(Updates with comment from Swiss Re in seventh paragraph.)
Dec. 12 (Bloomberg) -- Funds specializing in insurance- linked risks such as catastrophe bonds are benefiting as the $30 trillion pension industry increases bets in a market that hasn’t posted an annual loss.
At Leadenhall Capital Partners in London, assets under management have doubled to $1.6 billion this year with more than 90 percent coming from pension funds. Nephila Capital Ltd., manager of the world’s biggest fund of insurance-linked securities, or ILS, has seen assets under management triple in the past five years to about $9 billion.
The ILS market, which includes catastrophe coverage that was traditionally provided by reinsurers, may reach an all-time high of $50 billion this year and $150 billion by 2018 according to a Bank of New York Mellon Corp. report. Expansion is fueled by funds looking beyond asset classes like government bonds that have been paying near record-low yields, said Bill Guffey, chief underwriting officer at the special risks unit of Allianz SE.
“Pension funds are merely dipping their toes in the water,” Guffey said. “While part of the growing demand from that sector is most likely due to the lack of viable alternatives to invest your money, the limitation for further growth is more on the supply side, from insurers seeking coverage, than investors’ demand.”
In a catastrophe bond, insurers pay for protection against events like hurricanes or earthquakes. Investors get above- market yields for taking the risk that their principal could be wiped out by a large enough disaster.
Catastrophe bonds have delivered gains of 12.7 percent from the end of September 2012, through Dec. 6, a period that includes superstorm Sandy, according to the Swiss Re Cat Bond Total Return Index, which tracks dollar-denominated securities. That compares with about 8.6 percent for the $1.4 trillion of U.S. junk bonds tracked by Bloomberg.
“Cat bonds have been set up to cover for events that fortunately didn’t happen so far,” said Martin Bisping, head of non-life risk transfer at Swiss Re Ltd., the world’s second- biggest reinsurer. “The market has not been tested by the big hurricane yet.”
Only about five of the more than 200 cat bonds sold resulted in losses since the securities were introduced in the 1990s, Bisping said. Defaults were triggered by Hurricane Katrina in the U.S. in 2005 and the 2011 tsunami in Japan. Sandy last year caused losses of less than 20 percent of the principal on two bonds, according Munich Re, the largest reinsurer.
The European Insurance and Occupational Pensions Authority, the region’s top industry supervisor, said in its financial stability report published today that ILS developments need “close monitoring by supervisors.”
“The extensive usage of ILS tends to cloud the picture in terms of understanding the risk transfer,” it said.
Franklin “Tad” Montross, chief executive officer of the General Re reinsurance unit at Warren Buffett’s Berkshire Hathaway Inc., has said pension funds are too reliant on models in evaluating risks and may flee the market if a natural disaster leads to unprecedented losses. The models have “lent an aura of credibility” to pricing, Montross said at a conference in June. “Anyone who’s in the industry knows that the models are always wrong.”
“A solid portfolio over the long term will have some degree of losses,” said Joseph Higgins, who oversee funds at New York-based TIAA-CREF, which has $542 billion in assets under management including between $250 million and $500 million of direct insurance-linked investments. “We would remain committed to insurance-linked securities even after a major loss hitting half of the market.”
Reinsurance protects primary carriers from the biggest risks, and pension funds are attracted to the business because of its low correlation to equity and bond markets. They can invest directly in the securities or allocate funds to specialist asset managers, such as Nephila Capital.
“Pension funds are highly committed to the asset class, one of my investors even placed his money in a way that it immediately gets reinstated after a catastrophe hit so he can benefit from higher post-event prices,” said Luca Albertini, London-based CEO of Leadenhall Capital Partners. “Insurers seeking capital market protection will opportunistically switch from cat bonds to collateralized reinsurance back and forth.”
Pension funds provide about 85 percent of capital-market- based insurance coverage, according to Munich Re. The investments include cat bonds, collateralized reinsurance and industry loss-warranties.
In collateralized coverage, investors post low-risk securities such as treasuries in a trust account backing a contract arranged by a reinsurer. The collateral is paid to the covered carrier if a pre-defined disaster occurs. In return, investors receive a premium payment.
Funds invested in collateralized reinsurance have doubled to about $22 billion in two years, according to Hannover Re, which earns more than 10 million euros ($13.8 million euros) in annual fees arranging the contracts for ILS funds. That compares with about $18 billion of outstanding cat bonds.
“Collateralized reinsurance is less heavily focused on U.S. catastrophe risks and can include diversifying risk coverage, for example for Australia and other territories,” said Henning Ludolphs, head of insurance-linked securities at Hannover Re, the world’s third-biggest reinsurer. “It’s much simpler to put in place than a catastrophe bond.”
Typically, collateralized reinsurance provides about $2 million to $5 million of coverage per contract and the figure can be as high as $100 million according to Hannover Re. The minimum figures for cat bonds are larger because of costs including legal paperwork.
“There simply haven’t been enough cat bonds available to meet the growing demand by investors,” Swiss Re’s Bisping said.
“Collateralized reinsurance can focus on more local risks,” said Michael Stahel, fund manager and partner at LGT Insurance-Linked Strategies in Pfaeffikon, Switzerland, overseeing about 60 percent of its $2.7 billion of assets on behalf of pension clients. “A Category 4 hurricane striking Miami could potentially affect over 40 percent of all outstanding cat bonds, yet it might only affect 20 percent of a diversified portfolio of the collateralized reinsurance.”
Category 4 is the second-most severe in the five-step Saffir-Simpson scale. Such storms have sustained winds of at least 130 miles per hour (209 kilometers per hour).
Natural disasters affecting the U.S. such as Atlantic hurricanes make up 74 percent of cat bonds issued, according to Munich Re report on the market. The U.S. has the most expensive catastrophe risks and the biggest market.
Catastrophe bonds have posted a positive return every year, according to Swiss Re data going back a decade. Still, pension funds are realistic about what could go wrong, according to Barney Schauble, a managing partner at Nephila Advisors, a unit of the Hamilton, Bermuda-based fund.
“They won’t be spooked when a catastrophe happens in an asset class that has ‘catastrophe’ clearly marked on the label,” he said.
--With assistance from Charles Mead in New York. Editors: Dan Kraut, Simone Meier