White Paper by Florian Steiger
A Systematic Approach to
Cat Bond Portfolio Management
Whilst the cat bond market has been a huge success, there have also been failures and weaknesses in structures and strategies. The approach to managing cat bond portfolios employed by many asset managers in the space is often characterised by a lack of structure, robustness and transparency.
Furthermore, conflicts of interest by the involved parties, such as brokers and modeling firms, a limited understanding of qualitative aspects, and an overconfidence in quantitative risk models can result in poor investment performance. Differences in valuation methodologies can drive meaningful performance dispersion between otherwise comparable cat bond portfolios run by different managers.
All these factors can make it difficult, if not impossible, for investors to accurately assess the risks and returns associated with various cat bond funds. Additionally, many of the individuals and institutions that manage cat bond funds have a background in the insurance or reinsurance industry, which can result in intellectual biases that might negatively impact the performance of their funds.
We believe that investors should be aware of what has worked well and what needs improvement. We are happy to share our honest thoughts and how we deal with these issues as part of our investment process in this white paper.
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Examples of critical aspects covered:
Model uncertainty
Cat bond investors have long relied on the sophisticated and standardised models provided by external research firms to calculate their perspective on expected loss and other critical risk metrics. These models play a pivotal role in informing investment decisions, offering a quantified view of potential risks. However, it's becoming increasingly clear that these industry-standard models, while robust, may not fully encapsulate the dynamic and evolving nature of global risks – particularly in light of current trends like climate change or inflation.
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Private ILS & trapped collateral
Private ILS, also known as collateralised reinsurance, are illiquid and bespoke instruments within the ILS asset class. Unlike cat bonds, these structures provide investors with access to a broader range of perils for portfolio diversification. However, the lack of standardisation, along with modeling flaws and information asymmetries, has historically led to underperformance compared to cat bonds.
Transparency
In the world of cat bond investments, market transparency, or rather the lack thereof, poses significant challenges for investors, particularly in areas like pricing in the secondary market and the sharing of loss information. These challenges are not just logistical but also impact the strategic decision-making process for investors.
Fund valuation
Fund valuation is a critical process, with different approaches offering varying degrees of accuracy and insight. The methods used can significantly influence the perceived value of a cat bond fund. In our White Paper, we explore the most common valuation methods – average mid, average bid and mark-to-model – highlighting their implications for investors.