ILS Intelligence
However, the range of such investments available is small and the way
to effect such an investment can be tricky. To explore this particular alternative investment, this piece continues the metaphor of the Securities Sea and will describe the market in terms of a map-like description of the small archipelago of natural catastrophe islands of opportunities.
The use of the map as metaphor is helpful because there is still something
of a ‘terra incognita’ about the natural catastrophe (nat cat) market. Furthermore, like many archipelagos, the island chain is still evolving. The islands in the chain are the investment types, which we consider below, but their arrangement is important too.
First, examine the frame of the map. The lines of longitude that “The opportunities emanating from
ILS are a) pure nat cat plays, and b) known and declared specific risk and with known maturities. These deals are as close to corporate bonds as you can get in the nat cat world.”
separate the islands describe the way in which entry and exit from the investment in nat cat is effected. The right-most sector shows that area of the universe where the investment is ‘at market’, i.e. where you can buy in and sell out fairly easily in a regulated market. You have to suffer the prices of entry and exit—whether or not you believe that price to be correct.
The middle section covers opportunities where investment is more bond-like, i.e. for a fixed term. However, the term itself may have to be extended—sometimes considerably before one’s final returns are known. This region is known as the ‘indemnity’ zone. Investment in this sector is most insurance-like. The losses suffered to a protection provider are exactly equal to the coverage provided to each of the underlying insureds. Unfortunately, not all claimants do, or can, provide their claims promptly. When claims are slow, the maturity of the bonds may be extended.
The final shaded longitudinal zone is the ‘index’ zone. Here the
protection is measured by some index or parameter that is relatively easily gauged. The bond matures as soon as the index is calculated whether or not any real claims have yet to develop. Thus the exit point is well known. There may be secondary market opportunities for early exit as well, but at prevailing prices and in a market much less liquid than in zone 1. One other thing about these longitudinal zones is that there tends to be a division not unlike the 1494 papal divide between Spain and Portugal in the 15th century. Equity markets operate in the west; hedge funds tend to operate in the central and eastern zones.
The other important frame of reference is latitude. In our map, the most important latitude line is the ‘leverage’ line. Investment types north of the leverage line are, typically, investments that are leveraged. Let’s be clear: a leveraged investment is one where the total obligation to protect is greater than the resources necessary to provide everyone with protection at the same time. There are several ways to achieve this. One is to borrow cash to support underwriting activity, but since it has to be repaid, is not an ultimate reserve. This is ‘financial’ leverage. The other kind of leverage is ‘balance sheet’ leverage. In this, accounting treatment of obligations does not disclose total obligations. Correspondingly, reserves are required only for a fraction of obligations.
40 | INTELLIGENT INSURER | October 2011
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