Residents of Florida and the Southeastern U.S. aren't the only ones hoping the upcoming hurricane season will be calm.
Two public U.S. pension plans, the $51 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, and the $56.9 billion Oregon Investment Council, Tigard, in the past 12 months have invested in funds that can pay investors handsomely when the weather is clear but can cause major losses when the winds blow hard.
But because of the potential for losses — even a total loss — buying insurance-related securities, as they are called, can be controversial.
“By design, we know hurricanes happen, and sooner or later there is going to be hurricane that is going to trigger losses,” said Ryan Bisch, a consultant with Mercer in Sydney, Australia. “Bigger storms trigger larger losses, and the client should be comfortable with that before they make an allocation.”
The funds in which Pennsylvania and Oregon are invested were set up by Nephila Capital Ltd. in Hamilton, Bermuda. The company buys various insurance-related securities, such as multiple catastrophes bonds that reimburse insurers after major losses from such perils as hurricanes, tornadoes and earthquakes.
Catastrophe bonds are not new; they have been sold since the mid-1990s and are used by both hedge funds and major money managers like Pacific Investment Management Co. LLC. For the insurance industry, the bonds are a way to reduce risk.
But Nephila Capital, with around $5 billion in five funds, is taking the concept further; it also enters into private transactions with insurers and reinsurers, agreeing to assume some of their catastrophe risk. Its reinsurance company, Poseidon Re, can write policies so Nephila Capital does not have to rely on a third party.So far, initial investments by U.S. public pension funds are small: Pennsylvania PSERS invested $250 million in June, and Oregon invested $100 million in December.
But there is interest from other U.S. pension plans looking to diversify their portfolios, said Barney Schauble, managing partner of Nephila Advisors LLC, a San Francisco affiliate of Nephila Capital. He would not name any of the funds.
Mr. Schauble said Nephila Advisors was set up in 2010 as part of Nephila Capital's effort to extend the marketplace in the U.S for insurance-linked securities. He said some endowments in the U.S. and corporate pension plans are investing in its funds, but he would not name them. Other clients include the BBC and the Canadian Pension Plan Investment Board, he said.
Mr. Schauble said insurance-related securities offer a true diversifier for institutional investors looking to find an alternative to the lock-step drop of many asset classes during the financial crisis. He said returns for on the securities are almost entirely tied to payouts from catastrophes instead of being influenced by macroeconomic events like other asset classes.
They are also complex securities that are difficult to understand, said Jeffrey MacLean, Los Angeles-based CEO of consultant Wurts & Associates. He said his firm does not recommend them to clients because of the difficulty in understanding the risk level being taken and the potential for loss.
Mercer's Mr. Bisch agreed with Mr. Schauble that the advantage of catastrophe bonds is their diversification from other asset classes, but he noted institutional investors must be comfortable with the level of risk they are taking.
“Most of the institutional clients we work with prefer a more conservative approach,” he said. “They tend to go for very broadly diversified insurance linked securities that take on only very remote risk.”
Mr. Schauble said the securities in Nephila's funds are chosen to offset risk, so hurricane risks in Florida and the Gulf of Mexico are offset by earthquake risk in California or Japan.
In a presentation to Pennsylvania PSERS' finance committee on June 9, Nephila officials said its Palmetto Fund Ltd., the fund later chosen by Pennsylvania for its investment, has 182 positions on different catastrophes with a maximum expected loss of 2% to 3% per position. The fund's biggest exposure is to the Southeast and Northeast U.S. hurricane risk, followed by California earthquake risk, the presentation showed.
The presentation said the $387 million fund (before Pennsylvania added its $250 million) targets net returns of 8% to 10% per year and expected 10% to 12.5% over the next 12 months.
Spokeswoman Evelyn Tatkovski said system officials liked the fund's risk/return profile. “Over the past few years PSERS has endeavored to reduce the risk profile of the portfolio by looking for uncorrelated return streams,” she said in a statement. “The reinsurance market is one new area where we have found the risk/return/correlation profile to be attractive.”
Fund data obtained by Pensions & Investments show the Palmetto fund was down almost 15% in 2005, the year Hurricane Katrina hit, causing more than $40 billion in damage that was covered by insurance.
Mr. Bisch said some funds that invested in Japanese earthquake risk last year through catastrophe bonds and insurance-related securities experienced losses of 20%.
Investors in one catastrophe bond also lost their entire principal. A $300 million catastrophe bond issued in 2008 by Munich Re on behalf of Japanese insurance cooperative Zenkyoren was declared a total loss for investors following the March 11, 2011, earthquake. It was the first catastrophe bond ever to result in a total loss to investors because of disaster.
Nephila, founded in 1997, is the largest player in the insurance-linked securities industry, but it has around two dozen competitors.
John Soo, founder and managing principal at Fermat Capital Management, Westport Conn., with, $2 billion in assets, said clients buying in to his company's cat bond funds include some of the largest sovereign wealth funds in the world. He would not identify any clients.
Fermat's funds only hold catastrophe funds, but Mr. Soo said the bonds are diversified to minimize risk. He said the actual chance of any bond requiring a payout in a given year is 1% or less.