Research

Another Atlantic hurricane season looms over the ILS industry

The Eurekahedge ILS Advisers Index ended 2017 down 5.60%, breaking the streak of positive returns that lasted for five years, owing to the devastating losses incurred during the Atlantic hurricane season of 2017. The index, which tracks the performance of 34 ILS hedge funds with predominantly non-life risk exposure, declined by 8.61% in the month of September 2017 alone, as the extent of damage caused by hurricane Harvey and hurricane Irma started to come into light. Going into 2018, the index barely budged from its position as at the end of 2017, as it returned 0.07% over the first four months of 2018. Performance across fund managers were mixed, with strong primary cat bond market activities and healthy net inflows providing supports for them, while increased estimations on the losses induced by last year’s Atlantic hurricanes and California wildfire counteracted the gains. However, above-average activity forecasts for the 2018 Atlantic hurricane season may put pressure on ILS fund managers with high exposure toward cat bonds.

Insurance-linked securities (ILS) hedge funds trade in instruments whose values depend on insurance loss events. The majority of these instruments are reinsurance policies that assume the risk taken by insurance companies, which in turn assume the risk taken by individuals or institutions. A reinsurance policy allows a second insurer to take a share in the potential profit and loss from the underlying insurance policy. The ILS market covers the reinsurance of various types of risk, including life insurance risk, catastrophic risk and debt risk. Life reinsurance ILS protects the insurance companies against extreme events that cause the deaths of a massive number of people, such as terrorist attacks, epidemic, or natural disasters. On the other hand, debt reinsurance ILS covers the potential losses caused by debt defaults.

Figure 1 compares the performance of the Eurekahedge ILS Advisers Index against the wider hedge fund industry represented by the Eurekahedge Hedge Fund Index, as well as the global equity and bond markets represented by the MSCI AC World IMI Index and the Merrill Lynch Global Government Bond Index II respectively.

Figure 1: The Eurekahedge ILS Advisers Index performance since inception
The Eurekahedge ILS Advisers Index performance since inception

ILS hedge funds managed to outperform both the global equity and bond indices over the period starting in December 2015, by virtue of their immunity against volatile market situations such as the 2008 subprime mortgage crisis and the European debt crisis several years after that. The Eurekahedge ILS Advisers Index generated 5.17% annualised return since its inception, trailing behind the Eurekahedge Hedge Fund Index which returned 6.68% per annum over the same period, while maintaining much lower correlation against the equity and bond markets as well as alternative hedge fund strategies.

Table 1: Performance in numbers – Eurekahedge ILS Advisers Index vs. global equity and bond markets

 
Eurekahedge ILS Advisers Index
Merrill Lynch Global Government Bond Index II
MSCI AC World IMI Index
Eurekahedge Hedge Fund Index
2010
7.52%
3.64%
9.99%
11.57%
2011
(0.14%)
6.09%
(9.02%)
(1.74%)
2012
5.93%
9.08%
13.56%
7.36%
2013
7.61%
(4.67%)
23.80%
9.05%
2014
5.42%
8.37%
6.82%
5.09%
2015
4.24%
1.22%
(0.52%)
2.10%
2016
5.19%
2.96%
7.33%
4.67%
2017
(5.60%)
1.16%
17.51%
8.54%
April 2018 year-to-date returns
0.07%
(0.40%)
(0.63%)
0.19%
3 year annualised returns
0.87%
1.22%
5.59%
3.73%
3 year annualised volatility
5.27%
2.97%
9.80%
3.18%
3 year Sharpe Ratio (RFR=2%)
(0.21)
(0.26)
0.37
0.54
5 year annualised returns
2.68%
0.85%
8.34%
5.07%
5 year annualised volatility
4.15%
4.80%
9.12%
3.00%
5 year Sharpe Ratio (RFR=2%)
0.16
(0.24)
0.69
1.02
10 year annualised returns
8.06%
7.13%
8.73%
11.39%
10 year annualised volatility
3.43%
4.18%
14.31%
4.71%
10 year Sharpe Ratio (RFR=2%)
1.77
1.23
0.47
1.99
10 year maximum drawdown
(8.90%)
(8.88%)
(46.80%)
(12.38%)

Source: Eurekahedge

Table 1 provides the detailed risk return statistics of the four indices shown in the figure above. Key takeaways include:

  1. The Eurekahedge ILS Advisers Index posted a loss of 5.60% in 2017 weighed down by the damage incurred by hurricane Harvey and hurricane Irma, ending the year with their worst performance on record since the inception of the index, in contrast to the Eurekahedge Hedge Fund Index which generated their best yearly return since the end of 2013. The first four months of 2018 has been relatively uneventful for ILS hedge funds, as reflected by their 0.07% year-to-date returns. On the other hand, both the global equity and bond indices were marginally down, thanks to the volatile market conditions over the last few months, as well as trade war concerns between the US and China.
  2. Looking over the last three and five year periods, ILS hedge funds failed to generate competitive Sharpe ratio compared to their hedge fund peers utilising other strategies. This is largely caused by the significant losses they suffered in September 2017, which wiped out more than two years’ worth of gains and sent the index value below their August 2015 level.
  3. Over a longer period of 10 years, the Eurekahedge ILS Advisers Index generated a Sharpe ratio of 1.77, trailing behind the 1.99 Sharpe ratio posted by the Eurekahedge Hedge Fund Index, but outperforming both the MSCI AC World IMI Index and the Merrill Lynch Global Government Bond Index II, which posted Sharpe ratios of 0.47 and 1.23 respectively.

Table 2 provides the correlation values between the performance of ILS fund managers against the global equity and government bond markets, as well as their hedge fund peers.

Table 2: Correlation matrix
ILS hedge funds correlation matrix

As seen in Table 2, the Eurekahedge ILS Advisers Index is very weakly correlated to the three other indices, supporting the idea that ILS investments are able to provide uncorrelated returns for an investor’s portfolio.

Figure 2 provides the 12-months rolling alpha of the Eurekahedge ILS Advisers Index against both the Merrill Lynch Global Government Bond Index II and the MSCI AC World IMI Index, assuming a 0% risk free rate. As seen in the figure, ILS fund managers are generally capable of generating positive alpha against the bond and equity indices, with the exception of periods in which major catastrophes occurred, such as the 2011 earthquake and tsunami in Japan, and the 2017 hurricanes in the US.

Figure 2: 12-months rolling alpha of ILS hedge funds vs. underlying bond and equity markets (RFR = 0%)
12-months rolling alpha of ILS hedge funds vs. underlying bond and equity markets (RFR = 0%)

Figure 3 provides the performance distribution of all ILS hedge funds in the Eurekahedge database, including funds with life risk exposure. Despite the devastating blow dealt by hurricane Harvey and hurricane Irma, the median return of ILS hedge funds in 2017 remained barely above zero at 0.19%, while the third quartile return stood at 1.29% over the same period. Looking at the extremes, one ILS fund focused on life insurance managed to generate an extraordinary return of 17.87% in 2017, while on the other end, one ILS fund with high exposure toward North American cat bonds suffered a 27.61% loss throughout the year.

Over the first four months of 2018, ILS hedge funds posted a median year-to-date return of 0.93%, while the first and third quartiles stood at -0.16% and 1.73% respectively. It remains to be seen how these numbers would evolve over the remaining months of 2018, as we reluctantly welcome the new Atlantic hurricane season which started in June.

Figure 3: Performance distribution of ILS hedge funds
Performance distribution of ILS hedge funds

The full article inclusive of all charts and tables is available in The Eurekahedge Report accessible to paying subscribers only.

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