Independent Thinking^®

Q&A on Reinsurance with Amundi Pioneer

Editor’s Note: Evercore Wealth Management supplements its core investment capabilities with carefully selected outside funds across the range of the firm’s asset classes. Here we discuss opportunities in insurance-linked securities with Charles Melchreit, lead portfolio manager of the Pioneer ILS Interval Fund, after an eventful year in the global insurance and reinsurance markets. The fund seeks broad diversification in the industry, across geographic regions and security types. Please note that this represents the views of Amundi Pioneer and not necessarily the views of Evercore Wealth Management.
 
Q: How would you describe the reinsurance market?
 
A: Reinsurance is the protection that insurance companies purchase to protect themselves against very significant events. The combination of insurance company coverage and reinsurance coverage permits very large events, such as hurricanes, earthquakes, and other natural disasters, to be absorbed globally.
 
It is a big market. Swiss Re estimates that the global insurance industry collected over $4.6 trillion in premiums in 2016, 44% of which was in the property and casualty area. Within the reinsurance industry, the top 40 firms wrote approximately $194 billion in premiums that year, according to S&P.
 
Q: Please describe insurance-linked securities, or ILS.
 
A: The performance of ILS depends upon the occurrence of pre-specified catastrophic events. The events, though statistically unlikely, have historically been expensive to both insurance and reinsurance companies. ILS provide a way for companies to transfer a portion of their risk and premiums to the capital markets, which, in turn, allows investors to participate in the insurance markets.
 
ILS investors take on the role of a reinsurance company, receiving premiums in exchange for accepting the risk of a loss. If the triggering events do not occur during the tenor of the agreement, the investor enjoys a periodic coupon payment related to insurance premiums and principal repayment at the end of the investment term. If one of the specified events occurs, all or part of the principal is used to pay insured losses and the investors’ coupon payments cease or are reduced; at maturity there is either zero or a reduced amount of principal repaid.
 
Q: Can you explain what the interval fund structure is and what it means for investors?

A: To harness the full spectrum of ILS, as well as be able to offer a ‘40 Act investment vehicle, we chose to deploy an interval structure. Our clients see daily NAV pricing of the fund and receive a 1099 for tax reporting. The interval structure is aligned with the way ILS is sourced from a seasonality perspective. Although we encourage our clients to deploy this as part of a strategic asset allocation, we recognize that they also need to have planned access to the strategy for purchases and redemptions. Each year we provide a schedule for the periodic subscription and redemption periods for the fund. Approximately every quarter we make the fund available for those activities. The fund’s prospectus has more details on subscription and redemption.
 
Q: How does a mutual fund obtain exposure to insurance linked securities (ILS), and what types of ILS are purchased in the Pioneer ILS Interval Fund (XILSX)?
 
A: There are four basic types of insurance-linked securities, or ILS. Catastrophe Bonds, or CAT bonds, are the best-known ILS format. CAT bonds are issued as tradable securities, which allow them to have an active secondary market.
 
They provide a precise level of protection above a certain threshold. They also contain triggers with defined conditions, which must be reached before losses accumulate. For example, a CAT bond could cover the cost of Florida hurricane damage to a specific re/insurer between $3 billion and $3.3 billion. Alternatively, a CAT bond could be structured to cover multiple events, such as a Florida hurricane and an Australia cyclone.
 
Industry Loss Warranties, or ILWs, are private, customizable reinsurance contracts through which a re/insurance company can reduce or hedge risk exposure. The payout is based on industry-wide losses rather than company-specific experience. For example, an ILW could be triggered if industry-wide Florida hurricane losses exceed $15 billion for a given event. A benefit to investors is they are not reliant on the quality of the underwriting and claims management process of the individual insurer.
 
Collateralized Reinsurance Contracts are private, customizable reinsurance contracts that insurance companies use to reinsure losses related to company specific claims, or indemnity triggers. Collateralized reinsurance allows investors to take on the role of a reinsurance company. This product is increasingly popular, as it allows the cedent (the reinsurance protection buyer) to use capital markets as an additional source of reinsurance protection. Collateralized reinsurance provides investors broad diversification across geographic region and peril.
 
Quota Shares (also known as reinsurance sidecars) allow investors to share in the profit or losses of the reinsurer’s book of business. Investors do need to be vigilant with the pieces of business being shared to avoid adverse selection or the risk of participating in unfavorable “cherry-picked” risks. If structured correctly, quota shares better align investor and cedent interests than other forms of ILS. They are highly diversified across region and peril, with losses gradually paid out of the structure as they occur. Quota shares offer annual liquidity and typically include one- to two-year terms. These structures gained popularity following large catastrophic events such as Hurricane Katrina because they allowed the re/insurance industry to recapitalize itself quickly.
 
Q: What kind of catastrophic risks does XILSX insure against? Does it insure against risk globally or is it regionally focused?
 
A: Our goal is to build a diversified reinsurance portfolio, without taking aggressive risks or perils exposures, where we are able to collect sufficient premium to offset a reasonable level of losses and still have an attractive return for our investors.
 
We build a diversified portfolio by geography, peril and structure. The fund has exposures to a wider range of perils, including wind, earthquake, winter storm, inland flood, tornado and others. Geographically, the fund is diversified by region, including the United States, Japan, Australia, New Zealand, Canada, Europe and Latin America. Our goal is to have the fund broadly reflect the risks and returns associated with the reinsurance industry.
 
Q: How long has Amundi Pioneer been investing in ILS, and how much money does the firm deploy in the asset class today?
 
A: Amundi Pioneer was an early adopter, starting in 2007, in using ILS within a range of our diversified fixed income strategies. We currently manage over $1.36 billion (as of September 30, 2017) in ILS across the Pioneer platform.
 
Q: How do you assess – and set premiums for – the potential impact of global warming?
 
A: It’s important to distinguish between climate change, longer-term trends, and short-term weather. It’s also important for investors to understand that we typically take on one-year risks and that we are focused on making sure that we are being adequately compensated during that period.
 
Long- and short-term trends may exhibit themselves differently by peril, as well as geography. For example, 2017 was an above-average hurricane season for the North Atlantic region, while it was a very quiet period in the Pacific region. Further, the possible impact of climate change can exhibit itself very differently as it relates to hurricanes/cyclones, thunderstorms, wildfires, inland flooding and coastal flooding. These factors, along with extensive information regarding the insured properties and other relevant data, are the basis for catastrophe event modeling.
 
We deploy one of the industry-leading quantitative catastrophic risk-modeling tools, AIR Worldwide CATRADER. This can simulate events based on historical data and current conditions, and has the ability to estimate damages using detailed databases of structures and materials. Further, we can model the impact of warming sea surface temperatures in our scenario analysis for hurricanes and cyclones.
 
We believe by having a strategy that is diversified by peril, region and risk layers, our clients will continue to be able to take advantage of the attractive, uncorrelated returns offered with insurance-linked securities.
 
Q: Are insurance premiums expected to rise in 2018 as a result of the host of natural disasters in 2017?
 
A: The Pioneer ILS Interval Fund expects the overall reinsurance pricing to increase for 2018. This could strengthen the case for ILS.
 
Q: What are the long-term expected returns for investing in reinsurance?
 
A: The nature of catastrophe insurance, characterized by lowfrequency and high-severity events, means that investors may expect relatively higher annual returns potentially. They should also expect some years of sizable losses. Diversifying exposures across geographic regions and perils reduces portfolio level volatility. Nonetheless, we believe investors should maintain long-term time horizons when committing capital to the asset class. The risk and return potential for ILS are based on the modeled frequency and severity of the insured events. Investor demand and the reinsurance industry’s need for external capital can also impact premiums. During periods of strong investor demand, the return potential may be lower. Likewise, expected returns from ILS may be higher when reinsurers have a greater need to increase their use of external capital. This has typically followed a large industry loss.
 
Q: Why do you think reinsurance is a good long-term addition to consider in a balanced asset allocation?
 
A: We believe including ILS within a broader asset allocation can have powerful diversification benefits and total return potential. ILS portfolio returns are not determined by economic factors such as GDP growth, interest rates or corporate profitability. Rather, performance is driven by the occurrence of low-frequency, high-severity natural disasters, such as earthquakes and hurricanes. This is a key distinguishing feature, which has resulted in a very low correlation to other asset classes. The return profile and liquidity of the asset class does require a long-term investment horizon. Given these characteristics, we believe ILS may fit well within the fixed income or alternative asset class portion of an investor’s portfolio.
 
For further information about the Pioneer ILS Interval Fund and about other funds on the Evercore Wealth Management investment platform, please contact Stephanie Hackett at [email protected].