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MAY 2016

Examining the risk diversification potential of ILS investments for asset owners and the headwinds new investors face

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Javier RivasDirector of ILS, Credit Suisse

SECTION 1FUTURE DEVELOPMENTS IN THE ILS MARKET

1.1 INTERVIEW 6With increased uncertainty due to climate change and other related risks, how will risk modelling evolve over the next 5-10 years?Interviewer:• Colin Browne, Publisher, Clear Path AnalysisInterviewee:• Paul Maisey, Science Manager Insurance & Capital Markets, Met Office

1.2 INTERVIEW 9Insurance Linked Securities from an investor’s perspectiveInterviewer:• Colin Browne, Publisher, Clear Path AnalysisInterviewee:• Niklaus Hilti, Head of ILS, Credit Suisse

1.3 INTERVIEW 12What strategies exist for ILS managers to overcome challenges such as concentration risk in allocating large amounts of capital quickly?Interviewer:• Colin Browne, Publisher, Clear Path AnalysisInterviewee:• Jitzes Noorman, Delegated Chief Investment Officer, BMO Global Asset Management - Nederlands

1.4 INTERVIEW 15How should investors view the ILS opportunity today?Interviewer:• Noel Hillmann, Managing Director, Clear Path AnalysisInterviewee:• Greg Hagood, Co-Founder and Managing Partner, Nephila Capital

SECTION 2THE CHANGING FOCUS OF ILS

2.1 EXPERT DEBATE 19What are the challenges in developing a diversified approach with new ILS exposures?Interviewer:• Colin Browne, Publisher, Clear Path AnalysisInterviewees:• Dirk Lohmann, Head of Insurance Linked Strategies, Schroders• Todor Todorov, Investment Consultant – Hedge Funds Research, Towers Watson

2.2 INTERVIEW 24An introduction to weather risk as an ILS asset classInterviewer:• Colin Browne, Publisher, Clear Path AnalysisInterviewee:• Barney Schauble, Managing Partner, Nephila Capital

CONTENTS

Insurance Linked Securities for Institutional Investors

Paul MaiseyScience Manager Insurance & Capital Markets, Met Office

Greg HagoodCo-Founder and Managing Partner, Nephila Capital

Hemal NaranFormer Head, Government Employees Pension Fund, South Africa

Scott MitchellHead of Life ILS, Schroders

Dan BergmanHead of Investment Research/ILS, Tredje AP-fonden (AP3)

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SECTION 3THE DATA AND OPERATIONS CONUNDRUM

3.1 ROUND TABLE 31How can managers confidently pick an investment strategy with the unpredictability of weather conditions, such as, for example, the El Nino effect?Moderator:• Colin Browne, Publisher, Clear Path AnalysisPanel:• Joanna Syroka, Programme Director, African Risk Capacity• Dan Bergman, Head of Investment Research/ILS, Tredje AP-fonden (AP3)• Lorilee Medders, Director, Florida Catastrophic Storm Risk Management

3.2 WHITE PAPER 36Solvency II – fuelling growth of the insurance-linked investments market?• Michael Stahel, Partner, LGT ILS Partners

SECTION 4THE GROWTH OF LIFE RISK IN THE ILS MARKETPLACE

4.1 INTERVIEW 42What opportunities does life risk offer investors in ILS to diversify in a new, but related way? Interviewer:• Colin Browne, Publisher, Clear Path AnalysisInterviewee:• Javier Rivas, Director of ILS, Credit Suisse

4.2 WHITE PAPER 44Is life ILS an emerging standalone asset class? Or is it forever consigned to being simply a convenient add-on to a broader ILS strategy?• Scott Mitchell, Head of Life ILS, Schroders

SECTION 5EDUCATING THE MARKET AND CREATING TRANSPARENCY

5.1 EXPERT DISCUSSION 47Since aspects of ILS including pricing structures are non-traditional, how do we overcome the challenge of gaining trustee and stakeholder buy-in? Interviewer:• Colin Browne, Publisher, Clear Path AnalysisPanellists:• Hemal Naran, Former Head, Government Employees Pension Fund, South Africa• John Doak, Commissioner, Oklahoma Insurance Department

5.2 WHITE PAPER 50The growing challenges of asset valuation for insurance-linked securities funds• Aaron C. Koch, Director, ILS Group, P&C Division, Milliman

Michael StahelPartner, LGT ILS Partners

John DoakCommissioner, Oklahoma Insurance Department

Barney SchaubleManaging Partner, Nephila Capital

Lorilee MeddersDirector, Florida Catastrophic Storm Risk Management Center

Niklaus HiltiHead of ILS, Credit Suisse

Joanna SyrokaProgramme Director, African Risk Capacity

CONTENTS

Insurance Linked Securities for Institutional Investors

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LGT Capital Partners is a leading alternative investment specialist, managing over USD 50 billion for more than 400 institutional clients in 35 countries. An international team

of over 350 professionals is responsible for a wide range of investment solutions. LGT is also one of the world’s largest investors in insurance-linked investments, offering funds and mandates with a range of risk and return characteristics to optimally meet investors’ appetite.

Nephila Capital Ltd is the largest and most experienced investment manager dedicated to reinsurance and weather risk. Nephila has assets under management of ~$9.5

billion as of April 1, 2016 and has been managing institutional assets in this space since it was founded in 1998. The firm has 150 employees globally based across four offices.

Schroders is a global asset management company with $466.9bn* AUM across equities, fixed income, multi-asset, alternatives and real estate. The Schroders-Secquaero team

of 22 specialists have unrivalled expertise in insurance-linked securities. We manage $1.9bn* across the full ILS spectrum, from private transaction dominated strategies to liquid cat bonds funds.*As at 31 March 2016.

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Credit Suisse is one of the world’s leading financial services providers with presence in over 50 countries. The Insurance Linked Strategies team is embedded within the

Asset Management business and is one of the largest managers in ILS with $6.8bn AUM and a track record of more than 12 years.

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5

FUTURE DEVELOPMENTS IN THE ILS MARKET

SECTION 1

With increased uncertainty due to climate change and other related risks, how will risk modelling evolve over the next 5-10 years?

1.1 INTERVIEW

Current opportunities and challenges in the ILS market1.2 INTERVIEW

What strategies exist for ILS managers to overcome challenges such as concentration risk in allocating large amounts of capital quickly?

1.3 INTERVIEW

How should investors view the ILS opportunity today?1.4 INTERVIEW

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Colin Browne: With the additional spectre of climate change to add to the existing complexity of natural variability, how much more challenging is risk modelling today and how do you see that continuing in the future?

Paul Maisey: It adds an extra layer of complexity onto what modellers have had to deal with in the past. In the past, a lot of catastrophe and risk modelling has been focused on analysing historical periods and projecting these relationships into the future.

This is an effective approach in many situations but it doesn’t account for any changes that might occur in a future scenario and what scientists term as non-stationarity, with climate change being one of the key examples of this behaviour.

This adds a layer of complexity, especially when you consider how challenging future climate prediction is.

A lot of the focus is now on drilling into the detail and understanding whether the effects of climate change can be attributed to specific severe events.

The floods that were experienced in Cumbria during this past winter rekindled the scientific debate about the link between climate change and extreme events.

Cumbria was a good example. Persistent southwesterly winds picked up moisture off the Irish

Sea and deposited it over the high ground of the Lake District. From a

basic understanding of atmospheric processes it might be expected that a small increase in sea surface temperature resulting from climate change might enable more moisture to be picked up from the sea and carried over the land. In particular circumstances this could lead to heavy rainfall and more severe flooding.

Every such event adds further credence to the hypothesis that climate change has an influence on the intensity of extreme events1.

Colin: How is our understanding of climate drivers improving and what does that mean for risk modelling?

Paul: We have very sophisticated means of modelling the atmosphere and oceans and we use those for climate projections.

The first stage in developing these models and ensuring that they are giving us good guidance is to go back and run them over past periods.

Where we have a few decades worth of good quality observed data from multiple sources across the globe(e.g. surface stations, satellites), we can construct a good picture of what the atmosphere was doing during that period. We can use the model to recreate this period and assess the quality of the fit with observations, giving us confidence in the modelling.

Climate projections often predict ahead to the year 2100 but we have only had good quality observations, with global coverage, for the past 40 or 50 years starting from the satellite era. So we are trying to predict a long way

ahead in comparison to the data that we have about the recent past against which to test and validate climate models.

Climate scientists are constantly seeking different sources of data that will push that record further back.

Prior to the past century, during which surface observations and then satellite observations improved our monitoring of the atmosphere, studies are using other sources of data such as ice cores, tree rings, and log books from marine vessels to better characterise the past climate.

These all contain useful information that can help us to gain more confidence in the ability of our models to recreate that historic period.

Given that the physical processes operating in the atmosphere will remain the same into the future, we can use the same model to give us a prediction into the future.

As we continue to improve our understanding of the processes in the atmosphere, we can get more confidence to project further into the future.

Another method available for understanding the uncertainty in future climate is to generate a series of predictions that are spun off from a slightly different starting position, known as an ensemble forecast. This provides information on the range of possible climate variability

In terms of technical development, climate science continues to benefit

1.1 INTERVIEW

With increased uncertainty due to climate change and other related risks, how will risk modelling evolve over the next 5-10 years?Interviewer Interviewee

Colin BrownePublisher, Clear Path Analysis

Paul MaiseyScience Manager Insurance & Capital Markets, Met Office

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With increased uncertainty due to climate change and other related risks, how will risk modelling evolve over the next five to ten years?

from the increasing capacity of ever more powerful supercomputers.

These computers enable models to be run at a greater level of resolution, which can allow us to represent atmospheric processes in more detail.

Whereas in the past we have talked about changes in average conditions, in the future we hope we can start to pick up on more of the detail. Storm tracks might change and this might have an impact on individual storms. This is of particular interest to the insurance sector to understand what sort of extremes they might see in the future.

Colin: In terms of the linkages between hazard and loss data, what are the current trends and how are these improving?

Paul: In the same way that we are constantly seeking new hazard and historical information, in order to better understand the current and future climate, there appears to be a lot of work on the insurance side, to access better loss data.

This helps in combining the 2 elements in understanding vulnerability. This is a challenging area and is something that I have observed insurance companies continue to work hard on.

Another interesting aspect in this area is the focus on other regions in the world, emerging economies and the

benefits that insurance can have there in terms of underinsurance

When these events strike an emerging economy, the impacts can be much greater because there isn’t the same level of insurance cover.

The challenge there is around the fact that there isn’t as mature an insurance industry in those places as there is in most developed economies.

Understanding what the impacts are likely to be and linking the hazard and the loss data is much more of a challenge in these places.

One of the areas that is being developed in these countries more recently, is around using index insurance programs rather than more traditional indemnity insurance.

This is looking at contracts that pay out on the basis of a particular hazard occurring and threshold being breached rather than having to go out and assess a particular loss and pay out on that basis.

This is a very interesting area for us but it is quite challenging as it means that you have to be confident about the link between a particular hazard and the likely impact it is going to have.

It can be quite an efficient way of managing insurance over a large area especially in countries where the infrastructure really isn’t in place

to effectively run more traditional insurance schemes.

Colin: When looking at risk modelling over the next 5 -10 years, is that meaningful as a specific time frame?

Paul: It is meaningful as a lot of what will be done in climate research will be planned and executed on this sort of timescale and the reports of the International Panel on Climate Change (IPCC), to which the Met Office is a key contributor, as issued every 5 or 6 years, update the science that feeds into policy decisions.

The latest IPCC analysis fed into the UN climate conference (COP21), in Paris last December,at which agreement was reached on aspects of managing the implications of climate change globally.

There is an awful lot of work going on in climate research to continue to enhance our understanding.

One of the areas of focus at the moment is the attribution of climate change to particular extreme events.

This allows us to have a better understanding of what sorts of extremes we will see in the near and longer term and how we can then manage and adapt to them.

Mitigation might be in terms of building new infrastructure such as flood defences or use of insurance in mitigating the financial impacts on individuals and businesses

Another important area of research in the gap between next-day forecasts and climate predictions is forecasting on monthly to decadal timescales where there has been a lot of progress recently in the skill of the forecasts.

This is very interesting to many industries as the time from a few months to a few years are periods when planning decisions can be made in various different ways.

“Another important area of research in the gap between next-day forecasts and climate predictions is forecasting on monthly to decadal timescales where there has been a lot of progress recently in the skill of the forecasts.”

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With increased uncertainty due to climate change and other related risks, how will risk modelling evolve over the next five to ten years?

Whereas some of the longer term projections in some of the industries might be too far ahead for some businesses to respond to in a meaningful way. When you are looking on an annual timescale, which a lot of insurance companies work to, then you have some understanding of what sort of natural variability there might be on that time period. Along with any implications that you might see as the climate change continues to effect things 3-10 years ahead, is certainly gaining a lot of interest.

Colin: Do you have any final thoughts on this topic?

Paul: There is the question of impacts of particular climate drivers as we have just been emerging from a significant El Niño event which has got a lot of press.

This is more in the arena of natural variability rather than climate change, in the sense that it is something that occurs on a cycle of a few years and has very big impacts when it happens.

It is a sufficiently big enough event in its own right that the impacts during El Niño, as opposed to the impacts outside of El Niño, are much more significant than the impacts that any climate change might exacerbate that.

The annual variability of that is a much more significant thing in its own right and any climate change impact is a secondary factor.

These are areas that we are working on and have had interest from insurers and re insurers as well in terms of

possible impacts from an event like El Niño but also connections between other similar events.

There are a number of these atmospheric climate drivers that have global impacts in terms of extreme rainfall and drought.

The way that they occur together and the strength of these events is an area of active research.

In the past there has been an assumption of independence between these events and now that is starting to be looked at and questioned especially in relation to issues like regulation, Solvency II and reinsurers having to prove that they have taken sufficient steps to understand the risks that they are exposed to.

In terms of attributing particular extremes to climate change it is worth noting that this debate is still ongoing and it is fair to say that this is research that is still in its infancy.

It is a very active debate about how much we can say about linking individual extreme events to climate change.

Colin: Thank you for sharing your thoughts on this topic.

“It is a sufficiently big enough event in its own right that the impacts during El Niño as opposed to the impacts outside of El Niño are much more significant than the impacts that any climate change might

exacerbate that.”

1. Extreme events: The art of attribution by Friederike E. L. Otto (2016), Nature Climate Change

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Colin Browne: What are the major topics for the ILS market in 2016 and 2017?

Niklaus Hilti: We believe that during 2016 and 2017 the market environment will be very interesting.

The ILS market has seen a significant reduction of margin between 2011 and 2014, followed by a phase of stable margins since the end of 2014 until the first quarter of 2016. It seems that catastrophe bond (CAT) investors are disciplined and do not invest below a certain minimum margin over expected loss. It will be very interesting to see if reinsurers follow the example of ILS investors and stop the margin compression and not just slow it down.

If that happens, it will be a sign that the market has truly converged and does not fall into old reinsurance patterns anymore.

Colin: What kind of opportunities do you see in the ILS market?

Niklaus: The key opportunity we see from an investor’s perspective is that ILS has proven to be very low correlated to traditional asset classes and other alternative asset classes over the last 16 years and has delivered uncorrelated and attractive returns.

We see that more and more investors are appreciating this fact and recognise ILS as a true alternative investment strategy. The investors deciding to invest into ILS for uncorrelated sources of returns are generally longer term oriented than, for example, investors who are investing in order to tackle the current low interest rates. The first

quarter of 2016 has demonstrated how challenging, volatile and highly correlated global financial markets can be. We expect that in 2016 and 2017 new investors will invest into ILS and for the right reasons.

Colin: Do you foresee the ILS market to grow then over 2016 and 2017?

Niklaus: We believe the market will grow but not at the pace we have seen in 2011 to 2014.

This is actually a good sign if there is less capital flowing into the market as it helps to stabilise the margins. We think the market has now matured which means the information flow between insurers, reinsurers, ILS managers and investors and hence the market has become more efficient. We see growth potential around risk categories where the global reinsurance market is not large enough to absorb the volume at hand, cyber risk is an example of this.

Today, the insurance policies available only cover a tiny fraction of the cyber risk universe. The demand from corporates is significantly exceeding the availability of insurance coverage. The complexity within cyber risk is high and it poses a global threat, which means that the diversification potential is limited and hence capital intensity has to be high.

These are all ingredients, which are ideal for the capital market to absorb the shock scenarios of such a risk class. We should not forget that is why ILS exists and the capital market was involved in the property catastrophe market. The capital market is much larger and in a much better position

than the reinsurance market or some of the reinsurers to absorb events whose cost exceeds $60bn or more.

The scale and the sheer size of the capital market can better absorb very costly catastrophe events.

Colin: Do you believe the cyber reinsurance market is the next property catastrophe ILS market?

Niklaus: Modern society is changing and relying more and more on the stability of cyber facilities. Therefore, the society has become very vulnerable to break downs of IT infrastructure and data exchange. This is comparable to the value of property during the last century.

The insurance market in the industrialised world is desperate for growth but cars, homes and production facilities are insured and not growing at an attractive pace anymore. The insurance market is becoming more efficient but is not really growing at a high pace. Cyber risk is probably the fastest growing risk aside of life insurance in emerging markets.

If insurance products become more readily available, this market will grow significantly and the insured value can grow exponentially. But insurance products are only feasible if the risk transfer chain is secured and peak risks or large risks can be absorbed by the reinsurers and the capital market.

We therefore see an enormous potential for the cyber insurance market.

1.2 INTERVIEW

Current opportunities and challenges in the ILS market

Interviewer Interviewee


Niklaus HiltiHead of ILS, Credit Suisse

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Current opportunities and challenges in the ILS market

Colin: Do you see the introduction of Solvency II resulting in an increase of demand for ILS and increased issuance of CAT bonds and reinsurance?

Niklaus: So far it is very early to assess the implications of the introduction of Solvency II. Our assessment so far however indicates that there is an increased need for capital and slightly more reinsurance. The increased risk transfer on the reinsurance side is however of a scale which can be easily absorbed in the traditional reinsurance market and there is no need for ILS to step in.

We do not see cat bond issuance increasing, as the larger companies which are traditionally the ILS issuers are well capitalised and smaller sub-scale insurers, do not need ILS for risk transfer. Also it is costly in-efficient for them to use ILS. Again here we see the largest impacts of Solvency II on the life sector.

Colin: Last year, on your platform you launched a Lloyd’s syndicate named “Arcus 1856” as well as a the second rated reinsurer Humboldt Re Ltd. What is the rationale behind those structures?

Niklaus: For the investors in the syndicate as well as in the rated reinsurer, the benefits are manifold. The spirit and advantages of ILS are maintained such as the floating structure of returns with the short term highly secure investment portfolio delivering short term, low duration interest and a coupon which is generated through underwriting profits.

The low correlation to financial assets is maintained as well.

In addition, we believe these companies offer additional advantages such as better and broader access to risks, direct and hence more cost efficient access to risks (no need for a fronter). Last but not least, we believe that the rated reinsurers are providing a completely new and revolutionary investment case as the expense ratio is significantly lower than for any other reinsurer. Especially for property catastrophe biased reinsurers, we think the expense ratio is far too high in the reinsurance industry and the highly commoditised catastrophe market is not justifying such high costs.

Those rated reinsurers roughly have the expense ratio of the reinsurance industry which will in our opinion lead to a significant and sustainable outperformance compared to the market.

In addition, the investors benefit from the platform effect in the sense that they get access to risks, they benefit from the platform size and have the advantage of a one-stop-shop where insurers can get cat bonds placed, collateralised reinsurance and rated reinsurance.

Colin: What other challenges do you see for the ILS market?

Niklaus: Recently we have seen that the European Securities & Markets Authority (ESMA) and the Luxembourg regulator aim to introduce a limitation on concentration risk within UCITS funds with the 20%/35% rule, similar to rules applied to other assets classes, in order to reduce concentration.

Given the fact that the cat bond market is about 70% concentrated around U.S. hurricane risks and many funds are concentrated too, this new approach

will challenge some large UCITS funds, especially if regulators in other countries should follow suit.

Colin: What is your view on this new regulatory development?

Niklaus: We think it is very sensible, because in the event of a large catastrophe, uncertainty and illiquidity will be significant. Cat bonds will be difficult to valuate for months after the catastrophe event. We have seen that around hurricane Katrina in 2005.

These illiquidity issues do not fit the liquidity requirements under the UCITS regulation. In addition, we have seen when the first ILS mutual funds in the world were launched in Switzerland in 2000, the regulator imposed a 30% maximum limit to any single risk zone (such as U.S. hurricanes for example).

However, when we used to manage those funds, the cat bond market itself was much more diversified and by far not as concentrated around U.S. hurricanes as it is today.

As a consequence of the new rules in Europe, we closed our UCITS fund last year. We generally believe that the cat bond market with today’s large concentration in U.S. wind does not fit the regulators’ expectations and is not suitable to the mutual character of UCITS.

Colin: Thank you for sharing your thoughts on this subject.

“Catastrophe bonds will be difficult to valuate for months after the catastrophe event. We have seen that around hurricane Katrina in 2005.”

Credit Suisse’s Insurance Linked Strategies (ILS) team combines more than 190 years of experience from reinsurance, underwriting and risk modelling and has been one of the largest managers in the ILS market for more than a decade. The team today manages a breadth of ILS portfolios on behalf of institutional and private investors including onshore and offshore funds and customized mandates. For more information, contact your Credit Suisse relationship manager or visit our website.

credit-suisse.com/ils

Low correlation, an experienced team, attractive returns, and a diversified approach are the cornerstones of taking the L-E-A-D.

Credit Suisse Insurance Linked Strategies

109.14AM.010 RZ Inserat Institutional Investors.indd 1 05.05.14 17:03

Ltd

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Colin Browne: Do ILS yields continue to be attractive for investors?

Jitzes Noorman: Certainly. In terms of yields, the asset category is still attractive, although it is true that yields have come down in the past couple of years and that might be evidence of the asset class maturing.

It is also driven by the fact that risk premiums in the financial markets in general have come down, as well as the fact that risk free interest rates have also dropped significantly.

When making decisions with respect to asset allocations, it also comes down to relative yields not absolute yields and from a relative perspective this asset class offers a yield of about 5%, which is still very attractive as risk free rates are close to 0% or even negative for short maturities.

There is also another feature that makes this asset class interesting, which is that many investors fear interest rates might rise as we see the Fed start to tighten or embark on the tightening cycle.

Given that the risk free component of the coupon is floating, this asset class isn’t sensitive to any tightening cycle.

Colin: Why is it not subject to tightening?

Jitzes: Insurance linked instruments like catastrophe bonds have a coupon which usually has a floating risk free rate component (plus a fixed spread). Consequently, the coupon adjusts to the interest rates hence the price does not have to adjust and so it is hardly

sensitive for any possible rise in interest rates.

Whereas, a regular bond like a government bond has a fixed coupon so you get a fixed percentage for the next 5 years say. The price of such a bond is sensitive to the movement of risk free rates.

Colin: What are the relative merits in your opinion, of a concentrated portfolio and a diversified portfolio and when does one become preferable to another?

Jitzes: We are an asset manager with a fiduciary department, which is where I work, we give advice and implement for our end clients and there are pros and cons to both portfolios.

We have spoken to most managers in the market and some actually seek concentration risk because of the higher return. For instance, U.S. wind related bonds offer a higher spread given the expected loss.

Whereas, other managers choose to go for a diversification strategy because of a lower risk profile.

In the end it comes down to the investment beliefs of the pension fund: i.e. do they believe in active or passive management?

Our main objective is to gain access to the market and we want the beta in the portfolio.

The issue is not that relevant because from a portfolio context, this asset class only makes up a few percentage points of the overall portfolio. So even

if there was a concentration risk within the class on a portfolio level, it is hardly relevant.

Most managers state that once every 100 years the prices of the portfolio could drop by -30%, which seems significant but if you compare this to equities they showed a drop in prices of 30% on no less than 9 occasions over the last century.

It is less relevant than it appears on first sight. Moreover, the market is evolving over time.

If you look at the issuance during the first quarter of this year 10 new bonds came to the market and there was no single peril that dominated.

The asset class will become more diversified in the coming years as it won’t just be insurance companies in this area but governments will also be stepping into this market.

Caribbean, African and emerging market countries will also be in this market. Furthermore, we might see more issuance of other perils such as floods, droughts and earthquakes.

Colin: Can some other issues like cyber threats fall within ILS opportunities?

Jitzes: Yes, ILS also includes these type of risks, but for us we seek more natural catastrophe related investments.

Colin: Because they are more predictable and better understood?

Jitzes: Yes and it is a toe in the water type of approach for many institutional

1.3 INTERVIEW

What strategies exist for ILS managers to overcome challenges such as concentration risk in allocating large amounts of capital quickly?Interviewer Interviewee


Jitzes NoormanDelegated Chief Investment Officer, BMO Global Asset Management - Nederland

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investors. At first, they have to get acquainted with natural catastrophe risk and there is a lot of data on natural disasters. With many catastrophe models created by several agencies.

Cyber crime is much more difficult to get a handle on so we would prefer exposure within the “traditional” ILS markets.

Colin: What are the challenges around ILS investing with regard to getting inherently prudent pension funds to accept that they should invest in something called ‘catastrophe’ bonds?

Jitzes: There is definitely a red light here particularly in the Netherlands because before 2007/08 the Dutch investment scene was pushing the frontier of the investment universe and also experienced the downside when the Lehman crisis emerged.

The regulators are now focusing more on investments that fall into the alternative bucket. By law, although we as an asset manager provide the strategic advice and implement the actual investment, and monitor the ILS fund, the pension fund is still responsible for the investment portfolio and all strategic decisions made.

Pension fund boards always need to be able to explain themselves to the regulator, which for us is the Dutch Central Bank, what their investments are.

Given the complexity of this asset class it does come down to education which is the first step.

The second stage is selecting a manager based on the specific criteria of the fund and then implementation and reporting.

Education is very important. To illustrate, we implemented an investment for one of our clients a while ago that was preceded by education during a period of 1.5 years with the board of the pension fund.

Colin: ILS isn’t a particularly new area, and yet there still appears to be significant lack of understanding about what investors are getting into. Would you agree with that?

Jitzes: Yes and although it isn’t completely new it is still more exotic than a standard government bond or equity portfolio.

Also because of the different trigger types and structures that are out there in this space it can be more complicated.

Reputation risk is also an important issue for Dutch pension funds because there is a lot of media attention with respect to the Dutch pension industry and how they are investing the money of the pension participants.

On the one hand, this asset class is deemed to be positive from a Social Responsible Investing (SRI) perspective, because by investing in this asset class you enable insurers to provide more insurance to people in high-risk areas, which would otherwise have not been able to get insurance.

Also, as an investor you don’t benefit from a disaster and actually it is quite the opposite.

In terms of reputational risk, being that ILS is an exotic asset class, it might not fully be understood by participants of a pension fund, and hence it might raise eyebrows if they were to find out that their pension fund was investing in something called catastrophe bonds.

Hedge funds also have a negative connotation nowadays and the investment policy of many Dutch pension funds no longer permits investing in funds that apply performance related fees.

Some of the funds in this space still have performance fees so they are not an option for our clients so we only seek managers who charge only a management fee.

Additional factors for pension funds as well as the regulator are liquidity and transparency.

Luckily from a pension fund perspective this is a liquid category. First of all the bonds are publically traded which means objective prices, and within a week or so you can invest or redeem within most funds. So, from a pension fund perspective, that is rather liquid particularly if compared to some alternative investments.

Another positive point for this category compared with other alternative asset classes is the availability of public benchmarks such as the Swiss Re Cat Bond Index. This enables us to incorporate this asset class into ALM models and also compare the performance of managers versus a benchmark.

If a pension fund still wants to go into this asset class taking into account all

“Another positive point for this category compared with other alternative asset classes is the availability of public benchmarks such as the Swiss Re Cat Bond Index. This enables us to incorporate this asset class into ALM models and also compare the performance of managers versus a benchmark.”

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of these potential hurdles then the question is what the portfolio weight should be.

There is always a trade-off between optimisation and the regulator. ALM studies and optimisation tend to indicate that the optimum weight is high due to the strong diversification characteristics in combination with the historically low volatility and high return. On the other hand, in case of portfolio weights in excess of 5% to 10%, the regulator will look more closely at this specific investment and possibly put the spotlight on the pension fund.

Somewhere around 2.5% is a good weight to start with.

Colin: As low as that?

Jitzes: At least 2.5% because you have to spend a lot of time on governance in this asset category and to make it worthwhile you should at least invest an amount that has an impact on the overall portfolio and so 1% wouldn’t be enough.

Colin: In terms of the governance in this area are you meaning the due diligence of what you are investing in?

Jitzes: Yes as well as education, and once in a while focusing on the asset class, the instruments and the ins and outs so that the board is in control.

It also relates to the reporting of the external manager because the Dutch regulator requires a lot of detailed information on a quarterly basis from the pension funds about all of its investments which also holds for this category.

Colin: For those pension funds who would rather steer clear of this asset class, do you feel that they are missing something by not having cat bonds as part of their investment strategy? Is it just a matter of preference?

Jitzes: You are missing something as the Lehman crisis proved that this category provides true diversification. Other assets classes that were supposed to diversify versus traditional assets such as hedge funds and private equity did not deliver in 2008 and 2009 and also went down.

Catastrophe bonds together with government bonds were the only two categories showing a positive return during the Lehman crisis.

Colin: Thank you for sharing your thoughts on this subject.

“Catastrophe bonds together with government bonds were the only two categories showing a positive return during the Lehman crisis.”

15

Noel Hillmann: Is an investment in ILS still attractive for institutional investors in the current market environment?

Greg Hagood: Our position is that ILS is still attractive as the asset class has a positive expected return and is not correlated to the broader financial markets. This is our 18th year in the business and we have lived through several disruptions in the broader capital markets, such as Long Term Capital, the 9/11 terrorist attacks, the tech bubble and more recently the 2008 financial crisis. In each of these dislocations, our returns held up and the integrity of the non-correlation story was demonstrated. The traits of the asset class are both rare and valuable.

Noel: Should investors wait to enter the market – perhaps after a large catastrophe event when pricing may have improved?

Greg: Each investor will take their own view of market timing, but obviously post a catastrophe, spreads should widen and we have seen this historically. After hurricanes Katrina, Rita and Wilma in 2005, spreads in the reinsurance market approximately doubled. If a similar event were to happen today, we believe spreads would not widen nearly as much, simply because new capital could flow to the opportunity so much quicker now that fund managers, side cars and cat bonds are so much more developed.

In terms of whether investors should wait to enter the market post-event, many of our investors think about their

allocation with us as a core strategic weight for the diversification benefit, with the ability and plan to tactically adjust up or down based on market conditions.

Investors might have a core strategic weight of 2% and the ability to dial the weight up to 4% post event or take it down to 1% if market conditions were tight. Given current market conditions, most of our investors are at strategic weight and post event our expectations are that most investors would dial that up to above weight as you would do in any other asset class.

We do have some purely opportunistic investors who only enter post event and it is nice to have that “accordion capital” in dislocated markets.

Noel: Is there a particular environment that is opportune to be entering into the ILS sector?

Greg: If you take at face value that the asset class has a positive expected return and is non-correlated, that is a benefit in and of itself.

The perfect environment would likely be after a series of large catastrophes where the market is quite dislocated and there is a shortage of capital in the broader market.

Noel: How do managers add value to this market?

Greg: Reinsurance is not an exchange traded risk. Therefore, strong and deep origination capabilities are very important for optimal portfolio construction. In all markets, a larger

investible universe is better to choose from than a smaller one.

Investors also need to find out how strong a manager’s research and risk analysis teams are. The best managers will have a deep and experienced research team, primarily focused on making the baseline catastrophe models more robust and fully understanding the market landscape.

Another advantage investors should consider is the benefits of scale with their manager. Post the financial crisis in 2008, insurance companies became more focused on the creditworthiness of their trading partners. This led to much more reinsurance business being placed with larger, better rated, more strategic trading partners. This development has been termed “tiering” in the reinsurance market and it basically means the larger, more strategic managers are receiving better pricing and better signings than the smaller players who trade only in the broader syndicated reinsurance markets.

Currently, in the syndicated market, if you want 100 dollars of a particular transaction, you are only able to get 50.

If you are a manager in the top tier of the market, not only do you get better pricing for the risk, but if you want 100 dollars you are more likely to get that 100 dollars which is helpful for investors.

Noel: What is it that investors need to be looking for and what questions do they need to be asking managers to determine the best fit for them?

1.4 INTERVIEW

How should investors view the ILS opportunity today?


Noel HillmannManaging Director, Clear Path Analysis

Greg HagoodCo-Founder and Managing Partner, Nephila Capital

16


Greg: They need to see what value that manager adds, how big their staff is, what is the experience of their team, have they been through a series of losses with investors alongside and if so, how did they manage risk?

They also need to focus on all-in fees and not just the headline fees. Many times the headline fees might seem to be lower for one manager over another, but investors need to dig deeper to see what the hidden fees are.

There are many places where fees might not be as transparent. For example, is the manager investing in side cars or quota shares and if so, what fees do they pay to the sponsor for sourcing risk on the manager’s behalf? Do they use a fronting company and do they use leverage? If so, what are the fees for these services? Do they source risk or obtain modelling services from a parent company and if so, what fees are paid to the parent for these capabilities? Is the manager large enough to negotiate lower brokerage fees on behalf of investors?

Investors need to ask questions relating to the fees coming out of the entire proposition as opposed to just the management and incentive fees to help differentiate the value a manager provides.

There are also potential conflicts of interests that arise, whether perceived or real, that can occur when the manager is part of a larger organisation and these should be explored as well.

Noel: Nephila has recently begun to source risk in the insurance market as well as the reinsurance market. What are the main reasons for doing that?

Greg: Portfolio construction benefits from having as large an investible universe as possible from which to choose.

We have 150 people at our firm and certainly have the capability to see the

risk in the insurance market and be closer to the original point of sale.

For investors, we started down this path about 3 1⁄2 years ago and have built out a platform to see and analyse risk in the market and we feel that one of the biggest benefits to investors is just having a larger investible universe.

For example, there are times when reinsurance pricing is better than insurance pricing and vice versa. Thus, if we access the risk in both markets, we can tilt the portfolio accordingly and this will be of benefit to investors’ expected returns over time.

The other big benefit is by being closer to the original point of sale, there are some cost efficiencies that can be gained and this is something that

we are also focused on to benefit our investors’ returns.

Noel: How has the market changed in recent years and what can investors expect in the medium term from this asset class?

Greg: The biggest change in the last 10 years is that the capital markets have gone from taking no reinsurance risk to being about a 20-25% market share of the world’s catastrophe risk today. As premiums have come down in the last 5 -10 years, we would argue that is somewhat due to a lack of catastrophe losses, but some of it is also because of the type of capital that is financing the risk.

There is a more efficient cost of capital financing the risks from the capital markets and the natural clearing price for this risk has come down.

So, part of the decline in premiums over the last 5 years in our view is secular in nature and will most likely not return, and part of it is cyclical because there hasn't been a lot catastrophe loss activity.

In terms of what the future holds, technology will likely play a larger role in our market down the road.

We also feel that efficiencies will be brought to the distribution chain for risk and more of the original premium dollar will go to the people who assume the catastrophe risk.

Noel: In terms of new investors who are coming to the market, do you see a shift in the investor profile that still hasn't tucked into this market place who really should be giving it greater consideration?

Greg: In the first 8-10 years of our business, our investor base was more fund of funds, family offices and hedge funds.

In the more recent 5-10 years it has transitioned primarily to pension funds and university endowments etc. and we expect this trend to continue.

One channel that hadn't come into the market until recently was retail investors.

“Investors need to ask questions relating to the fees coming out of the entire proposition as opposed to just the management and incentive fees to help differentiate the value a manager provides.”

17


There have been some products in Europe and more recently in the U.S. that are bringing retail customers to the market and we are still evaluating the market impact.

Noel: Do you feel that the term of insurance linked securities is one that has an inherently risky attitude associated with it?

Greg: One of the issues that we run into a lot is that people don't have a natural bucket for it in their strategic asset allocation or policy.

They have a bucket for equity, private equity and even hedge funds and many times ILS ends up in another bucket like absolute return or core fixed income.

This said, the attributes of the asset class are so powerful that people try to find a home for it.

More broadly, the acceptance of the asset class is light years ahead of where it was even 10 years ago. Education on the space is much higher and the conversation now is more about differentiation amongst fund managers and approaches than it is what is re insurance or insurance, so we have come a long way.

Noel: Can the asset class continue to grow?

Greg: It will continue to grow as it is just too powerful a story. Investors are looking for diversifiers and the world’s global capital market assets are becoming more correlated due to the global interconnectivity, so something

that is truly not correlated that has a positive expected return will continue to attract capital.

Noel: How do you decide when you can take in more investor money?

Greg: It is very simple, as we have different funds with different objectives and we take the amount of capital that we feel that we can to make those stated objectives.

As an example, we have not taken capital as a firm for the last 2.5 years and we believe this is the right thing to do as a fiduciary of investors’ capital.

We have recently reopened our funds for a limited amount of capital for certain funds as we thought we could accept this additional capital while still meeting their required return/risk metrics

Noel: Thank you for sharing your views on this topic.

“When the market pricing gets better, it may be that we can take more but right now we have been very judicious in our capital approach and doing the right thing for investors will serve both them and us in the longer term quite well.”

18

THE CHANGING FOCUS OF ILS

SECTION 2

What are the challenges in developing a diversified approach with new ILS exposures?

2.1 EXPERT DEBATE

An introduction to weather risk as an ILS asset class2.2 INTERVIEW

19

Colin Browne: Let’s start with the obvious question, considering the topic: what would you consider to be new ILS exposures?

Dirk Lohmann: It depends what you are talking about with regards to the underlying risk peril.

If you are talking about catastrophe what I would consider to be new is risks covering new territories or peril regions. This could be perils such as flood or it could cover regions such as Latin America or China where last year there was a small cat bond done for the China Re called Panda Re.

This transaction (Panda Re) was more of a test as an earthquake in China is a peril that will have significant demand in the future. I see that as new ILS in the context that right now this isn't available to the market.

Another area which might be categorized as new ILS in the cat space would be instruments focusing on the frequency type perils rather than the severity perils; so tornado / hail aggregate covers possibly also including winter freeze where we have seen significant demand and a lot of activity for companies to limit their aggregate exposure on any given year on their retention losses.

This is an area where we as a manager write quite a bit of business in the collateralized reinsurance format but where you currently only have a handful of tradable instruments that have focused on so-called severe convective storm frequency exposure.

There have been some privately placed or cat bond “lite” transactions in this area. One was for the Cincinnati Insurance Company called Skyline Re. Another one where there was a severe convective storm element is the cat bond called Gator Re but this also has a hurricane section.

Bonds focused on frequency risk is something that is potentially diversifying, probably more so if it wasn't combined with a hurricane section.

Beyond this you could go into other lines of business like life, where we do have extreme mortality but where there is going to be an increased need for financing in the life insurance business, partly as a result of Solvency II.

We have had a handful of bonds that have been issued like Chesterfield which was an embedded value transaction and where I feel there is more appetite for similar deals.

There will be more need for shock mortality protection under Solvency II and there could be more reserve type securitisations which were more common pre 2007/2008.

The banks initially got into this business but now the rules are changing and this may offer a new window there for the ILS market.

On the non life side you could be looking at solvency related type structures that could provide capital relief against extreme movements in reserves.

Todor Todorov: If you take the view of the asset owner or investor it is important to keep in mind the role that the ILS allocation plays in the overall portfolio.

It is usually a relatively small allocation and is valued by the asset owner for its diversification benefits.

Bearing this in mind the more interesting risk premium and return drivers that are available. The asset owners can build a better diversified overall portfolio.

Within property cat the need for that allocation to be overly diversified and stable would depend on governance factors than portfolio benefits.

If an asset owner, most would put a cap to their total exposure to cat risk, the need for that cat allocation on its own to be steady is less obvious.

The investor can take on volatility within that asset class and what they should care about here is its capacity to matter within the overall portfolio context.

There is an argument for the efficient investor to not stick to over diversify and cure the volatility within ILS exposure.

Most of the institutional investors should theoretically be able to take on more risk.

Dirk: I agree that it depends on the individual investors appetite for risk and tolerance for volatility.

2.1 EXPERT DEBATE

Interviewer


Interviewee


Dirk LohmannHead of Insurance Linked Strategies, Schroders

Todor TodorovInvestment Consultant – Hedge Funds Research, Towers Watson

20


There is no need to look for ILS that are diversifying simply for the sake of diversification because diversification can be very expensive and not really bring much value to the investor.

The other question is that of size. Even if the capital markets were to take 100% of the catastrophe risk limit that is currently purchased by the insurance market, it is still a drop in the bucket as far as the size of the asset class relative to total assets managed by institutional investors.

I mentioned new ILS from the context of the ILS market today. Chinese earthquakes and the other areas offer the scope to make the asset class a broader asset class which is something that the market also needs, as it doesn't have that big a size.

Todor: Diversification for the sake of diversification within ILS is not necessarily the top priority within institutional investors but indeed focusing on risk perils where capital is truly needed and that can play a role in that portfolio is more than welcome.

Where institutional investors have expressed interest but there hasn't been that many available products is targeting different parts of the insurance industry and return drivers.

This could be on the life side or in other lines of business but these would bring something truly different and interesting to their portfolios.

Colin: Are we talking about related things like weather risk or very dramatically different things like cyber crime?

Dirk: Insurance risk in general needs to be structured in a manner which fits a collateralized context because with an ILS instrument, whether it is privately placed collateralized reinsurance or in a bond format, it only functions where collateral is there to secure the payment obligation for an

insurance event that is underlying that transaction.

It is also important that collateral can be released quickly when the risk period has expired and no loss has happened.

There are natural constraints with regards to where this concept of collateralized cover might be applied. I don't see it happening to long tailed risk like D&O or product liability, so these constraints are something we need to think about when assessing other lines of insurance risk.

There are applications beyond just catastrophe risk like weather, crop insurance or tornado hail which is a different type of risk and is more at the money but it is diversifying both geographically and from a seasonal perspective.

Todor: For the investor it is difficult to lock the collateral for unknown periods so long tail wind bands are generally more difficult to expose in that format.

I wouldn't necessarily exclude them altogether and whilst today we don't have these structures I wouldn't disclude the possibility that a structured product might address this in the future as well.

Dirk: In the European context Solvency II provides some opportunity to look at risk in a different way.

Predominantly the discussion about risk has been event driven and severity type risk. Solvency II looks at an insurance company’s balance sheet and various components of risk; one of which could be called the deviation or reserve risk on a 12 month horizon. That is because Solvency II looks at a 12 month horizon and not the next 4 years.

You could buy structured products that provide companies with a surrogate form of capital that address some of the Solvency II capital requirements that are needed for addressing issues like the reserve or underwriting risk in a given period.

Todor made a very important point that in terms of what investor’s value. They value that they are buying a new type of risk and it isn't correlating to their existing investments in traditional and other non-traditional lines.

This brings up the question as to whether cyber is something that can be a new area for the ILS market.

I take the position that cyber risk is something that we do not believe actually has the characteristics that other types of insurance risk have. There is probably a high degree of potential correlation of a massive cyber event and disruption in financial markets. From this standpoint we don't believe that this can be clearly argued to be a non correlating asset as it could have a high correlation in its performance with the performance

“There are applications beyond just catastrophe risk, like weather, crop insurance or tornado / hail which is a different type of risk and is more at the money, but it is diversifying both geographically and from a seasonal perspective.”

21


of other assets if we had a major cyber event.

Colin: What is true diversification in the ILS space, in your opinion? Is it enough to have different assets? Is it specifically about including other ILS products besides cat bonds?

Todor: When I talk about diversification within the ILS space I am referring to different risk perils, geographies and different risks included within the portfolios.

The form via which they would be included in the portfolio, is it to be a cat bond focused on Florida wind is going to be collateralised private transaction focused on Florida wind or an ILW focused on Florida wind.

The form I am less concerned with and I do believe that a provider and manager who is able to take that exposure through any of these instruments or more would have the flexibility to pick the instrument that offers the best risk return characteristics.

Fundamentally the risks underlying it are what matters for the portfolio risk and the diversification benefits.

I am a bit agnostic about instrument form and more concerned about the underlying exposure.

Dirk: When we are looking for diversification within our strategies it depends on the nature of the product and the strategy that is being managed.

If we have a product that is only focused on short tail risk and does not allow us to look at life then there is the question of diversification and how we would go about it is different from one where we have a broader all ILS strategy that would allow us to entertain any type of insurance risk.

The key point is that you don't just buy diversification for it's own sake and get painted into a corner of writing very

expensive and low returning risks in geographies where there is excessive capacity, chasing a limited amount of demand.

Our focus has been to try and find risks that actually do not have a significant impact on the expected returns of the overall portfolio but maybe improve the overall portfolio dynamics with regards to its behavior in the tail and the distribution of expected returns.

If you can find assets where you add diversification without diluting much of your return but you do reduce the tail risk significantly then this actually bring real value to the investor.

Colin: What are some of the challenges in bringing new risks to the table?

Dirk: One of the challenges that you face if you bring in new risks is that you also need to be conscious of what sorts of information requirements are necessary in order for the market and investors to value them.

If all you have is headline peak peril risk, like the Florida hurricane, then there is not much information that the sponsor has to supply other than his exposure database at the point in time when he buys the cover or when he resets the cover.

After that you just have a static situation where you only have to look at it if there is a hurricane that hits Florida.

If you are looking at transactions which are more portfolio than event driven, where you are protecting against a shift in the actual behavior of claims or where you are not protecting against any particular single event but an

accumulation of events over time, in these situations the sponsor needs to be clear that they have to bring much more frequent information because we are closer to the money. We need to have more frequent updated information in order to properly value these positions, because the market needs to have a view on the performance of the asset not only at the end of the year but during the course of the year.

This is also true if we are talking about life insurance or other portfolio linked risks as it is not enough to have just one very big report from an actuarial consultant when you launch the thing, but that you receive regular updated reports where you show actual versus expected performance and provide that information on a regular basis.

Todor: From an investor perspective bringing more risk to the table is welcome as well as bringing investment opportunities that have different risk profiles as they allow investors to build a better portfolio.

For the insurance industry it is important to focus not only on re packaging new risks into collateralised format but also think about where that capital can be helpful, where the industry lacks capital and where having a fully collateralised basis would address those risks.

Packaging risk perils that are well served by the traditional industry and balance sheet model provides an efficient capital to address them although perhaps not the most obvious low hanging fruit for institutional investors.

There are pockets in the market that are not served where there is just not

“When we are looking for diversification within our strategies, it depends on the nature of the product and the strategy that is being managed.”

22


enough insurance capital to address them.

Third party fully collateralised ILS types of products can be very helpful here and I would encourage the industry and managers to keep an open mind and seek out those opportunities as institutional investors would welcome them.

Dirk: There is large potential in that if you think of ILS as another form of capital that is triggered by movements on the liability side of the balance sheet of the insurance company. This opens up the possibility of looking at things not only on an event driven basis but looking at portfolio linked transactions where companies could buy protection against deviations in movement. Or plans that are driven by various factors in the diversified portfolios that they have.

This type of instrument might help companies to manage their overall balance sheet and their P&L more efficiently than buying into individual silos of reinsurance.

We have seen some very large companies who increased their retentions and some of them are now turning around and going the other way. Perhaps this is a function of the soft market but some people realise that they perhaps went too far with regards to their retention strategy.

They set their retentions in the context of an enterprise risk management model of the company and their overall capacity to absorb risk. In determining their capacity they just focus on debt, sub debt and equity. The ILS market could offer them additional risk bearing capital in a structured format that could remove some of the volatility on the insurance side of the balance sheet more on an aggregate as opposed to individual risk or event basis.

This would be an area that could bring the industry and sponsors a lot of capital that they need as they

are being pushed by the regulators and rating agencies to increase their capital. Buying additional towers of reinsurance might not always be the best and most efficient way to do that.

Colin: Thank you both for sharing your views on this topic.

“The ILS market could offer them additional risk bearing capital in a structured format, which could remove some of the volatility on the insurance side of the balance sheet more on an aggregate, as opposed to individual risk or event basis.”

*Investor of the Year – Trading Risk Awards 2015. Source for all data: Schroders, as at 31 March 2016. For professional investors or advisers only. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested. Issued in May 2016 by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registered number 1893220 England. Authorised and regulated by the Financial Conduct Authority. w48839

The award-winning* Schroders-Secquaero team of 22 ILS investment specialists has unrivalled expertise in managing insurance-linked securities.We manage $1.9bn, from private transaction dominated strategies to liquid cat bond funds.

With a proven track record of constructing attractive investment solutions for our clients, we are ready to become your professional ILS partner.

For more information please contact:

Jonathan Hayward Product Executive [email protected]+41 (0)44 250 1417

Insurance-linked securities Shield against uncertainty

24

Colin Browne: To start with, since this is an introduction to the asset class, how do you define weather risk?

Barney Schauble: Catastrophe is really risk of damage and buildings being knocked down by natural hazards like winds, earthquakes and other storms.

When we talk about weather what we mean is more of a physical manifestation of normal weather so how much rainfall do you get in the course of a year for a hydro electric plant, how much snow do you get for a ski resort, what is the temperature for an energy company etc.

There is even a wind component, which is related to how much wind blows for your wind farm rather than the level of wind with respect to an actual windstorm.

It is still a natural variable, objective and measurable, but driven by Mother Nature, not human behaviours necessarily.

It retains that non-correlation component to broader financial markets but it is a different variable than catastrophe risk.

Colin: Is this an area that is going to become more difficult to predict going into the future or are the changes that are happening more gradual?

Barney: You have to look very carefully at the exposure that you have and how that is changing.

The implications for snowfall in the next 10 years, relative to the last 50,

years is very different than for the temperature in Arizona.

The way we think about weather and catastrophe risk as a variable is that it is a physical system and you can model it and you are not trying to predict the psychology of the stock or bond markets.

How you model it is different as when you are thinking about earthquake modelling you are thinking about historical fault activity and the underlying physics of that.

Whereas when you are thinking about modelling temperature you are looking at 50 years of information at say, Heathrow and you can look at the trend over the course of that time period to see a gradual warming trend, a stable trend, more frequent but less severe rain or snow storms, etc.

There is a huge amount of information you can use to make that determination and that is the advantage.

You certainly have to look at trends and changes but that is going to manifest itself differently in different places and you have to be aware of that as a buyer or seller of that kind of protection.

Colin: Is weather risk a more stable investment choice than catastrophe or are they just different animals?

Barney: I feel they are different animals and it is a much smaller sector.

Businesses and individual people have been buying property catastrophe risk protection for hundreds of years.

Weather risk is a little different in that way and really that is a question of pricing as if you had two risks, one of which you were extremely confident in the modelling but you got paid very little and the other you were less confident but got paid a much higher price, which is the most prudent investment? So it is not just a function of risk analysis.

We do believe that with weather risk analysis, both as a buyer and a seller, you can have some meaningful confidence that you know how this system behaves and you aren't going to have a day that is 0 and then the next day is 20.

You aren't going to have wind speed that goes from 0 to 100 miles per hour for an entire year at a wind farm so there is some fundamental stability built into the system in a way that is not for financial markets.

Colin: What are the factors that people need to know about this area to give them some insider knowledge?

Barney: There has always been some basic component of weather risk transfer in insurance as people would buy protection against low snowfall etc., but the weather market as we know it today came about with the growing popularity of energy trading in the late 1990s.

When you look at the trading of coal, natural gas, and power, people realised that this was really just being driven by the weather.

2.2 INTERVIEW

An introduction to weather risk as an ILS asset class



Barney SchaubleManaging Partner, Nephila Capital

25


You then had this development of a market, which initially started as weather derivatives where people would try and come up with a way to match each other’s exposure, which is where you come up with a standardised product that would be bought and sold through an exchange.

I was involved personally in some of those early transactions in my banking days and the idea made sense as there are a lot of companies out there with an exposure to weather. If you Google weather and earnings there are a shocking number of companies who either blame or credit a fluctuation in their earnings on the weather.

The idea of developing a risk transfer product to deal with that made sense.

I joined Nephila in 2004, having spent the prior part of my career largely in banking and thinking about risk management products. Our view as a firm was that if this market were going to grow then it wouldn’t be so much as an exchange-traded product.

This is because if we took someone who benefits from rain, like a hydroelectric facility, and someone who doesn't, like a nearby golf course, it is very unlikely that their exposure is exactly the same and that an exchange traded product is going to meet their requirements.

Our view was that this market would develop in a way which was similar to the catastrophe risk market meaning that you would want more customised coverage as a buyer, and as a seller you could assemble a portfolio of customised coverage and there would be investor interest in this idea of some 0 beta, positive return, natural statistically driven asset class.

This is what has happened over the course of the period that we started in 2005 in a dedicated fund for this product and it isn't particularly well known.

Part of this is that there is still a low level of awareness in most sectors about the availability of these tools, so we have spent a lot of time working with partners like KKR and Allianz as well as insurance brokers, banks and risk consultants, informing them that they should be aware that this is available.

We are letting them know that if there is a transportation, agricultural or renewable energy problem that is largely driven by the weather, they do have an alternative rather than saying that the weather was good or bad.

It isn't well known from either an investor or user standpoint right now but that is starting to change.

Part of what is changing this is the growing importance in renewable energy in a variety of power markets.

There is awareness that weather is driving earnings for companies and some sensitivity to that. The SEC and the Bank of England are asking for more information on the implication of weather or climate exposure to your company.

The message we are trying to get across is that there is a potential risk transfer solution for these kinds of exposures and if that results in an investable product, it may be of interest to investors.

Colin: Are these very long-term investments and are there tactical approaches to these types of risks or is this something that would factor into an existing product?

Barney: There are some periodic, climatic issues that you have to factor in and this is true for hurricane risk as well. An El Niño versus a La Niña year gives different implications for what you might see in terms of storm formation and that is something that we feel is important.

You may be operating a hydroelectric plant and you know that over a five year period, there will be at least one year where rainfall is going to be very low and you will have to go and buy power from somewhere else to supply it to your customers.

You don't know what year that is going to be and whether it will be driven by an El Niño or La Niña, but it is unexpected and you have a difficult time planning for it.

In this case you could say that you would like to buy protection over the course of the next 5 years for 1 or 2 of those years and you are willing to accept that when that happens, it costs you a certain amount of money and you are willing to pay from premium against that downside.

It is different than catastrophe risk as you are not saying a 1 in 100 year earthquake is going to impact me but rather a 1 in 10 year probability but you want to buy protection over the next 5 years.

This is a risk smoothing and risk transfer exercise that makes sense as you now have more predictable cash flows.

Where it doesn't work is where you may have a hydroelectric plant in a place where you know that when there is a La Niña there you get very low rainfall.

When you get in a situation like we are in today, where there is an increasing probability of moving into a La Niña at the end of 2016, and somebody calls up

“Part of what is changing this is the growing importance in renewable energy in a variety of power markets.”

26


looking to buy protection for 2016 that is where it doesn't work.

There are situations where that will drive more demand and if you look at the impact of El Niño over the course of the last year and a half, all around the world, it clearly drives people risk awareness.

There are however the issues where the cyclical nature or the ability to forecast means that it starts to become less of an insurable risk.

Colin: With the move toward more weather-sensitive renewable energy sources, do you think this sector will become more mainstream?

Barney: We think so because in the development of renewable energy for a long time period, you often have early issues that have to do with technology; are the turbines and solar panels going to work; what is the local regulatory regime; do people want this, etc.

20 years ago in the early days of the weather market, renewable energy was facing those types of issues. But

now many of those changes have been met or well understood and growth of renewable energy is continuing in a pretty dramatic way.

If you are in the renewable energy business, then you are effectively in the weather business.

If you are financing that business or thinking about the variable cash flows from that business, looking at weather risk transfer makes a ton of sense.

We have a meaningful history and experience in hydro, wind and solar so we do feel that this is going to cause a real demand in uptake from these sectors in these kinds of products.

This is one of the factors that is causing growth in the weather market and by extension growth in the opportunity to invest in weather.

We did six transactions last year protecting against wind in one form or another and that includes not just protection for people who own a wind farm and want the wind to be high, but also includes someone who competes

with the wind farm and wants the wind to be low.

If you are in Texas and are operating something that is not a wind farm, the pricing in that market is driven by the overall level of wind in the grid, so there are many other people who are exposed to the impact of that natural phenomenon.

If we sell protection to one English wind farm and 10 others say they want exactly the same sort of transaction, that is obviously going to lead to an opportunity for us to raise more capital and for investors to say that they can now invest in this portfolio of wind alone.

We feel that this is a huge driver of potential growth in this space.

Colin: Although you aren't in the business of infrastructure, do you have conversations with energy clients and firms about potential opportunity areas for growth?

Barney: Absolutely. Some of your readers are going to be pension funds that do invest in infrastructure and are looking for projects and although it is true that we aren't going to go build hydro plants ourselves, there are many people who will.

Where this can be helpful is when an investor decides they want to put capital into a new project, but they are concerned that although they are good at building a certain type of operation and can raise the finance to build it, if they don’t get the rain they need, they won't recover the cost of that investment.

“Absolutely. Some of your readers are going to be pension funds that do invest in infrastructure and are looking for projects and although it is true that we aren't going to go build hydro plants ourselves, there are many people who will.”

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We have seen this is even at a greenfield stage, where the sponsor of a new project wants to buy protection to de-risk their weather exposure, so that if they build a dam and don't get rainfall, they will get a payment in the interim to allow them to service the debt on the project.

This removes that fairly large risk factor and allows them to get the financing that they need and complete their project.

Colin: Looking to the broader ILS space, there is still a perception that it is too new or too under- tested for it to be a smart investment choice. How do you counter that perception?

Barney: It depends on your perspective: personally, I don’t think of ILS as a new market. I wrote my undergraduate thesis on the idea of a catastrophe bond in 1994.

I then worked on the first catastrophe bond, which was executed in 1996 and this bond ended up paying some claims to its sponsor, though it ultimately did make money for its investors. So 20 years have now passed since that landmark transaction.

Having been at Nephila in 2004, 2005 and 2011 and seen market testing both from natural catastrophe events and financial market events, on the one hand it is new in that many people are unfamiliar or not invested in it, but on the other hand it is not new at all when you compare to peer to peer lending.

It is new in that its penetration is not like credit where everyone owns equities and credit and has some commodity exposure.

As a firm we don't think of it as new and untested in that we feel that both through financial and environmental catastrophes, the asset class has done exactly what it was supposed to do.

I would say the same about weather. We set up a dedicated fund to invest in weather in 2005 and that fund has had years of good weather and not so good weather, investors have come and gone from it and people who buy protection have been paid or have not needed protection etc., but it is still something of which many investors

and companies are not aware.

It is new to many people as an asset class in that they haven't invested in it but in terms of concern about whether it will work properly or the legal or regulatory environment for it, or what happens when there is a loss, we feel that we can point to a lot of factors that would give both buyers and investors comfort.

A question might be whether it is a good investment for your underlying pension constituents, in terms of: do you feel that you can quantify the risk and return relative to other things?

We feel that this is the case as we can show the underlying exposures and a realistic range of probabilities of

payouts and individual contracts on the overall portfolio.

This relies upon some stable, natural systems. We feel that a portfolio of wind, temperature and rainfall contracts is more quantifiable than a portfolio of technology stocks in terms of what its potential behaviour might be.

From this standpoint, we feel that there is a risk and return that an investor can point to as a prudent investment and can get an understanding of the upside and downside and make a judgement accordingly.

It won't necessarily be for everybody, just like other parts of ILS, but you can at least make that determination.

A second question might be whether it is a good investment to make from an ESG standpoint.

This isn't about selling firearms to another country but helping to provide a risk transfer buffer to sensitive businesses.

To the extent that you are losing money, you aren't doing so because someone made a bad loan or sold something undesirable, but rather that your money is being transferred to someone who has been impacted by a weather exposure and needs this capital to weather that volatility in their business.

Unlike the global financial crisis where you may have ended up saying we invested in products that were built upon some questionable underlying risk metrics, with ILS and weather it can be about people losing their homes, businesses, buildings and some of the money goes to repay them and transfer that risk to you.

This is an outcome that feels on a fundamental level to be a prudent thing to invest in relative to some other investment opportunities that are out there.

“This relies upon some stable, natural systems. We feel that a portfolio of wind, temperature and rainfall contracts is more quantifiable than a portfolio of technology stocks in terms of what its potential behaviour might be.”

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It is a positive contribution to society in the same way that a pension fund itself is a risk buffer for society in providing businesses and individuals with another form of risk buffer.

It is a non zero sum type of investing and not something where you might have one stock and I have a view on the same stock and one of us will be right.

Colin: Thank you for sharing your views on this topic.

Contact us at [email protected] or Visit us at www.nephila.com

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Markets Change.Weather Changes.Nephila’s focus remains the same.

Nephila Capital Ltd is the largest and most experienced investment manager dedicated to reinsurance and weather risk. Nephila offers a broad range of investment products focusing on instruments such as insurance-linked securities, catastrophe bonds, insurance swaps, and weather derivatives. Nephila has assets under management of approximately $9.5 billion as of April 1 2016 and has been managing institutional assets in this space since it was founded in 1998. The firm has 150 employees globally based in Bermuda (headquarters), San Francisco, CA, Nashville, TN and London.

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THE DATA AND OPERATIONS CONUNDRUM

SECTION 3

How can managers confidently pick an investment strategy with the unpredictability of weather conditions, such as, for example, the El Nino effect?

3.1 ROUNDTABLE

Solvency II – fuelling growth of the insurance-linked investments market?3.2 WHITE PAPER

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Colin Browne: Is there sufficient historical and future weather data for it to be possible to make investment predictions with real confidence, or does unpredictability simply go with the territory?

Dan Bergman: The climate and weather system is huge, complicated and chaotic. After all, it encompasses the entire globe. We are of course humble to this fact. Nevertheless, climate science has made major advances over the past decades, as have numerical weather predictions; and, depending on the investment we consider, there are now more or less robust tools for risk assessment or prediction at our disposal.

I would like to make a comparison with investing in corporate bonds. As a pension fund we invest in corporate bonds in order to earn a return. Should the company default or be downgraded we may lose all or part of our investment. The question becomes how reliable is our best assessment of that default probability X? Even if we use our full machine for credit analysis including analysis of the company’s balance sheet, its industry and the economic cycle, I would argue that our best estimate of X often is associated with more uncertainty than a well-modelled climate or weather risk. After all, X depends on complex economic and political interactions in society.

When we invest in hurricane risk, for example, our risk assessment typically depends on the likelihood of a hurricane making landfall at different locations. There is a robust set of statistics available to assess that kind of risk. In the case of the Atlantic there is reliable landfall data available since the early 1900s, there is aircraft reconnaissance data since the Second World War, and since the late 1960s satellites track all tropical cyclones globally. Clearly we have robust data to build an analysis on.

Of course assessing other types of climate related risks can be more difficult; it all depends on the type of investment and where you look in the climate system, but in many cases you can do a good job.

Lorilee Medders: There is plentiful data on some types of weather like tropical storms and other types of adverse weather.

If we take tropical storms and hurricanes, there is plentiful historic data and we unfortunately expect even more future data in these areas, given increasing storm losses. The data help estimate future losses with a confidence level that is meaningful.

That being said, there is a large amount of unpredictability that still goes with the territory as that is the nature of models, so even with great historical

and future weather data we have a lot of room for improvement in the models and the data.

There can also be improvement in the assumptions modellers make around the data as inputs to the model. Still, even if we were to get all of the assumptions correct on the modelling side we still have a real amount of model uncertainty.

You will still have residual uncertainty in the model that goes with the territory and that is just the nature of modelling.

Overall we have plentiful data and the ability to keep improving assumptions that are made around that data to improve the models up to a point.

Joanna Syroka: There is plenty of information available to analyse and assess weather risks. I work for the African Risk Capacity, Africa’s parametric natural disaster sovereign risk pool. We have nearly 35 years of consistent historical data that we use to underpin our drought and tropical cyclone insurance products and are developing a parametric flood insurance model that will have over 25 years of consistent historical data across the continent. If we have enough data to design and underwrite our insurance programmes, it exists elsewhere.

3.1 ROUNDTABLE

Moderator


Panellists

Joanna SyrokaProgramme Director, African Risk Capacity

Dan BergmanHead of Investment Research/ILS, Tredje AP-fonden (AP3)

Lorilee MeddersDirector, Florida Catastrophic Storm Risk Management Center


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Of course weather is unpredictable, but that’s par for the course and the nature of taking risk. However, unlike some other markets, there is plenty of relevant information for investors and risk takers of all types to take a position on that risk and its uncertainty and therefore decide how they want to price it.

It’s a given that investors are comfortable with assessing the value and risk of traditional asset classes. But as Dan mentioned, the value of a stock, say, is made of many complex, man-made and diverse factors, which can sometimes lead to unexpected results. The climate system, whilst incredibly complex, has its physical bounds of variability – six standard deviation moves are not likely – and if you have 35 years of historical data to show you what has happened in the past, that’s a rich set of relevant data for the future, particularly if you are looking at annual weather risks.

Colin: How are climate and weather experts, and investment experts, working together to be able to create more clarity around this?

Lorilee: I work with the U.S. catastrophe loss modellers and these companies generally employ a number of full time experts in relevant areas like meteorology, atmospheric science, etc., some of whom disagree internally.

There is good input from experts going into the catastrophe models and there is enough disagreement so that they cautiously try to make improvements in the assumptions that they make around the modelling of the data.

One way they try to make improvements is by way of listening to different expert voices and taking in more than one opinion on what is happening that is moving the weather and climate patterns over time.

In terms of investment experts, typically there are a handful of companies who have people like

this in-house with the modellers. But there is increasing consulting and advisory work taking place across the investment and catastrophe modelling communities, to try to gain clarity around the issues of model uncertainty and residual uncertainty, as well as data and other input quality in the models.

In Florida, we have the Florida Commission on Hurricane Loss Projection Methodology, which frankly requires cross-information between people inside the modelling companies and the commission’s professional team. This communication is critical to be able to satisfy the commission that a model is using a reasonable process to arrive at modelled results.

The modelling companies also generally recognise it’s important to work with investment and insurance experts, as well as experts in other areas, to ensure client users are getting what they need from the models

but to also improve the data that the modellers receive from them.

Both voluntarily and on a required basis, we are seeing increased collaboration in getting at the right information between the modelling companies who have their own

meteorologists and climate experts and the investment and insurance communities.

Joanna: There is more and more collaboration between the research community and the practitioners, underpinned by the wealth of free information generated by Met Services and research centres such as NOAA and NASA. This information, albeit with some level of technical and quantitative skill, can be used by anyone with interest in analysing and assessing risk.

In parallel there is a growing number of specialist groups and companies being

“There is good input from experts going into the catastrophe models and there is enough disagreement so that they cautiously try to make improvements in the assumptions that they make around the modelling of the data.”

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set up to help those who either want to consider insurance-like products for their business or want to de-risk their investments. Lorilee was talking about very sophisticated modelling, but in many cases end-user clients simply need to know the basic things: where to get their hands on the right or best weather data and how to interpret that weather data to create a product or source of information that is relevant to them. There are many resources now for that kind of advice.

In the specific space I work in, emerging markets and developing economies, there has been an inflection point in the past year or so. This has been with countries and the international development and humanitarian community, who are now seriously considering risk financing products as tools for managing natural disaster risks. This bodes well for the future in terms of additional investments in better data, modelling, products and analytics to help a wide range of clients with their risk management needs. It will also mean more collaboration between experts across sectors. It’s an exciting time to be in this space.

Dan: I work for the Third National Swedish Pension Fund (AP3), a Swedish government agency, and we invest to secure the pensions and generate returns for the present and future pensioners of Sweden on a 50-year horizon. As an investor, we need to ensure that our investments are sustainable and that we generate robust returns regardless of the development of the broader climate system on that time horizon.

We therefore monitor the climate development and collaborate with different universities and institutions to assess climate change and how that may impact our investments, particularly our weather and climate related insurance investments. Generally speaking, the longer the time horizon of the investment, the more challenging the assessment of climate risk becomes. Since we need to assess the consequences of climate change on a 20 to 50 year horizon, issues such as slowly rising sea levels become important. We need to assess its potential impact on our real estate and infrastructure investments in different parts of the world. Such risks are in the more challenging end of the spectrum, moving partly into uncharted territory with perhaps more reliance on models and less on historically established climate norms.

I would ask a question to Lorilee, particularly regarding Florida: with sea levels rising do you work on such issues and try to understand and asses this kind of risk and if so, how do you do it?

Lorilee: In some places Florida is experiencing very fast sea level rise while in others it is happening so slowly (or arguably not at all) that we don't really see anything yet.

Also, differing models make different assumptions in how quickly and dangerously all of this sea level rise could happen.

In terms of what we can see right now, Miami is already experiencing sea level challenges, but the contentious nature of that visible evidence still leaves room for doubt as to causal influences

or correlations. Some seem confident that this is systematic sea level rise occurring in Miami, others think that it is a cyclical pattern of tidal behaviour, and still others connect the issues with other factors, or merely believe it is random. So even when we see it visibly, it can be difficult to determine what assumptions to use about what this is going to be like in the future when you have differences of opinion on what is actually causing it.

Such issues are complicated and easily politicised as they can impact economic and social perceptions in a big way.

Colin: Since factors such as El Niño and increasing climate change are still largely not fully understood, how can we build them into investment modelling?

Joanna: El Niños happen. They have happened in the past and will happen again in the future. In some areas they do have predictable consequences, in others sometimes more unpredictable consequences. However, coming back to my point earlier, there is plenty of historical information available to assess these kind of risks for the near future, the next 5-10 years ahead. i.e. weather that will be, to a certain extent, still governed by the same climate. These kind of weather phenomena, the known unknowns, have happened in the past and you can use that information to assess how they could affect your business in the future.

However looking at the longer-term horizon, of say 50 years, is when things become interesting as in many areas we really don't know what is going to happen. How specifically climate change will manifest itself, where, when and how, is uncertain for many geographic areas and weather risks.

While there is stronger modelling confidence of the future climate in some areas and for certain weather parameters, such as temperature, there is a lot less in others. In some regions of

“In some regions of Africa, as an example, climate models cover the whole range of possibilities when looking 50 years out, with some calling for more rain and some for less in the same geographic areas.”

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Africa, as an example, climate models cover the whole range of possibilities when looking 50 years out, with some calling for more rain and some for less in the same geographic areas.

This is a big challenge for the continent and anyone who wants to invest in new infrastructure and decisions regarding the required tolerances and resilience levels that need to be made. As a result many are taking a flexible and iterative approach to making such investments by considering designs or strategies that can be scaled up or down or easily modified as more information on the future climate emerges. This same approach underpins all leading climate risk management strategies irrespective of what you’re invested in or concerned with. Risk financing and insurance tools, to de-risk and to build financial flexibility to the greatest extent possible, are also part of building a comprehensive climate risk management portfolio. At the African Risk Capacity, for example, we are developing the Extreme Climate Facility, a risk financing mechanism to help our Member States develop iterative and pragmatic financial climate risk management approaches for climate adaptation. We hope it will be a tool that will help countries be more responsive to the unknown unknowns of weather and climate ahead: the things we don’t yet know that are going to happen.

Dan: The ENSO or El Nino/La Ninja cycle is well studied and you have statistics and data going back at least 50-60 years on its irregular but still repeating cycle. There is uncertainty in its development, but also an element of predictability on a 6 month or in some cases, even on a longer horizon. At the moment we have a weakening El Nino and the consensus forecast is that we have a close to 50 percent probability of transitioning into a La Ninja phase in August or September of this year.

So, there is an element of predictability, at least in this particular parameter, but

there is also a significant amount of uncertainty, which is not uncommon in financial markets. We work with and balance our investments to account for uncertain outcomes every day. When we invest in equities, for example, we require extra returns to compensate us for the associated uncertainty, and insurance and weather markets function in the same way.

Since, generally speaking, uncertainty grows with the time horizon, the challenge becomes larger for investments with a longer duration. Real estate and infrastructure are two examples where the investment horizon may be several decades, reaching well into the timescale of potentially severe climate change where the range of potential outcomes can be wide.

Lorilee: The further out in the future you are trying to predict, the less confident you are in your predictions. Even if it were something simpler and more straightforward than climate change, it is still more difficult to predict further in the future than it is for shorter time horizons.

The length of time itself that climate change may take to develop into potentially adverse outcomes makes the whole challenge much more uncertain.

Internal risk reduction is in large part about improving your knowledge of the risk to reduce the risk itself, both to you, and the entities in which you are interested.

One thing we are doing over the long horizon is continually trying to improve our knowledge, but because we can't realistically improve it perfectly or even close to perfectly, it is important to consider investing in stronger infrastructure as a worthwhile loss control measure, given the potential magnitude of adverse outcomes.

Also important is giving serious consideration to use of Insurance Linked Securities around those possibilities or other types of securities that are in some way related to potential losses due to climate change.

Mitigation, via internal risk reduction and physical risk reduction, is critical, as is collaboration between entities invested in these risks.

The investment community must concede the models do contain significant uncertainty and much disagreement in the area of climate change; the extent to which it is occurring, how quickly it is happening, how devastating the changes will be and over what period of time.

It is important for the investment community to not trust a sole model or 2-3 models but rather to insist that they have a variety of assumptions available to them and when possible, to have a variety of model components that they can choose from so that they can plug and play with different assumptions.

Utilising a component from models in which you have more confidence in a specific area, say the meteorology assumptions or engineering and vulnerability assumptions, etc., you can

“Real estate and infrastructure are two examples where the investment horizon may be several decades, reaching well into the timescale of potentially severe climate change where the range of potential outcomes can be wide.”

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combine those results to get a better idea of what you think could really happen.

Where you don't have confidence and don't have the expertise to know what your level of confidence is with different models, you can certainly request modellers to make different assumptions for you, the user, to see how that impacts the model results.

You can then price based on not just the modelled results you are getting but on the variability end result that is created by changes in climate change assumptions.

It is important to price in, although it is more complicated and expensive to do. If you are running the investment side of a pension fund, or work within a reinsurance environment, you don't want to take too liberal an interpretation of the data. Taking into account some very conservative interpretations of what data is available, and making conservative assumptions that assume more likely unfavourable outcomes, is important as a component to pricing.

Colin: Are there any further comments?

Dan: As a pension fund we need to ensure that our investments are sustainable and that we generate robust returns. We need to secure the pensions and generate returns regardless of the development of the climate over the coming 50 years.

It is therefore key to us to understand the uncertainty associated with climate change and the limitations of models. We certainly don't want to go with the most optimistic view of the risk but rather make an informed decision about what the true risk is and the range of uncertainty. We have found it helpful to use different models and different assumptions to stress the results. And, we collaborate with universities and research institutions to monitor the climate development and

improve our assessment of these types of risks. I must say that we are very fortunate in Sweden to have a strong tradition in meteorology and climate science. And on a pan-European level we have the European Centre for Medium Range Weather Forecasts (ECMWF), a global leader in numerical weather prediction and climate monitoring.

Joanna: There is a responsibility for everyone to carry out their own risk assessment and with the information on the weather side there is data to do that to the best extent possible.

Colin: Thank you all for sharing your thoughts on this subject.

“There is a responsibility for everyone to carry out their own risk assessment and with the information on the weather side there is data to do that to the best extent possible.”

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3.2 WHITE PAPER

Introduction

“Solvency II” introduces a set of new regulatory rules with regards to the capital requirements of licensed insurance and reinsurance companies. The new regime harmonises the regulatory capital requirements across the European Union and replaces the existing directives commonly referred to as “Solvency I”. The original plan was to introduce this new directive in 2008, however, not least as a result of the global financial market crisis, the European Commission decided to postpone the implementation and review the guidelines again. As of 1 January 2016, the new solvency regime has been put into force – yet, companies affected by the new directive, essentially insurance and reinsurance carriers domiciled in Europe, are allowed a grace period of several years to become fully compliant. Still, the implementation affects the insurance industry in many ways already now in 2016.

This white paper summarises the key elements of Solvency II (“S-II”) and assesses the impact on the insurance-linked investments market. We first provide some background as to the origins of the new regime, then explain the pillars making up Solvency II before moving on to describe the implications for insurers and reinsurers. Although the new solvency regime applies to both insurers and reinsurers, for the sake of simplicity, we use the term “insurer” throughout this report to mean both.

Background

“Solvency II introduces for the first time a harmonised, sound and robust prudential framework for insurance firms in the EU. It is based on the risk profile of each individual insurance company in order to promote comparability, transparency and competitiveness.” This is the official introductory statement of the European Commission (Memo/15/3120) on the directive. The aim of the new Solvency II Directive 2009/138/EC is to codify and harmonise the EU’s insurance regulation. The guideline replaces all existing (local) regulatory directives with one single, pan-European guideline. The key focus is on the amount of capital that regulated insurers must hold in order to mitigate the risk of insolvency. In essence, the new regime should create one harmonised insurance services market that enables EU companies to operate with one single license throughout all EU member countries. It does not come as a surprise

that a number of non-EU jurisdictions such as Bermuda and Switzerland have worked towards achieving a “Solvency II-equivalent” regulatory framework in order to access and be accepted within the pan-European insurance market.

The directive is often dubbed “Basel III for insurers” and indeed, S-II is somewhat similar to the banking regulation; this was also a key reason for the delay of S-II. During the financial markets crisis, the global financial regulators realised that Basel II may perhaps not properly address all of the risks banks are taking onto their balance sheets. In response to the credit crisis, the Basel Committee published revised global standards, which are commonly referred to as “Basel III”. When considering the revised Basel framework, the European Commission decided to also review the planned Solvency II framework for insurers, which resulted in an implementation delay. Interestingly, Switzerland had also reviewed the S-II draft between 2006 and 2010 but had then introduced their adaptation of S-II labeled “Swiss Solvency Test” (“SST”). Given that the SST aims to be equally rigorous and to (eventually) achieve S-II equivalence, the early introduction of the new guideline on 1 January 2011 has served Switzerland well. In anticipation of the S-II implementation in Europe, a number of international insurers and especially reinsurers have chosen to set up new licensed carriers in Switzerland in order to receive insights, gain experience and ultimately have a head-start on the implementation of the new solvency regime.

The three pillars of Solvency II: describing the framework

The new solvency regime is based on three building blocks referred to as the “Three Pillars of Solvency II”. All three segments must be fully met in order to receive and maintain the EU insurance license.

Solvency II – fuelling growth in the ILS market

Michael StahelPartner, LGT ILS Partners

Pillar 1 Quantitative requirements

� Measurement of assets, liabilities and capital

� Calculation of SCR (Solvency Capital Requirement)

� Standard formular or internal ERM (Enterprise risk model)

Pillar 3Disclosure andtransparency

� Detailed (public) disclosure requirements

� Regulatory reporting requirements

� Improved market discipline to facilitate comparison

Pillar 2Governance andsupervision

� Effective risk management system

� Own Risk & Solvency Assessment (ORSA)

� Supervisory review and intervention

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Pillar 1: Quantitative requirements: enterprise risk model

In Pillar 1, the insurer has to demonstrate adequate financial resources to meet its liabilities. This is the key section of the solvency requirement as it defines the amount of capital a company must hold. This part of S-II is all about calculations and models: the Solvency Capital Requirement (“SCR”) targets a capital base that satisfies all financial obligations within the next twelve months with a confidence interval of 99.5% (i.e. up to the 200-year return period). The Minimum Capital Requirement (“MCR”) defines the minimum level of capital the insurer must hold in order to cover all risks thereby putting a lot more emphasis on quantifying peak risks in any aspect of an insurer’s business: event, market, credit, duration, liquidity and operational risks. Were the company’s capital base to fall below this MCR threshold, the regulator may ultimately withdraw the license of the company. The basis for this pillar is the risk model: the insurer can opt to use its own Enterprise Risk Model (“ERM”) to determine capital requirements, or apply the “standard model” as per S-II guidelines. If the insurer chooses to employ the former, the regulator expects auditors to stress-test the model. Establishing and running a tailored ERM is costly and complex – as such, the regulator anticipates that only larger (mainly international) companies will use their own risk model.

Pillar 2: Qualitative requirements: governance & supervision

The second pillar is the most qualitative element of the solvency test: The insurer has to develop its Own Risk & Solvency Assessment (“ORSA”). Such ORSA defines the processes and procedures applied to identify, assess, manage and monitor all company risks in order to warrant that the insurer holds sufficient funds for meeting the solvency requirements (SCR / MCR). In essence, this pillar scrutinises the method used by the firm to ensure that the SCR is met at all times whilst executing on its business plan. This pillar includes the description of the applied risk management processes and is therefore the link between business operations (underwriting policies, reserving and paying claims, client service, etc.) and the quantitative assessment of the SCR (Pillar 1). The ORSA must assume a forward-looking perspective with a target window of 3 to 5 years; it should not be overly complex and should include both actual (current) risks as well as potential (future) risks. The methods can range from a simple stress test across a range of scenarios to more sophisticated economic capital modeling – always aligned with the size and complexity of the company (e.g. a regional, locally active “mutual” insurer vs. a large, globally active corporation). There is no standard ORSA available from the regulator; the European Commission expects companies to develop their own version (and the mere fact that insurers have to establish such a process manual is already considered to be a ‘test’). Thus, the development of the ORSA supports

the scrutiny of the regulator with regards to the ability of the insurer to assess, measure, plan and manage their business risks. This assessment forces insurers to properly determine their overall solvency needs for short- and long-term risks and hence represents a sensible control measure.

Pillar 3: Disclosure requirements: transparency & reporting

The third pillar focuses on disclosure requirements and reporting and, as such, requires insurers to produce a standardised (and hence comparable) financial report referred to as the Solvency & Financial Condition Report (“SFCR”). The simple aim of Pillar 3 is to improve market discipline and transparency by facilitating comparison.

How insurers can benefit from Solvency II

Based on our assessment, insurers can derive significant benefits from a best-in-class implementation of the new solvency regime. The main goal of any insurer is to reduce the regulatory capital requirement, thereby freeing up capital (equity or debt) which in turn improves the return on the (remaining) capital base.

The following three areas are crucial to realise such benefits:

• Improvement of diversification: First and foremost, the new solvency regime provides a strong incentive to maximise diversification across business lines. If a mono-line insurer (an insurer that only pursues one business activity, UK motor insurance for instance) expands its activity into a new, diversifying business line, the capital requirements for this new entity will be significantly lower than the sum of those two stand-alone entities. Of course, the overall improvement of diversification is to a certain degree restrained by many additional risk drivers such as market, credit and operational risks that the inclusion of a new business line adds to the former, stand-alone entity. Yet, expansion across different business lines will lead, all else being equal, to a significant reduction of the insurance risk capital, thus, resulting in a much lower solvency capital. Hence, there is a strong argument to be made for increased diversification of insurance risk. As a result, we expect to see a significant increase in M&A activity in the insurance sector, as companies try to merge with “diversifier” firms. This is expected to result in a release of capital that in turn should increase equity returns for shareholders.

• Optimisation of the asset base: Another key driver of the solvency capital calculation is asset risk and asset / liability management, traditionally a very important element of the business risk of an insurer. S-II further emphasises this as Pillar 1 imposes different capital requirements for all asset positions, dependent on their duration, (credit) quality, liquidity etc. This is

38


particularly important for insurers carrying long-term risks on their balance sheet (casualty, liability, life and health risks etc.). The much greater focus on asset risks within the new capital requirements (together with the currently very low “risk-free” returns) puts in essence a lot more emphasis on generating positive underwriting results for an insurance company rather than the latter relying on asset returns to “mask” sub-par underwriting performance. Thus, in the current market environment, an insurer needs even more skills to develop an asset allocation which yields an optimal balance between generating returns on the one hand and minimising capital requirements for such assets on the other hand. The S-II framework defines key considerations for insurers by assigning specific capital charges on different types of investments. Top quality government and corporate bonds carry a capital charge of zero or even negative values (0% to -10%, i.e. holding such bonds would free up capital), but currently such investment positions do not generate any performance (the performance may actually be negative). Higher-yielding asset classes such as emerging market debt, infrastructure and alternative investments carry higher capital charges (from 10% up to 90%), but are an attractive solution in order to generate returns required to fund current and future liabilities. Finding the optimum balance between low-return / low-capital charge assets and high-return / high-capital charge assets is key in order to free up an additional amount of solvency capital.

• Purchase of reinsurance: Further, a very significant improvement of the Solvency Capital Requirement (SCR) can be achieved through the purchase of reinsurance. This is certainly the most important aspect for insurance-linked investors: buying reinsurance transfers part of the insurer’s underwriting risks to a reinsurance provider. The Pillar 1 insurance risk modeling component assesses three risk drivers: premium risk, reserve risk and catastrophe (event) risk. Reinsurance very efficiently reduces all three of these elements at the same time and can generate the greatest leverage for an insurance company aiming to increase returns. Therefore, purchase of reinsurance has a very significant positive effect on the SCR. – If the reinsurance purchased is fully collateralised (i.e. the type of reinsurance protection offered by LGT ILS), the counterparty risk is substantially mitigated improving the benefit of such reinsurance even further.

Impact on the ILS market

ILS plays a key role in the implementation of Solvency II for the reinsurance purchase. Figure 2 exhibits the current market size of the global catastrophe reinsurance capacity and shows the development since 2012 and our estimate

with regards to market size in 2020. In the past, growth of the catastrophe risk reinsurance market has been largely driven by three factors:

• inflation (which results in higher values for building and in turn leads to higher exposures);

• construction activity in developed markets (more buildings in exposed areas such as Florida triggers increased demand for insurance capacity); and

• higher insurance penetration, i.e. consumers who have not purchased insurance protection in the past are entering the market; this is seen both in established markets as well as in developing areas (e.g. Turkey, China, South America).

The drivers for growth within the reinsurance market therefore were, to a large extent, linked to increased exposures in the primary insurance market (higher values, construction activity and higher insurance penetration). As described above, the purchase of reinsurance becomes an even more important part of an insurer’s capital optimisation strategy within Solvency II. Yet, buying reinsurance protection ultimately again adds risk to the model: counterparty (credit) exposure. This results in a negative effect on the credit risk charge leading to an again increased Solvency Capital Requirement. Therefore, in order to maximise the benefits of the reinsurance purchase, it is important for insurers to choose their reinsurance counterparty very diligently. Insurance-linked securities (ILS / cat bonds) and collateralised reinsurance (CRI) both present the insurer with a very attractive feature: as the reinsurance limit is fully collateralised, any (reinsurer) credit risk charges within the capital requirement are greatly reduced. As such, the most efficient and effective way to buy reinsurance protection within the Solvency II capital requirement is collateralised reinsurance.

As a result and based on the positive experience gained from the collateralised reinsurance market over the past years,

39


insurers are expected to continuously shift a greater share of the reinsurance purchase towards fully-collateralised transactions such as ILS and CRI as part of their “S-II strategy”. We estimate that the current market for collateralised protection will more than double in size, from a current USD 70bn to an estimated USD 160bn by 2020 – whilst the natural growth of the market for catastrophe reinsurance capacity is a modest 3% to 5% per annum. Based on this growth, the collateralised market will make up more than 30% of the overall catastrophe reinsurance market by 2020 compared to about 18% today.

Conclusion

Implementing a new solvency regime, M&A activity and consolidation, new technology, demand for improved corporate governance, increased focus on financial modeling and the expectations from equity investors for “improved corporate value”...: recent changes affect the core foundation of the insurance industry, very similar to what Basel II / III did to the banking industry. In our view, the new solvency regime will change the way insurance companies are assessing, evaluating and ultimately purchasing reinsurance capacity. In the future, the reinsurance buying process will be even further geared towards assessing the positive impact of the purchase on the solvency capital requirement – which requires rigorous modeling, testing and validating a transaction in order to determine its benefits. Reinsurance buying will become part of an overall solvency equation rather than a standalone “risk protection” task. The decision of what to buy and whom to buy from will be based on capital efficiency rather than subjective perceptions of value. And as collateralised reinsurance virtually removes credit risk from the reinsurance purchase, the market for ILS and CRI is expected to substantially grow in the years to come.

Solvency II Glossary

SCR Solvency Capital Requirement; defines the level of

risk-based capital an insurer must at least maintain in

order to meet regulatory capital requirements.

Pillar 1 First of three building blocks of Solvency II; deals with

quantitative (capital) requirements

Pillar 2 Second of three building blocks of Solvency II;

sets out the requirements with regards to risk

management and monitoring used to calculate the

SCR

Pillar 3 Third of three building blocks of Solvency II; describes

the reporting requirements towards the public /

market and the regulator

ERM / Enterprise risk model or internal model; describes the

choice of quantitative model applied by an insurer to

calculate the SCR; a core part of Pillar 1

Standard Model Standard model supplied by the regulator primarily

geared model towards smaller insurers to calculate

the SCR; core part of Pillar 1

ORSA Own Risk and Solvency Assessment; manual

describing the risk management process applied with

an insurer to quantify risks; core part of Pillar 2

SFCR Solvency and Financial Condition Report; defines the

public reporting requirements that must be published

annually by the insurer

MCR Minimum capital requirement; defines the minimum

threshold of capital required by an insurer to uphold

its license

Sources

1. The European Commission; “Fact Sheet Solvency II”; MEMO/15/3120, Brussels, 2015

2. KPMG ; “Solvency II – A closer look at the evolving process transforming the global

insurance industry”; London, 2011

internal model

ORSA

Leading the way in alternative investing

400+institutional investors

50+USD billion AuM

350+employees globally

10 offices worldwide

Pfaeffikon | New York | Dublin | London | Vaduz | Dubai | Beijing | Hong Kong | Tokyo | Sydney | [email protected] | www.lgtcp.com

LGT Capital Partners Ltd. is a leading alternative invest-ment specialist with over USD 50 billion in assets under management and more than 400 institutional clients in 35 countries. An international team of over 350 professionals is responsible for managing a wide range of investment pro-grams focusing on private markets, liquid alternatives, and

multi-asset class solutions. LGT Capital Partners is also one of the world's largest investment managers for insurance-linked investments. Headquartered in Pfaeffikon (SZ), Switzerland, the firm has offices in New York, Dublin, London, Vaduz, Dubai, Beijing, Hong Kong, Tokyo and Sydney.

41

THE GROWTH OF LIFE RISK IN THE ILS MARKETPLACE

SECTION 4

What opportunities does life risk offer investors in ILS to diversify in a new, but related way?

4.1 INTERVIEW

Is life ILS an emerging standalone asset class? Or is it forever consigned to being simply a convenient add-on to a broader ILS strategy?

4.2 WHITE PAPER

42

Colin Browne: Where do you expect growth to come from in the Life ILS space?

Javier Rivas: We have established strong relationships with reinsurers and brokers in order to transfer Life risks to our platform. On this basis, the assets under management in our Life ILS strategies have experienced a strong growth in the last 4 years and we have reasons to believe that this growth will persist going forward. There are three main areas of potential growth in our view:

Firstly, as a consequence of the new Solvency II regulations, many insurance companies in Europe are trying to find out how to optimise their risks and capital positions, which can result in a new wave of reinsurance transactions, in which Life ILS can participate. For instance, we currently see plenty of activity on the longevity side, and are working on opportunities in several countries, not just in the UK and Netherlands as the historically key markets.

Secondly, another important regulatory change has taken place in the U.S. recently in respect of the financing of the so-called redundant statutory reserves, or regulation Triple X. In the last few years investments in this area were not interesting to our investors due to the low return expectations. Now, the new regulations may allow us to take a slice of the risk that could offer more attractive returns. Considering the massive size of the U.S. market, this could provide sizeable investments for our Life strategies, and this is why we keep close to the developments in this area.

Finally, we have what we call our reinsurance platform, something special to Credit Suisse ILS proposition. It consists of a number of fronters and rated carriers, and the recent addition of a Lloyds syndicate. For the first time this year, one of these carriers will be able to write traditional Life reinsurance, adding one more important way to transfer Life risks to our platform, in addition to already existing ways like cat bonds, notes and swaps. This will allow us to enter certain transactions and retro pools that were not accessible to us before. My colleagues on the non-Life side have been doing this successfully for many years, so this means a new era for sourcing investments in Life risks.

For all these reasons, we see potential for our Life strategies to keep growing substantially.

Colin: But growth may be difficult in a low return environment, how do you deal with this and are investors still happy?

Javier: We need to see this in the context of what has happened to other asset classes. In some countries our investors are even experiencing negative rates, so that puts even more pressure on them to find alternative asset classes that provide attractive returns with low correlation to the rest of their investment portfolio.

Despite this overall downward trend, which also affects Life ILS, the feedback from a large number of our investors is that they are satisfied with this investment class, as the recent performance was better than most other alternative investments.

Our overall Life strategy is not positioned as looking for an aggressive return by entering very volatile investments. On the contrary, short-term covers such as pandemic risk are typically on a very risk remote basis, and other covers are trend type risks. All of them benefiting from the law of large numbers, as we reinsure big portfolios of Life insurance policies or even whole population index related.

Fortunately we may be already experiencing a reversal of the downward trend. In the last Life cat bond that was issued earlier this year, the final price ended up at the top of the initial price guiding range, and higher than last year’s same bond issuance.

Although this asset class has a low risk profile, we keep in mind that our investors look for a minimum absolute return. For this reason, we have started discussing with our reinsurance counterparties to potentially add slightly more risk transfer to the transactions in order to increase the return to our investors’ targets.

Long story short, despite the general downward return pressures, investor interest in this asset class keeps growing. The key challenge for growth at the moment is to originate sufficiently attractive investments to feed into the fund.

Colin: So what is the biggest challenge in originating Life deals for the platform?

Javier: The key differentiator of Life business compared to other types of reinsurance is that most of our

4.1 INTERVIEW

What opportunities does life risk offer investors in ILS to diversify in a new, but related way? Interviewer Interviewee


Javier RivasDirector of ILS, Credit Suisse

43

What opportunities does life risk offer investors in ILS to diversify in a new, but related way?

transactions involve quite complex structuring and are also very tailored to our counterparties’ needs. There is very little copy and paste, which means that some transactions can take months from origination to execution.

On the bright side, this is precisely what makes the Life side so exciting. There is lots of innovation in each reinsurance deal and I enjoy this aspect of developing new ideas, structured solutions and finding ways to connect the two ends. On one side, our reinsurance counter party capital relief and risk management needs and, on the other side, our investors needs in terms of risk, return and diversification.

Colin: So, how do you select a diversified portfolio?

Javier: To have an optimal diversification you need to have a large and regular flow of deals, and the Life business is generally not like this. We have a number of transactions per year but they typically come whenever one of our reinsurance counterparties needs a solution. This makes it challenging to balance the portfolio at all times to the level of diversification we intend to achieve.

With that constraint in mind, our approach is to develop portfolios that are diversified in terms of risks between mortality and longevity, as well as other Life risk classes like morbidity or value of in-force.

We also try to diversify the types of instruments, from more liquid cat bonds and notes to swaps or traditional quota shares and stop loss reinsurance treaties via our fronting structures. And finally we combine all this with a geographical spread of the risk.

Colin: ILS is typically seen as participating in short-medium term deals, while Life reinsurance is often about very long-term risks. How do you bridge that gap?

Javier: Most of our current investment portfolio has bonds, notes and swaps that are around 5 to 10 years duration, but some investments even much longer. We do like to complement shorter-term shock-type of reinsurance covers, like pandemic, with trends risks typical in long term deals.

Our Life strategy is meant to be a long-term investment but still our investors have certain liquidity requirements typical within commingled funds. Therefore we need to be able to unwind reinsurance transactions in certain situations that are not at our discretion. We continue working with our reinsurance counterparties on exploring possibilities around exit options and recapture provisions that allow us to participate in very long term risks.

Colin: I understand you joined the Credit Suisse ILS team last year to lead the growth on the Life space, does this represent a new business area for Credit Suisse?

Javier: Credit Suisse’s ILS team started its dedicated Life strategy in 2009, so there are a number of people in the team here who have substantial experience. And even years before that, the Credit Suisse ILS team was familiar with Life investments that were included within our non-life focused portfolios. The rationale of introducing a Life specific strategy was to allow our investors to make their own decision about the allocation between Life and non-Life.

Colin: What is the understanding from the investor community around this topic and is it still an area that requires a lot of education?

Javier: Some investors are in the early stages of understanding all the details but in general by the time they decide to invest in this space they will have had several learning sessions with us. They get to see the history and the stability of the returns and understand the risks well. In any case, as they are involved in this risk class over a longer period of time, the knowledge and comfort level definitely improves. Many institutional investors start with a relatively small participation and then grow it year by year.

Other investors have been with us for many years, receiving regular updates and detailed commentary on the performance of our fund, so they have developed a good understanding of our Life reinsurance return and risk drivers. And we also listen to them regularly to make sure the risk return and diversification profile stays in line with their expectations.

Colin: Thank you for sharing your thoughts on this topic.

“With that constraint in mind, our approach is to develop portfolios that are diversified in terms of risks between mortality and longevity, as well as other Life risk classes like morbidity or value of in-force.”

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4.2 WHITE PAPER

1) What are life insurance linked securities?

Life insurance linked securities (Life ILS) are structured life reinsurance solutions packaged in investible form for capital markets investors. In this article we argue that Life ILS are a bona fide alternative fixed income asset class, given features such as long-dated cashflows and low correlation with other asset classes. These characteristics differ substantially from more common forms of ILS, such as cat bonds, which cover natural catastrophe risks and other non-life ILS. Furthermore, due to increasing demand in the life insurance industry, we expect Life ILS will develop into a more mature asset class over the coming years.

2) The Life ILS universe

The main types of life ILS are:

• Value of in-force (VIF) business transactions are primarily financing solutions based on the economic value (profit) embedded within a portfolio of life insurance policies. Risk-transfer can also play a prominent role in these transactions, depending on the structure adopted. Reserves financing is a specific form of VIF transaction, widely used in the life insurance market in the US in relation to term assurance (typically referred to as “XXX” transactions) and secondary guarantees (“AXXX” transactions).

• Mortality transactions involve transferring the risk of policyholders living shorter lives than expected. Transactions can target extreme mortality exposure (e.g. pandemic), longer-term mortality trend risk, or shorter-term volatility in the number of death claims.

• Secondary annuities, a subset of the mortality risk sub-class, are an emerging area in the UK that will involve annuitants trading their policies on a secondary market which is expected to launch in April 2017. Investors in these transactions will be exposed to mortality risk, as their principal is at risk in the event of the early death of the original policyholder.

• Morbidity transactions involve transferring the risk of claims for illness, disability or medical costs. Transactions might target extreme events or claims volatility.

• Lapse transactions involve transferring the financial risk that an insurer faces if higher than expected numbers of policyholders cancel their policies and/or discontinue their premium payments. Lapse trades are motivated by a need to transfer risk and/or raise capital.

• Longevity transactions involve transferring the longevity risk within a pension fund or annuity contract that pensioners or annuitants live longer than expected.

• Life settlements, a subset of the longevity risk sub-class, is a secondary market in the US that involves buying life insurance contracts that have been sold by the original policyholders.

Figure 1 illustrates the relationships between the various types of life ILS1.

The focus of our Life ILS strategy at present is VIF transactions, cost-efficient alternative capital solutions (e.g. for lapse risk) and transfer of mortality or morbidity risk. While some Life ILS managers have focused on life settlements or longevity, these risks do not currently form a part of our strategy.

In the following sections we describe the value of a Life ILS strategy in absolute terms, as well as underlining the fundamental contrasts with non-life ILS.

Is Life ILS an emerging standalone asset class? Or is it forever consigned to being simply a convenient add-on to a broader ILS strategy?

Scott MitchellHead of Life ILS, Schroders

1. Structured settlements - personal injury claims that are settled via ongoing annuity payments

rather than a lump sum - might also be considered here, although these remain outside our focus

area

45

Is life ILS an emerging standalone asset class? Or is it forever consigned to being simply a convenient add-on to a broader ILS strategy?

3) What does Life ILS bring to an investor?

As most Life ILS are fixed income-type transactions with medium to long durations, this asset class can be a good match for long-term fixed liabilities such as defined benefit pension liabilities or annuities. In particular, amortising assets such as VIF generate substantial cash-flows over a medium to long period which are fairly predictable. Life ILS also offer compelling risk-adjusted returns, in part due to their long-dated, illiquid, cash flows. While the illiquid nature of such assets requires a long-term commitment from investors, attractive liquidity premiums should offer more than adequate compensation at current yields. Given these characteristics, pension funds and other long horizon “buy and hold” investors might consider this more of an opportunity than a problem.

Most life ILS trades are highly structured and bespoke as a result of being designed to meet a sponsor’s specific objectives, which might relate to liquidity management, risk transfer and/or capital management. The risk profile of each trade depends on the combination of the underlying block of life insurance policies and the transaction structure. An understanding of the risk profile therefore requires intimate familiarity with life insurance products, biometric risk and structured life solutions. These attributes mean that a Life ILS investor will need to have access to a specialised set of skills and infrastructure to enable and support a robust investment process. Ultimately, the need for product, actuarial and origination/structuring expertise forms a barrier to entry into Life ILS for many managers and is a principal reason why there are relatively few Life ILS managers.

A minority of Life ILS transactions, such as extreme mortality/pandemic bonds, are tradable and therefore more standardised. These are simpler to understand and tend to be issued with an independent risk analysis. Such standardised transactions can bring several benefits to the issuer, such as scale and competitive pricing, which might be difficult to achieve on a private trade. Although these transactions are more accessible to investors than private deals, and might appeal to a more active ILS investor, they represent but a small and rather low-yielding segment of the Life ILS market.

Investing in Life ILS is better suited to a longer term investment strategy. Any investor who has dedicated the time and effort necessary for understanding the asset class will have done so in order to benefit from its performance over the long term.

4) Comparison with more common forms of ILS

With the exception of mortality and morbidity cat bonds, Life ILS transactions are typically driven by portfolio- specific risk drivers. This contrasts with the event-driven nature of non-life ILS. So, where ILS investors will have a good sense

of how the occurrence of a catastrophic earthquake or hurricane can act as a switch in the performance of a cat bond, Life ILS investors must have a thorough understanding of the underlying performance drivers of a portfolio of life insurance policies. The primary drivers are typically lapse risk, with policyholder behaviour potentially playing a role, and mortality risk, but can also include the other risks in the Life ILS universe discussed under 2 above. The portfolio-driven nature of life ILS leads to differences in the evaluation of risk in a transaction. Risk modelling for Life ILS transactions is usually undertaken through stress and scenario analysis, rather than distribution-based modelling.

5) Will Life ILS become a standalone asset class?

Life ILS can bring genuine and unique value to pension funds and other institutional, long-term investors seeking longer-dated, regular cash-flows. So what is the likelihood of Life ILS maturing into an asset class sizeable enough to catch and hold the attention of sophisticated alternatives investors? As long as there is substantial insurer and reinsurer demand for structured solutions, Life ILS investors will see a steady – and probably growing – deal flow. Risk-based regulatory regimes, such as Solvency II, are a true game-changer for the industry and force an economic view of risk, value and capital on the part of potential Life ILS sponsors. This in turn increases the focus on risk and capital solutions that can help to manage risk and/or enhance capital management. As insurer and reinsurer demand for structured solutions increases over the coming years, we believe the prospects for Life ILS investors are bright. Investors who have the access to the necessary skills and infrastructure are well- positioned to capitalise on the opportunities that will arise.

“As long as there is substantial insurer and reinsurer demand for structured solutions, Life ILS investors will see a steady – and probably growing – deal flow.”

46

EDUCATING THE MARKET AND CREATING TRANSPARENCY

SECTION 5

Since aspects of ILS including pricing structures are non-traditional, how do we overcome the challenge of gaining trustee and stakeholder buy-in?

5.1 EXPERT DEBATE

The growing challenges of asset valuation for insurance-linked securities funds5.2 WHITE PAPER

47

Colin Browne: Do pricing structures for ILS play a major or minor role in investment planning?

John Doak: This is an interesting question. As a regulator, I am looking first and foremost at whether the insurers operating in my state have access to the capital necessary to pay claims, and particularly in the event of a catastrophe.

Catastrophes are par for the course in my state. Last year, Oklahoma suffered four weather events that made it onto the National Oceanic and Atmospheric Administration’s (NOAA) billion-dollar disasters list, a list my state has been on every year since 2006. As the dominant form of ILS, catastrophe bonds are a critical piece of the financial tapestry that allows insurers to remain solvent and successful. As such, it is important that ILS markets appeal to a broad range of global investors, large and small.

This decade has been marked with global economic difficulties, and investors are always looking for opportunities to increase yield and diversify the risks that we are facing. The strong history of the success of ILS issuances and the rarity of loss of principal to investors has been a key driver of the growth seen in the ILS markets over the last 5 years. And although it appears from reports that 2015 saw a slowing in ILS issuances, the record-setting growth we just saw in the first quarter of 2016 is much more in line with recent trends.

We will see next quarter if this is an anomaly or a continuation of a trend, as the renewal period begins.

However, knowing the important role earthquake insurance is having in the broader insurance conversation in my own state, this quarter has emphasised the ability of the ILS market to address emerging issues, as several issuances covering US earthquakes have already been issued this year.

As competition in the alternative capital market continues, I believe the value proposition of the investment and the level of diversification obtained, particularly within large portfolios, will continue to be key drivers.

If trends within the ILS markets continue, pricing structures will be an important consideration among many to institutional investors in determining the value of taking on ILS investments.

Hemal Naran: As an allocator to various investment strategies, the pricing structure of ILS is a major factor when determining the relative attractiveness of the asset class against other available investment opportunities. The same will apply when investing in different ILS instruments.

As an institutional investor, we want to exploit the widest possible range of risk premia, when they exist, and in the case of ILS, we want to be rewarded in the form of an insurance risk premium for taking on insurance related risks i.e. fee for protection. Our base case is to provide capital in return for our capital back, a cash or risk free return and a risk premium. The quantum of this risk premium will depend on the pricing structure of the various ILS instruments.

There have been and will be moments when existing insurers’and re-insurers’ balance sheet approach may not be optimal for parts of the insurance business. An example would be low frequency but high severity catastrophe events, which may be better suited to be shared across large pools of capital such as pension funds and other long term investors.

More recently, regulatory and rating considerations have also prompted the outsourcing of risk by traditional players in the space.This has led to some higher expected returns in the ILS space as they are prepared to pay over the top to insure their extreme losses in order to manage their capital allocations efficiently.

The liquidity offered by the secondary market in ILS is likely overestimated or non- existent, which makes the pricing structure even more critical in considering ILS from an institutional investment perspective, as one cannot easily exit one's position.

Finally, ILS are uncorrelated with traditional investment portfolios of stocks and fixed income because their returns are determined by geological or meteorological phenomena rather than economic activity. It has also been noted that natural disasters or catastrophes do not cause negative market reactions and hence adding ILS to the traditional asset mix has been beneficial to those that have invested in the asset class.

Colin: Is it viable and is it desirable to establish a uniform procedure for transaction and deal pricing in this

5.1 EXPERT DEBATE

Moderator

Since aspects of ILS including pricing structures are non-traditional, how do we overcome the challenge of gaining trustee and stakeholder buy-in?

Panellists


Hemal NaranFormer Head, Government Employees Pension Fund, South Africa

John DoakCommissioner, Oklahoma Insurance Department

48

Since aspects of ILS including pricing structures are non- traditional, how do we overcome the challenge of gaining trustee and stakeholder buy-in?

space, in order to satisfy investors and stakeholders?

John: It is rare that industry comes to me in my regulatory capacity and asks to be regulated further, but it does happen at times and there can be good reasons to do it. However, when I am looking at a need for additional regulatory involvement in ongoing free market activities, I want to know what harms are coming to the consumers I protect and what the costs and impacts will be to all of the participants in the market. It’s highly debatable whether investors and stakeholders would ultimately be satisfied by being bound to uniform procedures and pricing.

ILS products have been operating successfully for so many years because of the rapid, innovative way they were created and their ability to adapt to the demands and needs of an ever-evolving, often cyclical financial industry. I believe that when a market wants to find uniformity in its operation, you will see key indications of that in the transactions occurring, with demand and pricing favoritism to those options that begin to align in procedure and price. Once those indications are identified, they can be most quickly acted upon by the players in that market itself, without a need to require further uniform constraints. And in the same way, as innovation and flexibility are needed to address emergent issues, investors and issuers will be rewarded for taking on those challenges.

Hemal: I do not believe that one should adopt a uniform procedure in the ILS space. For many years, the common theme was that ILS paid more handsomely than traditional insurance and that this extra premium was justified. Investors broadly were pleased with ILS performance with positive returns, some liquidity and low correlation with traditional markets.

The ILS space is also diverse and evolving and on a risk-adjusted basis, returns vary significantly over time due

to market inefficiencies and the supply and demand of risk capital. Studying the size and the growth rate of the ILS market, as well as pricing based on long-term modelling and short-term phenomena, will determine the expected returns and risk levels. These will vary from year to year.

Couple this with the fact that expert and experienced sourcing is key in building an effective re-insurance portfolio, including the understanding of complex accounting policies and risk assessment, and one can’t simply adopt the buy and hold strategy, that may work in other areas of investment.

As an institutional investor, we would like to hold a diversified portfolio of ILS, from equity-like positions in collaterised re-insurance arrangements to bond-like positions in cat bonds, thereby reducing any concentration in the ILS market, within large peril regions and also by counterparty.

Ultimately, we are aiming to profit by helping the insurance industry shed concentration risk and don’t want to end up concentrated ourselves.

Overall, traditional re-insurance or collateralised re-insurance has an advantage over, for example, cat bonds in that pricing is less stale as contracts are usually renewed on an annual basis. This compares to cat bonds that may be multi-year and issued at low rates in a low premium environment. In addition, rate rises in the re-insurance market are more predictable and adjust to uncertainties about risk and changes in supply and demand compared to cat bond markets where rates are harder to forecast.

Ultimately, the price level only makes sense if we are able to earn a respectable return for the level of risk taken relative to other opportunities or dislocations at that point in time.

In conclusion, I believe in a holistic yet active/opportunistic approach to investing in ILS because it is a diverse, evolving space where risk-adjusted returns for different areas vary significantly over time due to the inefficiencies mentioned above.

Colin: 20 years ago, Lane and Finn depicted the right price for an insurance risk as one “where the perfume of the premium overcomes the pong of the peril”. What are the challenges to that thinking for ILS investments?

John: I believe that the first consideration is an individual’s risk appetite, which cuts to the heart of this way of thinking. When taken as a risk-by-risk or investment-by- investment decision, this manner of analysis can work. But as investors consider the role ILS investments can play in a well-diversified portfolio, the conversation has to change.

I am an insurance commissioner now, but I have held many different roles in the insurance industry during my career, starting with selling policies. I understand the process consumers and producers go through when they are setting up an insurance program to protect themselves and their families. And through my positions as an executive in the insurance industry, I also understand the importance of managing those premiums and

“Studying the size and the growth rate of the ILS market, as well as pricing based on long-term modelling and short-term phenomena, will determine the expected returns and risk levels.”

49

Since aspects of ILS including pricing structures are non- traditional, how do we overcome the challenge of gaining trustee and stakeholder buy-in?

diversifying through smart, solid investments.

ILS investments allow investors to approach their financial structure from a different direction from a different perspective than other types of investments, allowing for major benefits for the investors and the issuers. The key is filling the holes in the investor’s current portfolio in a way that makes the whole bush smell better, not merely adding another layer of complexity.

Hemal: Our approach will be to invest in the best risk-adjusted transactions available in the market across peril, region and instruments available such as cat bonds, industry loss warranties or traditional re-insurance.

A key measure we use for investment decisions is the profit margin per risk, added to the portfolio by any transaction that asks for a new position, to improve the profitability of the existing portfolio.

This essentially means that diversifying positions can be accepted at comparably lower yields while peak risks, such as U.S. hurricane risks, have to carry a disproportionately higher yield in order to qualify for inclusion in the portfolio.

Diversification of an ILS portfolio may mean forgoing some of the yield offered by concentrated risks and makes sense if it results in a meaningful reduction in tail risk. However, defining tail risk for ILS is difficult and it will depend on whom you ask. It will also change over time.

The sustained growth of the ILS market has led to an increase in the number of protection buyers, new instruments to transfer risk, a dedicated investor base from outside the insurance sector, and more sophisticated and widely available modelling and rating for ILS. This new ILS landscape poses investors with new opportunities and challenges.

Colin: Thank you both for sharing your views on this topic.

“The key is filling the holes in the investor’s current portfolio in a way that makes the whole bush smell better, not merely adding another layer of complexity.”

50

5.2 WHITE PAPER

Introduction

Sometimes, the most fruitful seeds of innovation are sown on familiar ground. This has been the case for insurance- linked securities (ILS) funds, whose growth in recent years has primarily been driven not by an increase in securities- form instruments such as catastrophe bonds, but instead by private transactions that often closely resemble the traditional reinsurance market.

This expansion of collateralised reinsurance and other private risk-taking structures (such as Lloyd's syndicates and fund-sponsored reinsurers) enables funds to underwrite a much broader range of risks and access higher returns, but it also poses a set of new challenges. One such challenge is the valuation of these generally illiquid instruments.

Valuation is important in any alternative asset class, but is a particular challenge for private reinsurance deals. Such deals are predominately “mark-to-model” as compared with “mark-to-market” instruments such as catastrophe bonds. In addition, the customisable nature of reinsurance contracts can lead to deal structures that significantly increase the complexity of the valuation process.

Given the key role that reinsurance now plays in ILS portfolios, funds without an appropriate valuation methodology risk producing estimates of net asset value that differ from what a third party might consider a market-consistent value (e.g., the price estimated for an arm's-length transaction such as a commutation of a contract). If these differences are material, then the parity between a fund’s outgoing and incoming investors is imperiled, opening the fund up to significant potential liability. On the contrary, funds with a robust methodology will protect themselves against the potential of “investor arbitrage” and enhance their operational stability, particularly in loss-impacted scenarios.

In this paper, we consider three challenges that funds face in valuing their portfolios of private reinsurance deals.

Seasonality of risk

Many ILS instruments cover perils that are seasonal in nature. For catastrophe bonds, tranches covering seasonal perils typically see cyclical increases and decreases in their prices

on the secondary market, in order to align “earning” of the risk premium on the deal with the periods of time in which the greatest risk is present (e.g., July through October for U.S. hurricane).

Secondary trading does not exist for most private contracts, meaning that there is no convenient mark-to-market price to reflect risk seasonality. In addition, the cash flows on reinsurance deals are not generally seasonally adjusted. Funds are more likely to receive a single premium at the beginning of a deal, or equally weighted premiums at intervals throughout the length of a contract period.

As such, funds that wish to value their private reinsurance contracts consistently with their mark-to-market instruments must incorporate seasonality into their mark-to-model processes. In theory, this should not be difficult: Modelling done during the underwriting process often produces seasonally weighted outputs that can be used to set the premium earning pattern.

In practice, certain complex private deals may contain a blend of over a dozen perils across both property and specialty lines of business. In addition, some of these may be “non-modelled risks” for which supplemental models are needed to estimate an earning pattern. Obtaining an individualised earning pattern for each deal of this type requires substantial modeling resources and a nuanced understanding of the underlying risk covered by the transaction.

Risks-attaching contracts

A second valuation challenge associated with the growth of private reinsurance is the increased role of “risks-attaching,” also called “risks attaching during” (RAD) contracts—most commonly on quota shares, where an ILS fund will take a proportional share of an entire book of business written by a cedent.

In a traditional “losses occurring” transaction, an investor is subject to loss events that occur during a predetermined period of coverage (say, from January 1 to December 31 of a single calendar year). By contrast, an investor in a risks- attaching contract is instead responsible for a share of losses on all policies written by a cedent during a predetermined

The growing challenges of asset valuation for insurance-linked securities funds

Aaron C. KochDirector ILS Group, P&C Division / Milliman

51

The growing challenges of asset valuation for insurance-linked securities funds

period, whenever those losses may occur throughout the term of the policy.

A risks-attaching contract makes the valuation process more complicated in two ways. First, it extends the effective risk period: The investor is responsible for losses after the contract’s “expiration date,” as long as the loss is covered by a policy written during the contract period. As a result, the valuation process must extend the period during which contract premium is earned past the contract’s expiration date, in order to avoid an acceleration of profit while the contract is still actually “on-risk.”

Second, the earning pattern on a risks-attaching contract is highly dependent on:

• When the contracts in the underlying book of business are written

• The type of contracts written

For example, a cedent may enter into a number of European catastrophe contracts in January, but then write primarily Japanese business in April—each of which has a very different risk seasonality. As a result, an appropriate valuation process for risks-attaching contracts combines modeling of both the covered perils and the policy terms of the underlying contracts protecting those perils.

Accrual of IBNR reserves

While these first two topics discuss exposure-based recognition of premium income, the other side to the valuation of reinsurance contracts is recognition of the occurrence of losses. For most catastrophe bonds, it is relatively simple to know whether or not a loss has occurred that threatens the instrument, as the attachment point is usually set to exclude all but the most severe events (as we refer to them, “CNN Events”). When such an event occurs, the bond is usually marked down on the secondary market in anticipation of the potential loss.

Private reinsurance deals are often triggered by more than just CNN Events. For instance, private reinsurance deals may include the following:

• Contracts with smaller insurers who may suffer a relatively sizeable loss from a single “localized catastrophe” such as a convective storm or regional flooding

• Contracts that are subject to an aggregation of localized catastrophes, instead of a single major catastrophe

• Quota share contracts that are nearly guaranteed to have some accumulation of losses throughout the course of the policy period

As such, funds must consider whether they need to begin systematically accruing loss on their private reinsurance deals as soon as premium is earned and before a known loss event is reported. In short, the fund must decide whether or not to accrue incurred-but-not-reported (IBNR) loss reserves. The purpose of an IBNR reserve accrual is to account for the lag between the occurrence of an insurance loss event and when it is reported to the reinsurer (in this case, the ILS fund).

In each of the scenarios discussed above, a significant potential for “unreported loss” at any given point in time necessitates the inclusion of an IBNR provision in the valuation of the contract. Analogous to premium recognition, losses must be recognised in proportion to the level of risk exposure on the contract at a given point. The value of unreported losses is then adjusted over time, using actuarial techniques that are common in the traditional reinsurance reserving process. Without the use of IBNR, a fund risks over-accruing profit in the early part of a contract, only to then recognise a greater proportion of the loss later on—providing an inconsistent valuation over time.

Conclusion

With the significant recent growth in the use of private transactions such as collateralised reinsurance, ILS funds are beginning to hold portfolios that look increasingly like those of traditional reinsurers. While this provides a range of new opportunities to astute fund managers, it also brings a range of new operational challenges that have generally been associated more with the traditional reinsurance market. One of the most important new considerations is the additional complexity that private deals bring to the valuation process.

There has been very little published to date on best practices for illiquid ILS asset valuation, but this will change as the complexity of ILS portfolios (and operational risk to funds) continues to increase. In the traditional reinsurance market, premium earning and loss reserving practices can represent an important differentiating advantage—or shortcoming— for companies. We are quickly reaching a stage where the same is becoming true for ILS funds, a sign of the continuing development of the alternative capital market.

“As such, funds must consider whether they need to begin systematically accruing loss on their private reinsurance deals as soon as premium is earned and before a known loss event is reported.”

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