Our purpose in this paper is to conduct an in-depth examination of the historical record of ILS investing and to reflect on the implications for future risk and returns.
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One month to the official end of the hurricane season (November 30) shows the distinct possibility of a “loss-free” catastrophe year. It’s not over ‘til it’s over, or the fat lady sings, but so far so good. US wind losses are the lowest since 2006. And, as our title reversing of the old English proverb indicates, a quiet season has benefited a lot of people.
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Genuine Alpha, Perfect Security – Reaffirming ILS Rationales
January, 2009
By: Morton N. Lane, President
“Alpha” is the holy grail of the conservative investor. Alpha expresses that part of an investment’s return that is not related to general market returns. Thus an investment that does not fall when the Dow falls (and vice versa) is said to have high alpha. It would be a valuable diversifying asset to reduce portfolio volatility. Regrettably, such investments (or asset classes) are hard to find. Insurance Linked Securities (ILS) are, however, thought to be one such class. This chapter surveys the ILS market, its history and the claim that it provides genuine alpha.
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The objective of this paper1 is to examine the risk preferences of property catastrophe reinsurers. It is an empirical exercise and is focused on catastrophe reinsurance, particularly of the Bermuda companies. It is also a speculative paper. It is not clear whether trying to infer risk preferences from operating results is even possible, especially when such results have very short histories, in most cases of less than ten years2.
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The
early weeks of 2007 present a study in contrasts for both the property
catastrophe reinsurance and insurance industries. The reinsurance
industry has experienced a flood of new capital (of which more below)
and has seen premiums turn lower from their June 2006 peak. In
contrast, the insurance industry is galvanized by the actions of
regulators, particularly in Florida, who have essentially mandated
lower premiums for their citizen home-owners and decided to provide
reinsurance capital via the enforced subsidy of their taxpayers. The
reinsurance industry is largely unregulated, largely off-shore and
driven by competitive market forces; the insurance industry is heavily
regulated (by States) and appears to be largely driven by domestic
State politics. In Florida the regulators want to extend the
reinsurance that is provided at fixed prices from Citizens (their
assessment and public backed insurer of last resort). Question is,
which solution is likely to lead to lower prices over time (if they
indeed should be lower) and which provides the healthier source of
reinsurance capital? The answer seems self evident to us, and part of
the reason for that is the track record of the reinsurance industry
during the last 15 months. The amount of capital raised and the
innovation that has been displayed is impressive. The purpose of this
paper1 is to review and record that story.
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Sometimesit happens that one word so captures the zeitgeist that it isimmediately adopted into the language as if it were always present. Soit was with the word “sidecar” at the beginning of 2006 in the languageof the reinsurance world. In the scramble to replace capital lost inthe Katrina, Rita and Wilma (KRW) hurricanes of 2005 a variety of newmechanisms was being utilized; sidecars was one of them. It was notexactly a new mechanism; by our count in the preceding ten yearsbetween $2 and $3 billion of capital had been raised by a mechanismthat would now be called a sidecar. Those forerunners were called by avariety of names, but generically could be called capped quota shares.Since re-branding, the same vehicles have raised some $6.5 billion innew capital in a period of 15 months, see Figure 1. The purpose of thisnote is to record that dramatic development and to lay out an “issuesset” for issuers and investors in these vehicles.
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