As the best hedge fund strategy of 2023 becomes a magnet for mainstream investors, the risk models it relies on are getting a lot tougher to crack.
The strategy in question is tied to insurance-linked securities, which are dominated by catastrophe bonds (often dubbed cat bonds). In 2023, no other asset class produced a better-performing bet for hedge funds, with firms including Fermat Capital Management and Tenax Capital booking their biggest-ever returns.
Cat bonds have been around for more than 25 years and are used by the insurance industry to shield itself from losses too big to cover. That risk is instead transferred to investors who lose money if a pre-defined catastrophe hits, and rake in potentially huge returns if it doesn’t.
But calculating catastrophic risk is much more complex than it used to be. That’s because there’s a growing concentration of property in areas that are prone to increasingly frequent storms, fires and floods. Taken individually, each event is less intense than a major earthquake or hurricane. In aggregate, however, such losses can be a lot bigger, and that has major implications for the growing numbers of investors now adding exposure to cat bonds.
Traditionally, cat bonds have been used to shield insurers from the kinds of losses associated with once-in-a-generation natural disasters. But last year, those primary perils, as they’re known, accounted for only 14% of global losses, according to broker Aon Plc. Meanwhile, a category known as secondary perils “outpaced their cumulative costs in the 21st century by a large margin.”
Such secondary perils — mostly in the form of destructive thunderstorms — aren’t being consistently captured by models designed to measure cat bond risk, according to fund managers monitoring the development.
“We see that some models are actually not pricing these perils adequately,” said Etienne Schwartz, head of investment management at Twelve Capital, which holds $3.7 billion of cat bonds. In fact, he says “the expected loss on paper is way below what we actually think it is.”
Today, about 40% of cat bonds are for aggregate losses that accumulate over a single year, which is where investors are most likely to feel the fallout of secondary perils. The rest of the market is tied to losses that stem from one-off calamities such as a major hurricane, according to Artemis, which tracks the ILS market.
Globally, the total market for insurance-linked securities reached about $100 billion at the end of the third quarter, Aon estimates. Cat-bond issuance alone hit an all-time high of more than $16 billion in 2023, including non-property and private transactions, bringing the total market for the securities to $45 billion, according to Artemis.
After delivering returns of roughly 20% last year, cat bonds are now attracting many investors who would otherwise have avoided such a high-risk bet.
“Most of the clients that missed out on 2023, they now want to participate in 2024,” Schwartz said.
Investors who have been in the market a bit longer, meanwhile, are getting more discerning and moving away from bonds that are exposed to secondary perils, according to Andre Rzym, partner and portfolio manager at Man AHL, a unit of Man Group Plc, which is the world’s largest publicly traded hedge fund manager.
Read the full article here by Gautam Naik, Sheryl Tian Tong Lee of Bloomberg News, Advisor Perspectives
