Insurance-Linked Securities (ILS) as an investment Asset Class

Catastrophe bonds, also known by their abbreviation as CAT bonds, fall into the broader cate-gory of Insurance Linked Securities (ILS), which are financial instruments that transfer certain types of insurance risk from the insurance to the capital markets, where the risk is spread among investors.

Recently the buyers’ club widened with government agencies becoming, with increasing fre-quency, sponsors of CAT bonds for the purpose of emergency relief and reconstruction access to protect against events of a devastating scale. These initiatives have considerable support from the World Bank and UN, who see them as an important protection gap solution at the macro level.

There are three main types of ILS: CAT bonds, Industry Loss Warranties (ILW) and Collateral-ized reinsurance. Among these, CAT Bonds are the only liquid financial instruments that are se-curitized and traded on a secondary market; ILWs and collateralized reinsurance are annual pri-vate contract transactions.

CAT BONDS INDUSTRY LOSS WARRANTIES COLLATERALISED REINSURANCE

Description «Securities structured as floating rate notes that transfer insurance risks tied to natural events and extreme mortality or morbidity to capital markets»

Contracts based on the total industry loss for a given event, paying off when the total loss exceeds a predetermined amount

Privately structured customized transac-tions enabling investors to gain exposure to the traditional reinsurance market

Return profile Money market return plus spreads of 3% to 20%, with most issuance in the range of 5% to 10%

Money market return on collateral plus spreads of 5% to 40%, with most transactions occurring in the 10% to 15% range

Money market return on collateral plus spreads of 5% to 40%, with most transac -tions occurring in the 10% to 25% range

Maturity Typically 3 years Typically 6 or 12 month Typically 12 month

Liquidity Active secondary market Limited secondary market No organized secondary market

Avg. Transaction USD 150 million USD 10 million USD 5 to 200 million

Min Investment USD 250,000 USD 2 to 3 million USD 5 million

Market volume USD 25 to 30 billion USD 3 to 15 billion USD 30 to 35 billion

Private transactions

Source: Aon Benfield, LOIM, Q2 2015.

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Cat bonds return on investment is tied to the occurrence of predefined large catastrophic events, such as earthquakes, hurricanes, or floods. If nothing happens, the investor receives a floating coupon plus the principal at the bond maturity. Conversely, if the event specified in the contract occurs, the investor incurs a partial or total loss of principal depending on the scale of the catastrophic event or the losses caused by it. That is where market and analytical tools, management experience and quality investment strategies are the key to success.

Cat bonds, as a class of investment, offer stable high-yield fixed income returns independent from macroeconomic risks and cycles and widely perceived by institutional investors, especially hedge & pension funds as an ideal portfolio diversifier. For example, even before natural yields increase following Q3 2017 losses, almost 1/4 of pension funds consider ILS investments with average of AuM 1-4% allocations. By clicking here you may find some selection of news with in-dividual references.

Portfolios of ILS investments represent a carefully selected and balanced range of exposures.

Over the last 15 years, CAT Bonds have yielded very steady returns, only suffering mild volatil-ity, also during difficult market conditions such as the occurrence of hurricanes and earth-quakes. As shown below, these steady returns have so far translated in a risk-adjusted perfor-mance (measured by the Sharpe ratio) that is superior to that of bonds, equities or commodi-ties. The annualized return over the observed period is also higher than that offered by the other traditional asset classes whilst the annualized volatility is by far lower.

ANNUALISED RETURN ANNUALISED VOLATILITY SHARPE RATIO

CAT Bonds 8.1% 2.8% 2.18Equities 5.6% 15.6% 0.32Bonds 5.4% 6.8% 0.56Commodities -2.0% 23.7% N/A

Source: Bloomberg. Observation period: 1 January 2002 to 31 March 2016. CAT Bonds: Swiss Re CAT Bond Index.Equities: MSCI World Total Return Index (Net). Bonds: Citigroup World Government Bond Total Return Index.

Commodities: S&P GSCI Total Return Index. For illustrative purposes. Past figures are not a guarantee of future results.

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CAT Bonds

Equities

Bonds

Commodities

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CAT bonds returns are related to factors such as meteorology, geology or engineering and, as such, they are unrelated to the economic cycle. As a result of that, CAT Bonds as shown in the table below sport a very low correlation to other traditional asset classes (i.e. equities, bonds and commodities) thereby bring to the investor's portfolio a high degree of diversification.

CAT BONDS EQUITIES BONDS COMMODITIES

CAT Bonds 1.00

Equities 0.19 1.00

Bonds 0.12 0.17 1.00

Commodities 0.13 0.48 0.31 1.00

Source: Bloomberg. Observation period: 31 December 2001 to 30 October 2015. CAT Bonds: Swiss Re CAT Bond Index,Equities: MSCI World Total Return Index (Net), Bonds: Citigroup World Government Bond Total Return Index,

Commodities: Dow Jones UBS Commodity Index. For illustrative purposes

Additionally, CAT bonds are characterized by a high level of intra-class diversification given by their correlation to different and independent risk factors arising in different parts of the world (i.e. earthquakes, tsunami, tornados, floods, etc.).

As shown in the table below CAT bonds improve a portfolio's risk statistics such as volatility, value at risk and worst month return by increasing at the same time its average return. For this reason, CAT bonds should be present in any portfolio where a diversification from traditional market risk is desired.

BOND DOMINATED BALANCED EQUITY DOMINATED

0% ILS +15% ILS 0% ILS +15% ILS 0% ILS +15% ILS

Average return 5.62% 5.97% 6.15% 6.43% 6.69% 6.88%

Volatility 6.73% 5.82% 9.04% 7.78% 12.81% 10.98%

95% value-at-risk -3.08% -2.44% -3.76% -3.12% -6.49% -5.44%

Worst monthly return -5.42% -4.88% -10.50% -9.19% -15.58% -13.51%Source: Bloomberg. December 2001 to October 2015. Bond dominated: 80% bonds and 20% equities.

Balanced: 50% bonds and 50% equities. Equity dominated: 20% bonds and 80% equities.Bonds: Citigroup World Government Bond Total Return Index. Equities: MSCI World Total Return Index (Net).

ILS: Swiss Re CAT Bond Index. Monthly observations. Average return is calculated as arithmetic mean and annualised.Volatility is calculated as standard deviation and annualised. For illustrative purposes. Past figures are not a guarantee of future results

An obvious and important question is CAT bonds performance in Q3 2017 following an un-precedented market loss (approx. 100 bln) after Harvey, Irma & Maria US hurricanes.

While 2017 is likely to see more impaired cat bonds than any previous year, the total defaults are likely to be a modest proportion of the market, which is a good argument to intra-class di-versification and balancing factor of individual investment strategies. Also there are plenty of ILS funds, which incurred minimal or no losses at all due to minor exposure to North American perils or invested into bonds with higher triggering attachment points.

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Anyway the Swiss Re Total Return index is now (as of 1/11/2017) less than 5% below its peak.

Source: InsuranceLinked

The first bonds placed after the losses - XL Catlin's Galileo bonds - priced above recent issues:

Source: InsuranceLinked

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The ILS market has seen CAGR of 20% since establishment in 2002. Now worth a total of $80bn, ILS transactions account for 14% of the reinsurance market with anticipated increase to $224bn or 28% by 2021 and have become an attractive opportunity for leading institutional in-vestors worldwide who now consider these investments as partner to reinsurance world rather then alternative. Also the market is well analysed and clicking here you may see one of many comprehensive overviews.

Projected development of (re) insurance capital structure by 2021 (conservative scenario)Source: EY analysis, Aon Benfield Analytics data

For the purpose of this documents it is also worth separately to mention ILWs development as a riskier but more rewarding (double digits) usually small balancing component of many ILS funds strategies. The best illustration to be is Mercury investible Catastrophe Risk Index (MiCRIX), the first investible catastrophe risk index of its kind. This index, launched by Mercury Capital Ltd., tracks the performance of a diversified portfolio of peak peril industry loss warranties (ILW's) providing another useful proxy for the return of the catastrophe risk and reinsurance market. Please note, that picture below as well reflect Q3 2017 losses:

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Solvency II

As well it is worth to mention why (re) insurers use cat bonds issuance in a way to cope with Solvency II requirements, which became effective 1/1/2016.

Capital raise

EquitiesSubordinated debt

RISKS TRANSFER

Reinsurance Cat bonds

Limited number of reinsurers, rela-tionship driven;

Counterparty risk (promise to pay); Contracts renewed annually; Bespoke solutions possible.

Unlimited number of counterparts, sometimes no direct relationship;

No counterparty risk (collateralized); Lifespan usually 3 years;

Additionally, from investor perspective, our authentic ABILS offer for insurers in CEE give them a big advantage in both S2 issues and decrease in cash reserving for their property invest-ments from 25 to 4%.

To learn more on that please click here for example assessment report.

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Objective

The investment to generate a long–term return of 7-9% with low volatility and minimum correla-tion to the capital markets utilizing some unique features for market access and broad profile experience of the suggested team members. Out of industry scenarios typical entry ticket for such activity starts from EUR 10 mil.

Just for the sake of demonstration below are 3 different possible strategies (for illustration we took peak conservative, median and opportunistic variants):

Strategy I Strategy II Strategy III

Target Return 4%-6% 6-8% 8-12%

Probability of No Loss p.a. 90% 85% 78%

Return in No Loss Year 8% 10% 15%

VaR 95% 8-10% 10-12% 12-15%

VaR 99% 16-20% 20-25% 25-35%

Maximum Historical Drawdown (since 1900s)

-20% -25% -35%

Maximum Exposure per Event 35% 45% 60%

Liquidity: Quarterly with no more than 10% redemption of NAV (i.e. 10% Gate)

Number of Counterparties: 40 30 20

Management Fees: 1% 1,25% 1,50%

Hurdel Rate: 3% 5% 7%

Performance Fee with watermark: 10% 12,50% 15%

Lock Up (Hard): 18 months 18 months 18 months

Why us:

1) Unique amalgamation of industry professionals with traceable track records;2) Actively managed, risk-controlled approach;3) A to Z knowledge of the ILS market with access to most distinguished deals;4) Own unique growth concepts including ABILS and Russian Cat Bonds program;5) Ability to attract a wide range of third party institutional investors including Chinese,

Russian, CEE, Asian, Middle East and US capital.

WE CORDIALLY INVITE YOU TO THE INTERESTING AND FACTUAL DIALOGUE WHICH HOPEFULLY WILL LEAD TO A GREAT FRUITFUL COOPERATION

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