An interview with Dirk Lohmann, Chairman and Managing Partner, Secquaero Advisors, for the 2018 Insurance Linked Securities Asset Owner Insight Survey. We asked Dirk about the outlook for the global ILS market and the impact of 2017 events.
Noel Hillmann: Educating and getting trustees comfortable with the asset class was once again a high scoring problem, following similar results in our 2016 survey, that many investment officers face. Two-thirds of respondents claim the issue to be either a fairly high or very high hurdle to investing in ILS? How can investment officers best make the case for ILS in your view?
Dirk Lohmann: Educating the trustees is a big hurdle because insurance is somewhat of an invisible service. Therefore, it is difficult for them to get their heads around all of the different issues within this area. This also likely explains why most of the allocations and investments are in catastrophe risk as this is the easiest type of insurance exposure to comprehend and explain.
The nature of the risk is independent of the other risks that pension funds and asset allocators have in their portfolios. It is a truly diversifying risk asset and one that can also give comfort. If you stick to risks which can be modelled there is then also a basis to evaluate and assess that the risk that is being transferred at a fair price.
One of the more common concerns of many first-time investors is whether there is an information asymmetry and thus they are the greater fools that are being taken advantage of by the insurance industry.
It is important for everyone to understand that if you stick to risks that have good data and modelling you can get a good verification of the price of the risk transfer.
There are other elements of insurance linked securities which are beneficial in a portfolio context, one being that because it is floating rate instrument, the collateral is earning a floating return offering some inflation protection and no duration risk. This is a nice benefit particularly as we are in a low interest rate environment and a future with some rate rises on the horizon.
Noel: You mention that pricing information is available, and therefore price transparency exists, but do you feel that there is a nervousness amongst trustees, in that they don’t want to be seen as profiting from catastrophe, i.e. the risk and misery of others? Does this issue come up in conversations that you have?
Dirk: Not directly and I would argue the contrary point, one is earning a return for taking a risk and if the event happens then one is helping people to rebuild their lives after a major event. I don’t see it as negative.
There have been these types of connotations with life settlements where you profit if people die early but I don’t think this is quite the same for non-life insurance.
I do believe that insurance linked assets would fall into the sustainability criteria, as they are there to help rebuild and not profit from adverse events.
Noel: 31% of respondents commented that continued low interest rates were having a very high impact on how they select their investments overall. Given the volatility of returns in ILS and the potential for significant losses, is ILS a poor solution to such pressures or should investors not be put off by short term returns in favour of the long-term potential of the asset class?
Dirk: The question of volatility is a relative one, as if you look at the returns of the Cat bond index, it doesn’t exhibit as much volatility as other types of asset classes during times of financial duress.
There are certainly corrections when there are major events and you usually see a recovery over an 18-24 month period. This is because either instruments fall in price because of the repricing of risk or because there are impairments. However, there are higher premiums afterwards, so you do get paid back.
I don’t see it as volatile as many perceive it to be, although in fairness we haven’t had the 1 in 100-year type earthquakes in the US, although we have had them in Japan and other markets. Even in this type of situation the drawdown would still be manageable.
There is certainly volatility, but I don’t see it as being more or less volatile than other types of assets in the portfolios of investors.
With regards to moving into the asset class, because of the pressure of low yields in the market generally, this has been a driver for people to allocate to this asset class. That being said, it should not be the sole reason for doing so as there has to be the understanding that it is a diversifying asset and they do benefit from other aspects of ILS, such as the short duration and non-correlation to other investment assets.
One should take a longer-term perspective when allocating to the asset class and be willing to tolerate a certain degree of volatility as long as it is within the projected margins that were indicated when they first made their allocation.
In this context the recent events were a good test for the market, as most ILS funds performed within the risk parameters that they had communicated to their investors prior to the events occurring. Therefore, from this standpoint there weren’t that many surprises.
Noel: Do you feel that given the good performance of the ILS industry through the recent hurricane season, it could actually boost capital into the sector over the next year on the back of the reassurance the market has given that it can be resilient against such events?
Dirk: We have certainly seen this in the cat bond segment of the market because it took the least amount of hits compared to strategies that were focused on more collateralised re insurance and retro-cession, which is the re-insuring of re-insurers.
We have seen increased interest from existing investors to allocate more to the bond market, although the bond market does need to grow to absorb this. We would need to continue to see growth, as we have done in 2017, to achieve this otherwise we would have an overhang of demand.
To a certain extent we do see a little bit of overhang right now, there has been some issuance in the fourth quarter, but it hasn’t been as great as the flows that have come into the sector.
With collateralised reinsurance there are distinctive styles and risk appetites. Generally what I am seeing is that there is a continued interest to allocate to the asset class, post recent events. I believe that in part this is driven by the fact that the performance we saw in September and October was well within the expected ranges for the strategies that were impacted by events.
Noel: 64% of respondents stated they expect their allocations to be below 1% of total allocations 12 months from now. With such a small percentage of assets invested, should investors be concerned about diversification within the asset class?
Dirk: It becomes a question of their tolerance for risk and drawdown. If you are saying that you only have 1% of your assets within this asset class and have a certain tolerance for volatility, you may be better off just allocating to the highest risk. There are others who may not have that tolerance and therefore will look for more diversification.
Clearly Florida peak catastrophe risk has been the highest paying. Some people have made the argument and do follow the strategy of just going for the highest yield and only allocate a small percentage of their portfolio into that area.
We have others who have higher weighting to the asset class, in the order of 3-5%. In this case, diversification is a more important criteria for them.
Noel: What mixture of perils best fit together in your view?
Dirk: Our fund’s first product was an all ILS strategy, which included life and non-life risk, as that brought better overall return dynamics because we could handle the tail risk within the catastrophe section better. I still believe that this is one of the better ways of dealing with it.
Some managers only offer catastrophe products, but we offer a blend of either a single focus on catastrophe risk, a blend of all ILS risk and we have now added life only as some clients feel more comfortable in having an allocation to one fund for catastrophe risk and one for life only.
The other consideration is duration, ILS has been generally very short duration, usually a year with some bonds being 3-4 years. Most of them reset on an annual basis. If you think about life, there are risks and structures which are much longer and less liquid.
This becomes more of a factor for the allocator as to what their own investment horizons and durations are, what they are looking to invest in and whether they are able and willing to pick up illiquidity premiums for longer term commitments. This is the case for the largest section of our clients who are pension funds.
Noel: Do you have any concluding thoughts on this topic?
Dirk: I am interested to see in response to the questions, what level of drawdown would one find to be realistic in a major catastrophe event. The interesting aspect was that the range given indicated a fairly high degree of tolerance for volatility in this area, as half the response was 15-20%.
If you look at the actual performance of many funds, the bulk of them are below the 15-20%, there are some in the 15-20% or 20-25% range, but I haven’t heard of anything beyond that.
In a way, the actual performance we saw recently proves that it was within the tolerance that the allocators had for this type of risk.
The other interesting response was what investors allocations would be to the asset class after a large catastrophe event and a more than 15% draw-down. What we see is that over 80% of the investors would stay with the same allocation which means they would re-balance or increase their allocation to ILS.
This does show quite a bit of willingness to tolerate volatility in the short term. The real question then is if there were multiple events over a number of years how much tolerance there would there be for that and whether investors would be willing to top up a second or third time.
Noel: It also appears to be a matter of investor education. Investors have had a long time to get used to the asset class now, and as such they are more comfortable with it due to understanding how it works. Back when hurricane Sandy hit, we talked to investors who had started to look into this area but hadn’t yet allocated and now we see them as respondents to our survey, potentially stating – as the survey respondents were anonymous – they plan to allocate in the next 12 months.
Dirk: It depends on the individual market. Here in Switzerland we have a very high penetration and many major pension funds are allocated to this sector. There have been many who have been watching from the side-lines who have now allocated, post event, for the first time.
If I go to other parts of the world there are many more who are sitting on the side-line. This may also be because it is still viewed as a niche asset class and the overall size of the market is quite modest. This may put some off from making the effort to do all the learning that is required to allocate.
It is quite different if you compare North America to Switzerland, Australia and UK where there is higher allocation than in the US institutional market.
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