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Finding security in catastrophe

So-called catastrophe bonds have come under increasing scrutiny as the effects of the global credit crunch and market volatility deepen. With investors looking for asset classes uncorrelated with market conditions, the event-linked bond market has become a growing sector thanks to potential high returns in exchange for taking on the risk of events such as earthquakes, disease outbreaks or hurricanes.

And with the rise in risk aversion, bank failures and volatility, these insurance-linked securities (ILS) are considered by many as a safe haven in which to shelter from the credit crunch. In the institutional market, "cat" bonds let insurance companies transfer their risk of major catastrophes on to investors.

They are also seen as a way for insurance companies to offload pure volatility risk and focus on what they do best – claim adjustment, policy sales, and manage subjective and idiosyncratic risks. In a world where fixed income is anything but and hedge funds haven't lived up to their name, insurance-linked securities can offer genuine diversification uncorrelated with major asset classes, making them, by definition, almost immune to market movements.

A recent report by the World Economic Forum put the size of the tradeable insurance risk market at $50 billion, out of total annual insurance premiums of $4,100 billion.

Amidst robust returns, the market has even withstood a bout of forced selling, principally by hedge funds, after US bank Lehman Brothers filed for bankruptcy on 15 September. There were plenty of ready buyers for the bonds, however, which kept prices relatively firm.

Barney Schauble, a partner at Bermuda-based hedge fund Nephila Capital, which specialises in insurance risk, said the simplest way to eradicate credit risk was to use US Treasuries as collateral. "Obviously, investors like more yield if they can get it, but as they have learned, more yield comes with additional exposure," he said.

Many privately placed reinsurance transactions already use Treasuries as collateral, he noted. "From an issuer's standpoint, if you are using a catastrophe bond to buy protection, you want to make sure that protection is there," Schauble said. "So they are very happy for collateral to be in Treasuries."

Nephila Capital, 25% owned by alternatives specialists Man Group, is a leading investment manager specialising in the reinsurance industry with multiple investment products dedicated to investing in instruments such as insurance-linked securities, catastrophe bonds, insurance swaps and weather derivatives. Nephila has been managing institutional assets in this space since it was founded in 1998 and also counts wealthy families and family offices in its client base.

Schauble believes the current climate is producing some interesting movements in the market and thus some potential opportunities for investors."The reinsurance industry is gradually moving to more of a 'originate and distribute' model, which is the rule rather than the exception in credit markets.

This will result in broader opportunities for investors to choose specific underlying risks and profiles for their portfolios. Each type of risk not only has physical characteristics but they also vary by their risk/return profile."

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