UBP Alternative Investments

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1 COMMITTED TO YOU Whitepaper: Why Insurance-Linked Securities should be part of any portfolio UBP Alternative Investments A division of Union Bancaire Privée, UBP SA UNION BANCAIRE PRIVÉE, UBP SA Rue du Rhône CP Geneva 1, Switzerland ai_services@ubp.ch

2 1. What are Insurance-linked Securities (ILS) Insurance-linked securities are financial instruments by which insurance risk is transferred in a capital market contract. The emergence of insurance-linked securities has provided an alternative method for investors to access several insurance sectors and thereby discover a diversified source of return. There are a number of ways that investors can now take pure insurance risk through investment structures. Investments are similar to writing an insurance contract, colleting steady premiums, and then potentially making a large payment upon a trigger event. The catastrophe triggers are clearly predefined and based on an insurance-related event. The insurance can be categorized in Life and Non-life insurances. As life insurance events triggers being excess mortality or excess longevity, the Non-life insurance events triggers can rank from earthquakes, hurricanes, floods or other natural incidents. Terrorism risk has not commonly been securitized, apart from the Golden Goal Transaction where FIFA insured the risk of cancellation of the World Cup 2006 due to a natural or man-made catastrophe, including terrorism. Catastrophe bonds ( Cat bonds ) are fixed income insurance-linked securities that are typically issued by insurance or reinsurance companies. Cat bonds are structured like a conventional bond, with regular coupon payments and redemption payments. The key difference is that all cash flows are paid if catastrophe triggers are not breached. Cat bonds are the most liquid part of the market. The bonds are listed and traded in a standardized and structured market. Cat bond returns can be decomposed into a return for the invested capital (typically the risk-free rate of return) and a spread for the insurance risk premium taken on, known as the insurance risk premium. The greater the likelihood and/or severity of occurrence of an event, the higher the premium will be to compensate the investor for taking this risk. Though the Cat bond market is relatively young (first Cat bond issuance in 1994), it is continuing to grow and evolve with the increased involvement of new investors, such as pension funds and other institutional investors. According to Aon Benfield data, at June 30, 2013 total Cat bonds outstanding was 7.5 billion USD - up from 6.6 billion USD in with most being property issuance with some being life & health related issuance. Cat bonds currently have a set of indices, with the one of Swiss Re seen as the industry reference. Other insurance-linked securities are Industry Loss Warranties ( ILW ), collateralized reinsurance and collateralized retrocession, and other privately negotiated contracts (collectively OTC contracts ). These instruments are typically structured between investors and reinsurance/insurance companies, who directly seek each other for investment opportunities and reinsurance needs. OTC contracts are largely illiquid investments, typically with an accompanying illiquidity premium in addition to the insurance risk premium as seen in the Cat bond environment. 1

3 2. Risk, return and diversification characteristics Interest in Insurance-linked securities has risen in recent years as ILS has exhibited only limited correlation to other asset classes and financial markets in general. Asset class correlation between ILS and major asset classes is shown in the matrix below. Swiss Re Cat bond index correlation with other asset classes Short Term (Oct10 Dec13) MSCI AC World HFRI FoF S&P GSCI Barclays Global Agg Long Term (Feb02 Dec13) Source: UBP, HFR, Bloomberg. Performance Comparison of the Swiss Re Cat bond index with other asset classes Feb02 - Dec13 Swiss Re Cat MSCI AC World 2 Barclays Global Agg S&P GSCI HFRI FoF Annualized Return 8.60% 6.93% 6.19% 4.89% 3.82% Cumulative Return % % % 76.60% 56.30% % 12.70% 5.50% 9.00% 5.70% % -7.30% 5.60% -1.20% -5.70% % 16.10% 4.30% 0.10% 4.80% % 22.80% -2.60% -1.20% 8.80% % Positive 92.00% 60.00% 63.00% 60.00% 66.00% % Negative 8.00% 40.00% 37.00% 40.00% 34.00% Worst Month -3.90% % -3.80% % -6.50% Volatility 2.90% 16.70% 6.00% 23.60% 5.20% Sharpe Ratio Source: UBP, HFR, Bloomberg.

4 The Swiss Re Global Cat Bond Total Return index ( Swiss Re Cat Index ) for the years 2002 through December 2013 had an annualized ROR of 8.6% with a volatility of 2.9%, and correlation of 0.12 to the S&P 500 Total Return Index. For 2013, the Swiss Re Index was +11.4%, building on the +10.5% return made in 2012 and +3.3% in Comparative Cumulated Return of the Swiss Re Cat bond index with other asset classes Barclays GlobalAgg MSCI AC World Swiss Re Cat HFRI FoF S&P GSCI Source: UBP, HFR, Bloomberg. 3. Too good to be true - where are the risks? Insurance linked securities, by their very construction around the occurrence and expected losses of insurance events, present a very large tail risk to investors. The greater the probability of occurrence and expected loss of a given insurance event is, the greater the tail risk will be for the investors. Once the trigger of the underlying security has been breached, the investor will typically have an absolute loss on the investment. It should be noted that any loss is limited to the invested capital only, as the investor is not liable for any loss in excess of their invested capital. Other risk lies in the relatively slow growth in the issuance of new Cat bonds. Concentration risk lies mostly with the exposure to the same region and catastrophe types. Diversification within Cat bonds is thus limited due to limited issuances. OTC contracts present liquidity and marketability risks. Liquidity risk can be limited by holding the underlying investments until maturity. ILS also carries an underlying default/credit risk for the issuer. However, the increasing use of Special Purpose Vehicles ( SPV ) in the securitization process has vastly helped to minimize this risk. There is also a small side pocket risk as liquidity may be limited after a catastrophic event as investors await resolution of amounts or disputes. This will typically be industry wide to a particular event, and not fund specific. The remaining risk that is not diversifiable in ILS is the rare and extreme situation when a combination of various trigger events at a number of places at the same time happens. 3

5 4. The importance of selecting the right manager Investors looking to invest in insurance-linked securities should aim to modestly diversify their portfolios by type of security, peril, risk exposure, geography and trigger. Given the complex structure within the ILS market we believe it is preferable for Investors to select a dedicated ILS manager to identify the ILS offering and within an efficient fund structure. Given the required knowledge and legal and structural expertise associated with ILS, the fund manager needs to demonstrate a proven track record in identifying, analyzing, selecting and managing ILS investments. When choosing an ILS manager special attention has to be placed in the team experience in ILS and the insurance/reinsurance sector in general, and particularly the modeling capabilities of trigger risk, pricing risk and trading. While it is necessary that fund management runs separately from the underwriting business, the unique benefits that come from being associated with a large reinsurer can be significant. 5. Conclusions Insurance-linked securities present investors with an opportunity to access insurance risk directly and diversify away from traditional assets classes. Allocating to insurance-linked securities can increase the diversification within a multi-asset combined portfolio, thereby reducing the overall portfolio risk without compromising expected return. The diversification capabilities within the ILS portfolio and the strong underwriting, pricing and risk management skills are important attributes so that losses, if and when realized, are manageable within the context of the portfolio. We believe that investment teams that are highly experienced in ILS and integrated within the insurance sector in general - including the modeling of natural disasters, pricing risk, and trading - have a critical advantage in this industry. An asset management team that can construct a diversified ILS portfolio to meet each fund s risk return profiles whilst running their activity separately from underwriting can provide an attractive risk-adjusted offering for sophisticated investors. We recommend taking this crucial point into consideration when analyzing and selecting the ILS manager for a well-diversified portfolio. 4

6 DISCLAIMER This document is confidential and is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of, or is located or incorporated in, any jurisdiction where such distribution, publication, availability or use would be contrary to applicable laws or regulations, or which would subject UBP and/or its subsidiaries or affiliates to any registration or licensing requirement within such jurisdiction. This document may not be modified, distributed, reproduced or referred to (in whole or in part) without the prior, express written consent of UBP. This document reflects the opinion of UBP as of the date of issue. The information, opinions and analysis contained herein have been based on sources believed to be reliable. However, UBP does not guarantee their timeliness, accuracy, or completeness. All information, analysis and opinions are subject to change without notice at any time and with no obligation to update. This document is not intended to provide a sufficient basis on which to make an investment decision and is not a personal recommendation or investment advice. It is intended only to provide observations and views, regardless of the date on which the reader may receive or access it. Each person is urged to determine whether any investments suit their particular circumstances and to independently assess, with professional advisors, the specific risks incurred, including without limitation at the financial, regulatory, legal, accounting and tax levels. Past performance and/or financial market scenarios are no guarantee of current or future returns. Where these materials contain statements about future performance, such statements are forward looking and subject to a number of risks and uncertainties. The opinions, analysis and information herein do not take into account circumstances, objectives, or needs of any specific person. Investments may be subject to risks that are difficult to quantify and to integrate into their valuation and significant fluctuations in their value or return may occur. Products with a high degree of risk, such as derivatives, structured products, or alternative/non-traditional investments (hedge funds, private equity, real estate funds, etc.) are suitable only for sophisticated investors who are capable of understanding and assuming the risks involved. Investments in foreign securities or currencies involve additional risk as the foreign security or currency might lose value against an investor s reference currency. This document is without express or implied warranties or representations of any kind and UBP will not accept any liability whatsoever for any loss or damage resulting from the use of, or reliance on, the information, analysis or opinions contained herein. In Switzerland, Union Bancaire Privée, UBP SA, is authorized and regulated in by the Swiss Financial Market Supervisory Authority (FINMA); in the United Kingdom, it is authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority (FCA). 5