Long-term investors well compensated for taking on hurricane risk: Schwartz, Twelve Capital

With the Atlantic hurricane season officially underway as of June 1st and forecasts calling for a particularly active year, insurance-linked securities investment manager Twelve Capital believes investors with a long-term view are well-compensated for shouldering this exposure.

Speaking with Artemis, Twelve Capital’s Head of Investment Management, Etienne Schwartz explained that investors benefit from taking a long-term view when investing in catastrophe bonds and other reinsurance-linked assets, and that even if losses do occur the market has the mechanisms in-place to ensure they are compensated for this risk.

“In the current market environment with a very active primary market, spreads widening and an expected elevated level of hurricane activity, Twelve Capital believes that long term investors are well compensated for this short-term and long-term climate variabilities,” Schwartz explained.

He noted that for most investors, Twelve Capital recommends an allocation of around 2% to 5% to a catastrophe bond strategy, depending on portfolio composition and risk level, so it tends to be a relatively small component of their overall assets.

But allocating to experienced ILS managers is seen as key, on which Schwartz advised, “Investors should be aware of the importance of manager selection and the associated investment philosophy. At Twelve Capital we do not only consider quantitative factors such es expected loss but also look at qualitative factors like legal language, cedant quality and model quality.

“As insurance experts we have a lot of expertise from our Equity and Debt team which we can leverage and apply on cat bonds.”

With the hurricane season forecasts suggesting a highly active season, Schwartz explained that Twelve Capital does not hedge its portfolios directly, instead preferring to utilise portfolio management techniques.

“Growth in the cat bond market has provided more choice to investors. This enables
diversification not only geographically, but also by cedants and through structure (e.g. an occurrence deal will correlate less to an aggregate level) and risk level (e.g. picking different tranches of a cedants tower).

“The improvement in the terms and conditions of indemnity bonds over the past few years has led to an increase in our indemnity allocation, subsequently reducing the tail.

“However, it is important to not over-diversify otherwise you find yourself in a position of making compromises on quality and can earn significantly lower returns.

“This has been one of the key lessons in recent history. Especially in a collateralised product, each dollar of limit has to earn itself on its own merits, otherwise it is “di-worse-ification”.

“Ultimately, ILS is a diversifier for investors, so it’s important to provide them with systematic exposure to well-modelled, well-compensated catastrophe risk.”

Schwartz also noted that Twelve Capital does not weight the types of cat bonds that have most commonly seen losses in previous hurricane seasons in its portfolios.

He said, “The types of transactions most exposed to an active hurricane season are high-risk, low-attaching deals in potentially aggregate structures. Our investment philosophy doesn’t concentrate on these types of trades, and as such our approach to portfolio management we feel sets us up best for long term investors – whether we approach an active season or not.”

Twelve Capital also operates private ILS strategies, that allocate to reinsurance and retrocession arrangements that aren’t in 144A cat bond form.

But Schwartz said the same approach applies, as the manager looks to construct portfolios that meet investor’s needs, while managing them to avoid undue exposure.

“Our private ILS strategy is the same as our cat bond strategy, high quality, well- modelled peak perils. Therefore, the same holds true,” he explained.

“Our private ILS deals are top, to mid, layer retrocession transactions, i.e. the level just below cat bonds.

“The majority of private ILS transactions are done at 1/1 so well before any (accurate) seasonal predictions, but our approach to modelling and structuring deals takes into account a long-term view of variability to account for what the following year may bring.”

With Twelve Capital also investing in insurance and reinsurance related equities and debt instruments for some of its dedicated and combined strategies, it is interesting to know how hurricane outlooks affect that area of the business.

Schwartz told us that, “In our multi-asset portfolios, we are mindful of the hurricane risks and shift the portfolio composition in the equity and debt space prior the hurricane season away from reinsurance towards other business lines. In past events, we saw many opportunities in the equity space (i.e. with primary insurance companies in Florida).

“Our pure debt portfolios are well diversified when it comes to the underlying business lines. Re/insurance companies with exposure to hurricane or earthquake risks in the US make up a small allocation only.”

Should the market be affected by hurricane activity this year, Twelve Capital’s view is that prices would likely move to compensate investors for any impacts.

“The first thing people think about is pricing. Yes, if we see cat bond losses, then there is a high likelihood we would see rates harden and spreads widen,” Schwartz said.

Adding that, “The value of structural and underwriting improvements in the re/insurance space has a significant impact on the quality of cat bonds, and we would expect these to remain or even improve under a scenario where we have cat bond losses.

“The move from aggregate to occurrence structures, buffer-loss language and underwriting that considers key risk measures such as year-built and construction quality is important.”

He also explained that just because we see hurricane impacts does not necessarily equate to large ILS market losses, especially now with reinsurance attachments and terms set higher and stricter.

“If there is a large event in a very populated area this could cause drawdowns in the cat bond market, but if there are say a series of smaller or more medium events such that it is severe in the aggregate, this would have a much more material impact on the general re/insurance markets and leave cat bonds relatively unscathed. Cat bonds really are focussed on large events happening.

“In case of a large event, a significant share of the worlds reinsurance capital would be depleted.

“Overall, we would expect the cat bond market growth to further accelerate as it has proved to be a reliable partner for reinsurance capital,” Schwartz told us.

He noted that the private ILS strategies can be a little more susceptible to loss, given they tend to sit just slightly below catastrophe bonds in the reinsurance and retrocession risk towers.

“But they pay more to offset this in the long run,” he said.

Taking a longer-term view on investing in catastrophe bonds and ILS is perhaps more important than ever in the new market reality.

Just because the hurricane forecast numbers look high, it does not necessarily mean major market impacts are ahead and when impacts do occur the market is ready to reset its expectations and risk appetite once again, to ensure investors are compensated for the risks they assume.