Dexion Capital explains the growing diversification opportunity in natural catastrophes

Investing in the catastrophe market is increasingly being sought out by investors keen on uncorrelated income streams, explains Ana Haurie, executive group managing director at Dexion Capital plc & Dexion Capital (Guernsey) Limited.

How is a catastrophe defined?

The natural catastrophes to which insurance companies are largely exposed are wind storms (including hurricanes and typhoons), earthquakes and floods. It is losses from these categories of events that insurers (and re-insurers) predominantly aim to limit through the issuance of securities such as cat bonds and through entering into private contracts with counterparties (which include other re-insurers and investment funds investing in insurance linked strategies).

Recent high profile examples of such events include Hurricane Sandy (which impacted the Caribbean and eastern seaboard of the US in October and November 2012, leading to $18.75bn of insured losses according to the latest estimate from Property Claim Services), the Tohuko earthquake in Japan in March 2011, and the floods in central Europe which occurred in June this year, for which the latest insured loss estimates are close to €6bn.

Other natural catastrophes to which insurance companies are exposed to include crop failure (for example, due to adverse weather), aviation and marine disasters – however, the insured losses are, in aggregate, less for these types events than for wind, earthquakes and flooding.

What is the state of catastrophies currently – are they becoming more or less frequent?

Credit Suisse, the investment manager of the DCG IRIS master fund, have said that they see no evidence of trend in terms of an increasing number of hurricanes or typhoons, despite the fact that insured losses due to wind damage seem to be increasingly making the news headlines.

What has changed over the last 20 years is the increase in claims (in terms of both the number and the monetary amount) due to increasing population density, wealth, insurance density and building quality. The same conclusions apply to the frequency of earthquakes, acknowledging the fact that severe earthquakes have in recent years affected Japan, New Zealand and Chile.

According to the US Geological Survey, since 1990, there have been on average around 15 earthquakes per month globally with magnitude greater than 7, and variations around this average number have been relatively small. In addition, there have been five earthquakes of magnitude greater than 9 since 1950 (including Tohuko in 2011) and these large earthquakes have themselves triggered devastating earthquakes; that is, there is some evidence of clustering around large events having taken place. However, there are no indications of an increase in the frequency of magnitude 9 earthquakes, themselves.

What is the market for this type of financial activity, eg, size of catastrophe reinsurance market, numbers of players in market, how accessible to investors from across Europe and/or other regions?

There are two parts to the market in which insurance linked investments are made, namely the securitised part (which includes cat bonds) and the non-securitised part (or private transactions).

The former had an outstanding volume of just over $16bn as at the end of March 2013, and covers mainly US natural catastrophe risk. There is some secondary market liquidity associated with these securities, but given the rather small range of natural catastrophe risks and geographical regions covered, relatively limited diversification is achievable compared to that for private transactions.

The non-securitised market is much larger, at around $400bn of market volume as at the same date. These are privately negotiated contracts between insurance and re-insurance companies and counterparts that are willing to take on board part of the risk exposure in return for earning a premium (these include other re-insurers and investment funds investing in insurance linked strategies).

These markets do not have any secondary market liquidity, with the parties to the contracts being “locked-in” for the length of the contract term (which typically runs for between 3 and 12 months, with renewals at set times of the year). This is a obviously much larger market, covering a greater range of geographic regions and natural catastrophes (or perils), and for that reason a greater degree of diversification is attainable with investments in these markets.

Investors are able to access these markets in a number of ways. There are a number of open-ended funds (some in a Ucits structure) which make investments into the securitised part of the insurance linked market. Recent performance for these funds has mirrored that of the cat bond indices and been attractive, as these assets have seen greater interest from investors searching for uncorrelated, yielding places to put their money.

More relevant for this discussion, there are now three London-listed investment companies engaged in insurance linked strategies (CATCo Reinsurance Opportunities, DCG IRIS and Blue Capital Global Reinsurance), all of which have launched since December 2010.

Within the portfolios of these three companies, the bulk of the exposure is currently in private contracts, with DCG IRIS also having some exposure to insurance linked securities – however, the portfolios in which the companies invest have some degree of flexibility with regard to their allocations in this regard. CATCo, contrary to the other funds, engages in retrocessional contracts, that is, it provides re-insurance cover to re-insurance companies; this can have the effect of elongating the time period necessary to estimate actual losses, as the risks are one further step removed from the actual insured loss.

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