Nine unanswered questions of insurance-linked fund strategy: Part two

This is the second part of the article on the strategic choices made by insurance-linked funds. Click here to read part one.

5. Leverage. Some insurance-linked funds sit on cash, while others use leverage to amplify gains and losses. How much leverage should be employed by insurance-linked funds?

Fund returns can be leveraged in different ways. One approach is to use catastrophe bonds as collateral for bank loans. Another approach is to use the rating of a controlled vehicle or the rating of a third party fronting carriers to invest in unfunded limits.

6. Liquidity. Insurance-linked funds vary considerably in the liquidity they offer to investors. How much liquidity can be promised to investors given the underlying investments?

Most insurance and reinsurance contracts are annual, but claims – or potential claims – can lock up capital for much longer. Some funds provide the manager with permanent capital, while others offer daily liquidity.

7. Third-party catastrophe models. All funds use third-party models as part of the risk-evaluation process but they vary in their willingness to assume unmodelled risk. How important is it to use third-party catastrophe models to evaluate all risks?

Third-party catastrophe models provide a standardised way of evaluating the risk of each deal, whereas quantifying unmodelled risks require fund managers to make highly subjective judgments - though the models themselves contain large uncertainties and provide materially different results to one another.

Many insurance risks are not modelled by the third-party vendors so avoiding unmodelled risk significantly reduces the number of investable opportunities.

8. Reinsurer relationship. Some fund managers are independent or owned by larger asset managers, while others are owned or partially owned by reinsurers. What are the advantages of a close relationship with a reinsurer versus independence?

Independent managers avoid potential conflicts with the reinsurer's balance sheet (although may still have to manage the conflicts between their various funds).

Access to business in various market conditions is important to the success of insurance-linked funds. A relationship with a reinsurer may help smaller funds see more of the market. Reinsurers can also offer their sister funds access to back office infrastructure and cheap fronting.

9. Hedging. Increasingly, funds use ILWs and other mechanisms to hedge insurance risk. Is the downside reduction worth the reduction in expected returns?

Most hedging strategies reduce expected returns, so investors need to decide if they are targeting a strategy that maximises returns or one that limits downside risk.

These choices are specific to insurance-linked funds, but there are other important strategy decisions are generic to all asset classes. These include the jurisdiction and regulatory environment; the alignment of interests and governance; and, of course, the quality of the systems and people.

Click here to read part one.

Posted: Monday, November 21st, 2016