Research

Hurricane Season Takes Toll on ILS Managers

After 5 consecutive years of positive returns, hedge funds with exposure to catastrophe bonds or Cat bonds for short, are on track to post their first year of losses as the full extent of damages from Hurricane Harvey, Irma and Maria come to light. An index of such funds tracked by Eurekahedge who explicitly allocate to insurance linked investments and have at least 70% of their portfolio invested in non-life risk – the Eurekahedge ILS Advisers Hedge Fund Index1 was down 0.33% in August and 5.46% in September, bringing the year-to-date return into negative territory with a loss of 3.69%. This comes after ILS hedge funds delivered compound returns of 15.60% versus 12.21% for the average hedge fund in the three year period ending December 2016.

Insurance-linked securities (ILS) hedge funds trade in instruments whose values depend on insurance loss events. The majority of these instruments are reinsurance policies that assume the risk taken by insurance companies, which in turn assume the risk taken by individuals or institutions. A reinsurance policy allows a second insurer to take a share in the potential profit and loss from the underlying insurance policy. The ILS market covers the reinsurance of various types of risk, including life insurance risk, catastrophic risk and debt risk. Life reinsurance ILS protects the insurance companies against extreme events that cause the deaths of a massive number of people, such as terrorist attacks, epidemic, or natural disasters. On the other hand, debt reinsurance ILS covers the potential losses caused by debt defaults.

This report will feature on ILS managers that are predominantly exposed to non-life risks and have significant exposure to ‘Cat bonds’, or catastrophe bond, which are a type of ILS that specifically deals with risks induced by catastrophic events such as earthquakes, hurricanes and other natural disasters. Cat bond return is largely uncorrelated to the return from other investment vehicles such as equities or fixed income, and hence could be used as a hedge against the market to help with portfolio diversification. While cat bonds are mostly independent of the financial market condition, they still carry a very big risk from the potential amount of loss caused by a catastrophic event, and generally ILS hedge funds diversify their cat bond portfolio by investing in different types of catastrophic events (e.g. wind events, earthquakes) over different geographic regions, under the assumption that these events are independent of each other. In addition to the aforementioned, further diversification is added to the ILS portfolio mix through exposure to different maturities and grade of insurance linked securities.

The ILS market has grown rapidly since its inception in the mid-1990s after hurricane Andrew, which caused massive damage and forced several insurance companies to declare bankruptcy. While the market has grown significantly since then, capacity constraints still remain which have acted as the natural cap on the growth of this sector when compared to other competing hedge fund strategies.

Figure 1 depicts the performance of the Eurekahedge ILS Advisers Hedge Fund Index versus the SP500 Index and the Eurekahedge Hedge Fund Index since 2007. Over the period depicted, the Eurekahedge ILS Advisers Hedge Fund Index has posted annualized returns of 4.54%, which compares with annualized gains of 5.69% for the SP500 Index and 5.40% for the average hedge fund manager as represented by the Eurekahedge Hedge Fund Index. The most striking observation that can be gleaned from the chart below is the lack of correlation between ILS hedge funds and the wider market as well as competing hedge fund strategies, which has helped ILS managers post consistent returns barring the dips seen in March 2011 (earth quake in Japan) and the more recent August-September drawdown coming on the back of exposure to US hurricane events.

Figure 1a: Eurekahedge ILS Advisers Hedge Fund Index since December 2007
ILS funds since December 2007

Table 1 summarises the key performance statistics for the Eurekahedge ILS Advisers Hedge Fund Index relative to the SP500 Index and the Eurekahedge Hedge Fund Index. Key takeaways include:

  1. ILS hedge funds offer uncorrelated returns to the market and competing hedge fund strategies, outperforming the SP500 Index by 42.31% in 2008 and the Eurekahedge Hedge Fund Index by 13.56% at the height of the global financial crisis.
  2. ILS hedge funds have outperformed the average hedge fund in 5 out of the 10 last years – mostly notably during 2008, 2011 and 2015 when the latter came under pressure against a difficult market backdrop.
  3. Over the near 10 year period starting from January 2008, ILS hedge funds have delivered better risk-adjusted returns compared to both the traditional market as depicted by the SP500 Index and the average hedge fund – with a Sharpe ratio of 1.33 vs 0.32 and 0.91 for the SP500 Index and the Eurekahedge Hedge Fund Index.

Table 1: Performance numbers - Eurekahedge North America Long Short Equities Hedge Fund Index

Eurekahedge ILS Advisers Index
S&P 500 Index
Eurekahedge Hedge Fund Index
2008
3.83%
(38.49%)
(9.73%)
2009
8.99%
23.45%
21.31%
2010

7.52%

12.78%

11.56%

2011

(0.14%)

(0.00%)

(1.73%)

2012

5.93%

13.41%

7.36%

2013

7.61%

29.60%

9.28%

2014

5.42%

11.39%

5.06%

2015

4.24%

(0.73%)

2.11%

2016

5.19%

9.54%

4.59%

2017 September YTD

(3.69%)

12.53%

5.64%

Annualised returns since December 2007

4.54%

5.69%

5.40%

Annualised volatility since December 2007

2.66%

14.79%

4.85%

Sharpe Ratio (rfr=1%)

1.33%

0.32%

0.91%

5 year annualised returns

3.84%

11.83%

5.67%

5 year annualised volatility

2.85%

9.52%

2.84%

5 year Sharpe Ratio (rfr=1%)

1.00%

1.14%

1.64%

3 year annualised returns

2.23%

8.50%

4.39%

3 year annualised volatility

3.49%

10.04%

2.84%

3 year Sharpe Ratio (rfr=1%)

0.35%

0.75%

1.19%

2 year annualised returns

0.99%

14.55%

5.75%

2 year annualised volatilities

4.20%

9.40%

2.41%

2 year Sharpe Ratio (rfr=1%)

0.00

1.44%

1.97%

Source: Eurekahedge


Table 2 depicts the correlation matrix for ILS hedge funds versus the SP500 and the Eurekahedge Hedge Fund Index since January 2007. As shown in the table, ILS hedge funds are uncorrelated the wider market movements and have a small positive correlations to wider hedge funds which is not statistically significant. In contrast, the average hedge fund has a positive correlation of 0.780 to the SP500 which furthers helps to put in perspective the appeal of ILS strategies for investors looking for true diversifiers in their portfolios. However, given the size and inherent liquidity and capacity constraints within the ILS market, there are natural limits on the amount of exposure large investors can take to this sector.

Table 2: Correlation matrix (for returns since January 2007)
ILS funds since December 2007

Source: Eurekahedge

With multiple hurricane events and the earthquake in Mexico, ILS portfolios could experience further losses as the full extent of losses is revealed. For the moment, managers with exposure to these events are taking partial to full write downs on their positions. As the hurricane season concludes towards October end, there should be a favourable impact on secondary market prices assuming no further major storm develops.  In the meantime, with insurance losses running high and a lack of liquidity in the market during the hurricane season, opportunities could emerge for managers as premiums increase and steep discounts are offered on existing secondary market cat bond offerings which could help managers recuperate some of their losses. In the interim though, 2017 could be the worst year for ILS hedge funds in more than decade.

 

The full article inclusive of all charts and tables is available in The Eurekahedge Report accessible to paying subscribers only.

Subscribers may continue to login as usual to download the full report and non-subscribers may email database@eurekahedge.com to enquire on how to obtain the full research report.


Footnote

1 The Eurekahedge ILS Advisers Index is ILS Advisers and Eurekahedge’s collaborative equally weighted index of 33 constituent funds. The index is designed to provide a broad measure of the performance of underlying hedge fund managers who explicitly allocate to insurance linked investments and have at least 70% of their portfolio invested in non-life risk.
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