including details about the key personnel in your team?
Our Credit Suisse Insurance Linked Strategies (CSILS) team has one of the longest track records in the ILS space dating back to 2003 when members of our team first managed ILS funds at Bank Leu, a former Credit Suisse Group subsidiary. Today, we sit within our own legal entity – Credit Suisse Insurance Linked Strategies Ltd, a Credit Suisse Group subsidiary – and have built out a very successful ILS platform with currently more than $8bn assets under management.
Given that the skillset required in ILS is very similar to that in the reinsurance industry, many members of our investment team have previously worked for leading insurance and reinsurance companies in underwriting, risk modeling and risk pricing – i.e. similar to their current roles. Our 20 investment professionals have combined more than 220 years of relevant experience and, on average, have been with Credit Suisse for more than 11 years. In total, we have more than 55 people fully dedicated to ILS and in addition supported by various teams within Credit Suisse.
- What was your motivation for venturing into the ILS space, and how has the business grown and changed over the years?
The appeal of the ILS space is that it applies established, proven reinsurance concepts in a more dynamic and innovative capital market environment. The capital market with trillions of dollars of capital is a natural risk taker for the kind of low frequency, high impact catastrophes that have previously only been covered by reinsurance companies in the traditional market. The transfer of part of these catastrophe risks is really a win-win-win situation: the overall risk taking capacity in the re/insurance industry is enlarged which allows insurers and reinsurers to provide additional coverage where they were previously constraint by capital requirements which ultimately benefits insurance buyers; insurers and reinsurers can stabilize their capital base by transferring part of their peak risks to the capital market; and capital market investors benefit from access to a niche asset class with attractive return potential, a floating-rate return structure and truly low correlation to traditional and alternative asset classes.
Our CSILS business has grown to more than $8bn in assets under management over the last years. While we started out managing pure cat bond portfolios, we soon saw the need to access more diversified reinsurance risks and were the first in Europe to launch a commingled fund that invested into both cat bonds and collateralized reinsurance contracts. Over the years, we have continuously strived to maintain a competitive edge by developing new structures and investment solutions for clients. In 2009 for example, we launched the first commingled pure life fund with a main focus on macro longevity and excess mortality risks. In 2014, we became the first ILS manager to invest in a start-up rated reinsurance company, funded by an existing investor of a CSILS managed fund. The year after, we funded the Lloyds syndicate ‘Arcus 1856’ through CSILS managed funds which made us the first ILS manager in the market with the ability to transact in cat bonds, collateralized reinsurance, rated reinsurance and a Lloyd’s syndicate.
Given the size of our team today and the risk limits we write each year, CSILS compares to the largest reinsurers in the world in the property catastrophe segment. We believe that innovation and flexibility is key to adapt to the changing market environment and offer investors attractive investment solutions suited to their needs and the market conditions.
- Can you briefly describe and explain the differences between the various IRIS funds offered by Credit Suisse? What is your edge over competing ILS products?
We offer a comprehensive range of ILS investment solutions. Our commingled funds have different risk/return and liquidity profiles allowing investors to choose according to their risk tolerance level and liquidity requirements. “Risk” in this context typically refers to the expected loss in the portfolio and the maximum drawdown potential. Our offering ranges from a fund expected to yield only a few percentage points a year to double-digit return potential. In addition, we have structured several bespoke client mandates for large institutional investors which can be very much tailored to the client’s preferences.
Having a comprehensive fund offering and bespoke client solutions has become even more important as competition in the ILS market has certainly increased. When our team first started managing ILS portfolios back in 2003, the ILS market was around $7 billion in size and there were only a handful of ILS managers around. Since then, the ILS market has grown to approx. $75 billion1 in size with today probably several dozen ILS managers. Even reinsurers have launched in-house ILS management boutiques or are offering investment solutions to external investors. So in terms of competition, we face other ILS managers as well as reinsurers. Overall, the market has become more commoditized; barriers to entry have reduced and today the entire market is using similar risk models. For investors and non-insiders it can be difficult to differentiate between the players given the persistent intransparency in the ILS market.
Nevertheless, we believe there are opportunities throughout the entire investment process for an ILS manager to gain a competitive edge and add value for investors. For us this means:
- having a strong and broad origination network to have access to good investment opportunities across the full range of ILS/reinsurance instruments; coupled with large assets under management this can offer economies of scale and access to “private” reinsurance layers
- experienced underwriting and risk modeling with proprietary adjustments to properly price risk and assess whether the resulting risk margin meets the portfolio’s requirements
- Portfolio construction focusing on diversification and minimizing tail risk (drawdown risk) for a given target rate of return
- Real-time event assessment and possible trading (cat bonds) or hedging to reduce the potential loss impact on the portfolios
- To help our readers understand this better, how does exposure to ILS sit within a hedge fund structure? What kind of instruments do you have exposure to and how liquid is the market - with reference to spreads and the cost of borrowing for short positions?
ILS funds allow investors to access reinsurance-type risks as well as premiums in a capital market friendly structure. Although fund structures and terms such as liquidity are often similar to other hedge fund strategies, the underlying investments in the portfolios are rather different.
As mentioned, we are able to transact across the breadth of ILS instruments including cat bonds, collateralized reinsurance, rated reinsurance and quota shares:
Cat bonds are the instruments most well-known also outside of the ILS space. These are securitized, standardized instruments issued by a sponsor (e.g. an insurance or reinsurance company) to capital market investors. Thanks to their standardized nature, cat bonds provide certain liquidity and are traded OTC on a secondary market. However, the spreads and liquidity are not comparable to listed equity/bonds. Also, with a size of $24.3bn the market is comparably small and therefore imposes certain restrictions on a manager’s ability to select risks and construct a well-balanced portfolio.
Private ILS private transactions on the other hand are non-standardized and are structured directly between the manager/fund and the re/insurance counterparty via a risk transformer. Terms and conditions of the transaction such as premium and risks covered can be negotiated between both parties. The transactions are typically fully collateralized giving the counterparty certainty that liabilities can be paid should the trigger event occur. Collateral is often held in a segregated account and invested in money-market investments providing a floating-rate return. The investment universe for ILS private transactions is much larger than cat bonds with approximately USD 350bn (i.e. the estimated property natural catastrophe limits), which offers much broader potential for diversification. ILS private transactions are not tradeable and usually have terms of up to one year. ILS private transactions can be further split into:
- Industry Loss Warranties (ILW). Trigger based on the loss to the entire insurance industry, e.g. $30bn, $50bn etc.
- Collateralized (traditional) reinsurance. Trigger based on the actual loss of the counterparty, so called “indemnity”
- Retrocession. This is reinsurance on reinsurance
- Other collateralized transactions with various different trigger types (e.g. parametric that is based on physically measured values)
Quota shares (or portfolio trades) are also a form of a private ILS transaction. The risk taker (e.g. ILS fund) assumes a pro rata share of the re/insurer’s book of business for a specific region or risk class. The two parties share the liability, premiums, and losses according to the agreed percentage, which allows a full alignment of interests. For the ILS fund, this allows access to an attractive and diversified book of business in areas in which they may not have direct access.
While the business model of ILS funds is to assume risk and receive a premium in return, short positions or “selling” risk is possible. Short positions – i.e. paying a premium to receive cover – can be traded in two ways: (i) as part of the portfolio construction process, e.g. to reduce specific risks in the portfolios or to take advantage of pricing differences between long and short risk. However, these opportunities have become increasingly rare as the market has become more efficient. Furthermore, the match between long and short risk is often not perfect, i.e. leaving basis risk. (ii) During live event trading, e.g. when a hurricane is approaching landfall. Pricing indications are often only available on request between established players and can vary significantly. Nevertheless, even a high premium may be worth paying if the short position (a de facto hedge) later pays out to reduce the event impact on the ILS fund.
- The IRIS funds have varying portfolio diversification across different types of catastrophic events and geographic locations. Can you run us through how your internal models identify and execute the best opportunities in the ILS space?
There are traditional “renewal” dates in the reinsurance market when annual contracts are renegotiated and potentially renewed. Traditionally 1 January for many global or European risks, 1 April for Japan risks and 1 June/July for US hurricane risk. Negotiations on pricing and conditions start months before these dates. We will closely monitor and research expected pricing and profitability levels across market segments, risk classes and instruments to define the strategic asset allocation. Then, when assessing specific new investment opportunities – i.e. the underwriting and risk modeling in the investment process – we use the same principles and systems that reinsurers use or can use. Most of the members of our investment teams have previously worked for leading insurers and reinsurers as underwriters or actuaries and have now very similar roles within our ILS investment team. This is important because underlying risks of ILS investments are insurance and reinsurance catastrophe risks. Rather than just taking the data provided by the counterparty at face value – a strategy that can also work fine as long as there is no catastrophe – we spend considerable time on in-depth due diligence of the counterparty and their business (i.e. true “underwriting”), reviewing and validating the risk modeling data with more than one of the industry-wide catastrophe models and making adjustments (both quantitative or qualitative) where we feel necessary. There are many good, “blue-chip” counterparties out there, where our underwriting and risk modeling simply shows that we feel the exposure and risk data provided is high quality and accurate; but in today’s market we also see more and more risks brought to the reinsurance and cat bond market, where this is not the case and risks are often significantly underestimated with sometimes no or negative risk margin after adjustments.
- Risk management is a key to any investment strategy. How do you protect your portfolio against downside risk which could be extremely idiosyncratic given the nature of your strategy? In particular, what was the fund’s experience in 2011 in the aftermath of the earthquake in Japan and how well is it positioned now to cope with any losses arising from exposure to hurricane Harvey, Irma and Maria?
US hurricane risk is the predominant risk in the cat bond market and also the reinsurance/ILS market. A concentrated portfolio runs the risk of being unable to recover losses should the worst-case catastrophe occur. To avoid that, we believe disciplined portfolio diversification is key to limit the maximum drawdown potential from any catastrophe event. Our portfolio construction focuses on minimizing tail risk for a given target rate of return taking into account diversification goals. ILS portfolios can be diversified across risk classes, but also instruments and trigger levels. Meaningful diversification within the ILS investment universe can only be achieved through private ILS transactions as the cat bond market is too US hurricane concentrated.
While this diversification strategy meant that our portfolios typically outperformed in 2005 (hurricane Katrina), they were more affected by the Japan earthquake in 2011 because Japan quake risk is a diversifying risk. However, drawdowns were in line with what was expected for such an expensive insurance catastrophe and loss recovery was supported by increasing premium levels after the event. In general, the first action after such a large catastrophe is to try and assess the estimated impact to the portfolio as accurately as possible and update investors; later the focus shifts to re-positioning and re-investing the portfolio to take advantage of increasing premium levels and other investment opportunities.
Hurricanes Harvey, Irma and Maria were unprecedented in US hurricane history: since records began in 1851, 2017 is the first year in which three hurricanes with category 4 or 5 made landfall in the US. Generally, based on insurance catastrophe modeling, the probability of having two hurricanes in one season causing insured losses of more than $20 billion each is around 1%, which is in line with historical hurricane statistics. The probability of having three such hurricanes in one season is 0.1% or once in 1’000 years. Currently, insured losses from each of the hurricanes are expected to be in excess of $20bn. The short time intervals between the three events – which occurred within just 4 weeks – poses additional challenges in assessing the likely extend of losses. What seems to be clear is that 2017 may well end up as the most expensive year in history in terms of insurance losses, which are currently estimated to end up between $100bn and $200bn. This will have a significant impact on the reinsurance and ILS markets but also create new opportunities as premiums are expected to increase significantly.
- Computational models and simulations often come into play when early data related to catastrophic events are available, so that portfolio managers can “predict” the extent of damage that would be caused and determine the optimal course of action. For the Credit Suisse ILS team, to what extent do such numbers affect the decisions made during such times?
Live event assessment and potential trading can be an important source for a manager to add value to the portfolio. While earthquakes can naturally only be assessed “post-event”, hurricanes or other storms can already be monitored while they are developing. For example, during the annual US hurricane season from June through November each year we closely monitor the developments of tropical storms and hurricanes and how they are forecasted to strengthen and move. If the forecast shows a potential landfall where our portfolios could be exposed to a loss, we run the event with the catastrophe models but make proprietary adjustments based on where we believe the models do not accurately reflect the loss potential (e.g. flood-related losses). Based on the loss estimate and associated estimated impact on portfolios, we can potentially trade around an event: for example, at times we were able to sell cat bonds at still very good pricing levels which later had a substantial or full loss. Also, we have at times been able to purchase “short positions” shortly before or after an event to hedge long exposure in the portfolios; these later triggered and reduced any event impact on the portfolios. Sometimes, even so called “dead cats” can be traded, i.e. a short positions is traded after the event has already happened. This typically occurs when the two parties to the trade have a different view as to what the event loss will be. Whether any such event trading is done will depend on the level of certainty regarding the loss estimate as well as pricing of the short position.
- ILS hedge funds have outperformed the average global hedge fund over the last three years, delivering three year annualized gains of 4.59% vs 4.13% for the Eurekahedge Hedge Fund Index. Based on your experience, has this translated into increased investor interest into the ILS offerings such as those managed by Credit Suisse? What are the different challenges when marketing this product to institutional investors?
Although ILS is still considered a niche asset class, investor interest has increased substantially. As previously stated, assets under management in dedicated ILS investment vehicles has increased more than tenfold over the last decade or so. Investors value the attractive return potential offered by ILS especially in the continuing low interest rate environment, but also the floating-rate return structure and low correlation to traditional as well as alternative asset classes.
As “ILS” is not your typical asset class, marketing it to investors requires a lot of education on the specifics of the asset class and the reinsurance-type risks, returns/premiums but also liquidity. In our experience, it can easily take a year and several rounds of education/information sessions with investors before they feel comfortable with the asset class and start looking into what type of risk/return profile they would most prefer. At this stage, investors then typically want to understand the differences between the various funds as well as differences in strategy across ILS managers. Given the persistent intransparency in the ILS market, the latter is a constant challenge for investors.
- Historical loss data for catastrophes show a trend of increasing losses due to the increase in population density and wealth, among other factors. Should this be a cause for concern for ILS managers?
It is not so much a concern as it is a factor to take into consideration during the investment process. In reinsurance as well as ILS it is all about getting the right price for the risks you take on. It is a known trend that insurance exposure especially along the US coast have been increasing for years and premiums should be increasing accordingly. Of course, premium development is also driven by other factors such as supply and demand and the overall cost of risk capital. Nevertheless, even if premiums remain constant or are falling – which we had observed during the last few years given the absence of larger catastrophe losses – the increased underlying exposure is still reflected, e.g. in reduced risk margins calculated for new investments. It should be noted however, that the exposure increase is not significant year-on-year but rather a trend that has been observed during the last decades. The catastrophe models are regularly updated to reflect this trend.
Climate trends such as global warming is also often mentioned in relation to increasing insurance losses. However, it cannot be proven yet that climate trends have increased the frequency of extreme events such as hurricanes. What has been observed, however, is that there are hurricanes seasons every few years in which there are not necessarily more hurricanes but stronger ones. For example, the El Niño/La Niña cycle with changes in sea surface temperature (warm sea surface temperatures provide the energy a storm needs to become a hurricane) and upper winds that can hinder or support hurricane formation. These factors are very relevant to the risk assessment each year and are considered in pricing negotiations.
- What are the primary challenges faced by the ILS industry? How do you expect the industry to transform in the face of these challenges and how well is Credit Suisse positioned to maintain its edge in the market?
The challenges faced by the ILS industry have changed significantly over the course of September. Previously, the continuous inflow of investor money into the ILS market put ongoing pressure on pricing with associated premium declines. The combination of large money inflows with a lot of new players in the market led to what we considered a much less disciplined investment approach and we saw risks offered to the ILS market that re/insurers would not have been able to place at these prices previously. For us, this meant even more thorough underwriting and assessment of new investment opportunities.
Hurricanes Harvey, Irma and Maria now have brought very different challenges. Insurers, reinsurers but also the ILS market have all suffered losses. Some segments or players that were specifically exposed e.g. in Puerto Rico where hurricane Maria struck will struggle to survive. The retrocession market (i.e. reinsurance on reinsurance) might see two thirds of the capital either lost or locked. “Locked” means that the underlying collateral is not released while loss estimates still develop. As ILS private transactions are typically renewed on an annual basis, this will mean that part of the capital, though not lost, is not available for renewal. The high insurance losses together with limited capital supply are expected to significantly increase premiums. And while this is a rather favorable environment for ILS managers to invest, it remains to be seen how much “free capital” each will have to deploy and take advantage of the forthcoming attractive premium environment. For us this means working closely with investors to update them on existing investments but also new opportunities; and on the underwriting side we are in close contact and have already started negotiating interesting investment opportunities with counterparties for the year-end renewals.