Update From Hedge Fund Land - February 2020
This article is Aon's bi-annual update on hedge funds. This article explores: What can we expect from Insurance Linked Securities in view of recent experience and climate change?
As equities continue to rally questions on hedging and diversification come to the fore.
New Buy Rated Funds
Time to Tail Hedge?
The S&P 500 returned 13.6% annualized for the past 10 years1 and other markets around the world have generated similarly robust returns. Many investors are contemplating the impact of the inevitable correction on their portfolios. While some sort of tail hedge seems sensible, there are a number of implementation questions to address.
Sizing and Cost A tail hedge constructed to provide meaningful protection in a large equity market downturn comes with significant cost. Our research indicates that a hedge designed to provide protection in market drawdowns of greater than 20% costs the portfolio on the order of 100-200bp per year. Tail hedges are not cheap.
Hedge Management Tail hedges also require active management. If the market falls 20% and the tail hedge starts to kick in – What now? Should the investor monetize the position to lock in gains? Or should the position be maintained in case the market falls further? Not an easy choice in the midst of a major sell-off. Investors should have a pre-specified plan for managing the hedge in a variety of market scenarios. None will be exactly right but they can provide a framework for the decisions involved.
Redeploying Gains When tail hedging profits are monetized, they need to be reinvested or spent. If the hedge was matched to a specific cash flow need then this step is easy. If the hedge was portfolio “insurance” then the profits should be reinvested. Rebalancing to targets seems logical but this means buying assets that have suffered a significant drawdown. This can be a psychological challenge and, again, calls for an a priori plan of action.
This very high level examination of tail hedges leads us to two conclusions: 1) they are not suitable for many investors, and 2) for the special cases where they do make sense they require a considerable amount of planning and analysis to ensure that the potential benefits are worth the cost.
Reexamining the ILS Market
After three years of significant losses from hurricanes, floods, and wildfires how has the insurance market adjusted?
Insurance linked securities (ILS) generate returns by reinsuring property damage from natural disasters – hurricanes, earthquakes, wildfires and the like. Investors are paid a premium for taking on a specific tranche of risk from a pool of insurance policies. In good years the premiums paid on the policies are greater than the damage claims from covered events.
Returns to ILS are orthogonal, or fundamentally uncorrelated to stocks and bonds. They are driven by (the lack of) insurance claims due to natural catastrophes. Hurricanes and earthquakes don’t generally have much correlation to corporate earnings, credit spreads or interest rates.
Hurricanes, Earthquakes and Wildfires
The last three years have been active ones for the insurance industry. In 2017 we had hurricanes Harvey, Irma and Maria as well as significant wildfire activity. Total insured losses for 2017 were a record $144.8 billion1. In 2018 hurricanes Michael and Florence, Typhoon Jebi and the Camp and Woolsey fires in California caused $83.8 billion1 in insured losses, again well above average. Finally in 2019 we suffered through typhoons Hagibis and Faxai in Japan, hurricane Dorian in the US, the Paradise wildfire and a huge (and continuing) bush fire season in Australia. Losses for 2019 are estimated between $501 and $71 billion2, in line with to slightly above the long term average.
After three tough years some ILS investors are questioning the fundamentals of the insurance business. Global warming comes immediately to mind. Putting aside the political debate, global warming is real. That said, its impact can be complicated and difficult to discern. Tropical storms are a good case in point.
As shown above, the frequency of the largest tropical storms has not increased meaningfully over the last 30 years. That is not to say that global warming is not having an impact, but to date it is showing up in more subtle factors such as storm path and development cycle. The year to year variation is currently much larger than any longer term trend.
Another relevant trend to examine is insurance industry losses over time. While the jury is still out on hurricanes, secondary perils such as wildfires, tornadoes and floods have become more frequent.
Total global insured losses have been rising at a rate of about 4% per year. At first one might attribute this increasing risk to climate change. In fact, the rise is completely explained by the growth of the insurance industry itself, which has been expanding at about 5% per year, marginally faster than claims. Losses per unit of premium written have been steady for the past 30 years.
The evidence suggests that while the planet is warming and weather patterns are changing, neither the risk of a major hurricane nor the other major risks included in catastrophe insurance have changed much in the last 30 years. To date, the variation in storms from year to year far surpasses any impact from global warming.
Price of Insurance
The most pressing question for ILS investors is are they being fairly compensated for the risk of loss? The price of the reinsurance imbedded in insurance linked securities is driven by two factors, modeled risk and supply and demand.
To model the risk of loss market participants first model the potential perils - hurricanes, wildfires, etc. These models adjust over time to account for global warming, fuel accumulation, and other factors. The insurers then model the impact of the perils on the insured businesses and homes which change as the pool of insurance policies changes. Finally they model the insurance claims that result from the occurrence of the specific peril in the specific geography to come up with a loss estimate. These models are run across thousands of scenarios to get a perspective on the distribution and price of risk.
The second factor in determining prices is the supply and demand of reinsurance capital. A year with large losses that are paid out in claims will reduce the supply of available reinsurance capital for the following year. Likewise, after a major hurricane more homeowners tend to buy insurance, increasing demand. Both of these factors cause the price of reinsurance to rise in the year following major disasters in what the industry calls a “hardening market.“ This supply/demand dynamic tends to dominate pricing during the reinsurance renewal season. Modeled risk helps set the upper and lower bounds.
Forward looking nat/cat risk does not change much from year to year. Therefore, it is logical for investors to increase their exposure to ILS in hardening markets when they are being paid more for taking on the same amount of risk and pull back when they are being paid less.
While it makes sense to tactically time an allocation to the ILS market, an investor’s time horizon should be relatively long, much like the insurance business itself. In any given year there could be a major storm or earthquake and investors could suffer a substantial loss. Those losses are generally recouped over the following years as losses, and natural disasters, revert to more normal levels. The tendency for premiums to rise after major events increases the speed of this recovery.
Conclusions
Over the past three years we have had a number of major hurricanes make landfall, two significant earthquakes and several wildfires. This lead to two years of well above average losses for the insurance industry and one year that was about average. The price of reinsurance has risen significantly from the lows of 2017 and premiums are expected to continue to rise through the rest of 2020.
For new ILS investors now is a great time to allocate to the strategy and for existing ILS investors the next few years should help make up for the losses of 2017 and 2018.
1 Past Performance is no guarantee of future results. Indices cannot be invested in directly. Unmanaged index returns assume reinvestment of any and all distributions and do not reflect our fees and expenses. Please refer to Appendix for Index Definitions and other General Disclosures. Source: S&P Dow Jones
1 Source – Swiss Re Institute
2 Source – Aon plc
Data in this document is sourced by Aon unless otherwise stated. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
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Index Definitions:
HFRI Fund Weighted Composite Index – Equal weighted peer group of self reported returns of hedge funds to Hedge Fund Research
HFRI Equity Hedge Index – Equal weighted peer group of self reported returns of hedge funds with hedged equity investment strategies
HFRI Event Driven Index – Equal weighted peer group of self reported returns of hedge funds employing an event driven investment strategy
HFRI Macro Index – Equal weighted peer group of self reported returns of hedge funds employing macroeconomic investment strategies
HFRI Distressed/Restructuring Index – Equal weighted peer group of self reported returns of hedge funds employing distressed and restructuring oriented investment strategies
HFRI Relative Value Index – Equal weighted peer group of self reported returns of hedge funds employing relative value investment strategies
S&P 500 Index - A capitalization-weighted index representing stocks chosen by Standard & Poor's, Inc. for their size, liquidity, stability and industry group representation. The companies in the S&P 500 Index are generally among the largest in their industries.
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