14 October 2013

A short history of insurance-linked indices

An index is, by definition, an imaginary portfolio of securities representing a particular market or a portion of it, constructed using a strictly defined constituent universe, transparent formulae and rules for calculating the weight for each constituent part. Indices have become an integral part of the investment world, providing investors with an easy way to track the performance of different markets and asset classes and compare them with one another.

Insurance-linked securities (ILS) as an asset class are still relatively new, with the first catastrophe bond having been issued in 1994; it took another 13 years for the first asset class-specific indices tracking the performance of cat bonds to be launched.

Cat bond indices

Probably the most widely known index for cat bonds are the Swiss Re Cat Bond indices, launched in June 2007. At the time Swiss Re said that the reason for its starting its cat bond indices was to improve the transparency of cat bond returns, with the ultimate goal being to attract additional investors to the asset class. The Swiss Re Cat Bond indices are a series of performance indices constructed to track the price return and total rate of return of dollar-denominated cat bonds.

The Swiss Re Cat Bond index tracks the performance of the main basket, meaning all outstanding dollar-denominated catastrophe bonds. In addition, 18 different sub-indices are available. The main sub-indices areSingle-Peril US Wind Cat Bonds, Single-Peril California Earthquake Cat Bonds and BB Cat Bonds (Standard & Poor’s rated). The index methodology is owned by Swiss Re and the index is calculated on a weekly basis by S&P Custom Indices and published on Bloomberg. The index is based on Swiss Re pricing indications only and base-weighted back to January 2002.

"The primary goal of the Eurekahedge ILS Advisers Index is to raise the visibility and transparency and realise the full potential of the insurance-linked investment space."

Three years after Swiss Re, Aon Benfield Securities, the securities and investment banking operation of Aon Benfield, launched its own ILS Indices in 2010. These indices are base-weighted back to December 2000. The ILS Indices from Aon Benfield Securities tracks the performance of catastrophe bonds in four different baskets: All Bond, BB-rated Bond, US Hurricane Bond, and US Earthquake Bond. Each index is a total return index representing the return an investor would have achieved by allocating an amount of capital weighted to each catastrophe bond available in the market at a particular point in time. The indices are calculated monthly by Thomson Reuters and are based on Aon Benfield Securities month-end indicative prices.

There is, however, one important difference with such indices when compared with most other benchmarks that measure the performance of financial assets. Returns in this asset class deviate strongly from the normal distribution of returns commonly used to describe the return distributions of traditional asset classes. Cat bonds typically provide stable premium income in good times, resulting in a smooth upwardsloping line on the performance chart. However, from time to time,large and unexpected losses are caused by triggered insurance events, which distort the otherwise stable performance. This behaviour leads to a heavy tailed and skewed return distribution, also known as a fat tail, which deviates strongly from the normal (Gaussian) bell-shaped distribution of returns.

Despite this inherent complexity, ILS issuers and investors have started to embrace this new emerging asset class, evident in its evolution over the past six years. Despite continued uncertainty and volatility in the global capital markets generally, the global ILS market continues to provide value to investors thanks to uncorrelated and stable returns, as reflected in the different cat bond indices.

Both cat bond index families have been widely accepted by the financial community and have served the goals Swiss Re and Aon Benfield Securities formulated at the launch of their indices: to improve transparency of cat bonds returns, to demonstrate the value inherent in the asset class and to make the returns of cat bonds comparable to those of other financial assets—with the ultimate goal of attracting additional interest and investors to the asset class.

The most recent numbers show more than $5 billion of newly-issued catastrophe bonds so far in 2013—bringing the level of total outstanding cat bonds to a new record of over $18 billion—and that this goal has been achieved in a big way.

Indication of a maturing market

The development of catastrophe bond risk spreads is another clear indication of the success of the catastrophe bond market and its corresponding indices. Despite occasional spikes as a result of catastrophe events, the general trend in primary market risk spreads of the different cat bond indices versus benchmark interest rates has been downwards over the last couple of years. In 2013 the risk spreads have reached new historic lows, reflecting a market situation that is constrained by supply of bonds, rather than available capital.

The same trend holds true for the development of secondary market cat bond risk spreads, which apart from major events and seasonality have come down over the years, based on a analysis published by Munich Re. This trend has accelerated since the beginning of 2013, when hardly any new catastrophe bonds came to market and aggressive bids could be observed in the secondary market. This led to spread tightening well below historical levels.

What is also interesting to note is that fluctuations in secondary risk spreads have come down in recent years. This seems to imply that investors have become more comfortable with holding catastrophe bond positions until maturity. While a sign of confidence on one hand, the increase of buy-and-hold investors in the catastrophe bond market is at the same time limiting trading volumes. As a result, trading volumes in catastrophe bonds have been stable, but at relatively low levels despite the increase in the total amount of outstanding catastrophe bonds.

A divided market

The Swiss Re and Aon Benfield indices both focus on catastrophe bonds, which are the most transparent and liquid instrument in insurance-linked investments. The asset class has not only seen a fast growth trajectory, but has also resulted in interesting developments with respect to the instruments available to specialist investors in the space. Based on industry estimates, the insurance capital provided by the capital markets to the global property catastrophe market has grown to approximately $45 billion. This means that the cat bond indices representing about $18 billion of capital as of July 2013, reflect approximately only 40 percent of the overall alternative risk transfer market. Most of the remaining 60 percent not covered by the cat bond indices is invested in financial insurance contracts such as collateralised reinsurance. The challenge with this is that there is no transparency for the private ILS market.

In order to overcome this opacity, in March 2012 ILS Advisers and alternative investment researcher Eurekahedge launched the Eurekahedge ILS Advisers Index, reflecting the performance of the entire insurance-linked investment space, rather than only a part of it. This equally weighted index, which is calculated monthly by Eurekahedge and published on Bloomberg, currently tracks the performance of 30 funds investing across all available instruments in the space—net of all fees. The index was base-weighted at 100 in December 2005.

The primary goal of the index is to raise the visibility and transparency and realise the full potential of the insurance-linked investment space, while offering a benchmark for investors to compare specialist funds in the space. The ultimate goal of all this is to attract new clients and more funds to the asset class. Based on industry estimates, the top 10 dedicated ILS managers have added more than $3 billion of new money to their asset bases and now control more than $31 billion of assets under management. This is another clear indication of the growing interest not only in cat bonds, but also in the asset class as whole.

Among the ILS funds growth seems to be more constrained by the lack of investment opportunities than by the lack of investor interest. A number of ILS funds are now limiting access of new capital to their vehicles as they do not see enough interesting opportunities to employ their capital. One pressing issue is the lack of diversifying opportunities, particularly for funds that operate under fund regimes with strict diversification requirements such as, in the EU, the Undertakings for Collective Investment in Transferable Securities directives (UCITS).

Based on analysis from Munich Re, 75 percent of outstanding cat bonds currently cover US perils (56 percent US wind and 18 percent US earthquake). Hopefully the addition of new perils and growth in the supply of non-US perils in future will remove this obstacle to the next phase of growth in the insurance-linked investment space.

Stefan Kräuchi is a partner at ILS Advisers. He can be contacted at: sk@ilsadvisers.com