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The ILS Funds. Investing in Insurance Linked Securities – An Opportunity for Buy Side Innovation November 2008. Executive Summary.

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The ILS Funds

Investing in Insurance Linked Securities – An Opportunity for Buy Side Innovation

November 2008


Executive Summary

  • Insurance linked securities (“ILS”) have performed remarkably well - both the historical performance and current yields of the securities make them an attractive diversifying element of the bond and/or alternative asset portfolios of institutional investors. High relative value, high non-correlated returns, resilience in market downturns.
  • Developing and managing a portfolio of these securities requires a detailed understanding of the underlying portfolio exposures and the complex models used to measure the embedded risks. Investing in the securities requires knowledge of insurance operations and capital management.
  • The ILS Funds have been organized to bring insurance operating experience to ILS investing. The fund is being formed by three seasoned professionals expert in risk modeling and capital management. Other funds seeking to enter the space are backed by conflicted intermediaries.
  • The target is a $250 million fund, deployed over 12-24 months, providing returns of LIBOR + 500 bps. It is organized as a closed end bond fund with two subfunds, one investing in “life” ILS (embedded mortality and morbidity risks) and one focused in “non-life” ILS (embedded property risks). Targeted formation date is March 1, 2009, following the close of the 2009 reinsurance renewal season.

$15 b of non-life ILS outstanding

In 2008, origination has slowed only slightly. New uses for ILS (e.g., facilitating transactions) are adding to the new origination volume. Soft reinsurance pricing has not stopped ILS growh.


Attractive Performance of the Asset Class

A basket of BB-rated ILS (SRCATTRR:IND) returned 44.0% from 11/7/2003 through 11/7/2008. This period includes the only insurance loss yet to occur – a recovery after the Katrina – Rita – Wilma storms of 2005. A well-regarded managed portfolio of corporate BB bonds (BHYAX:US) had negative returns over the same period. The most recent returns have sustained this view …


Strong but Imperfect Non-Correlation

In the six months ending 11/7/08, two market changes have affected ILS prices. First, a repudiation of risk generally (flight to Treasuries) and of modeled risk in particular. Second, collateral quality is now a major issue in market pricing and four ILS issues traded sharply lower due to the use of corporate paper. ILS have still performed much better than similarly rated corporate bonds.


Excess Spread Opportunity

Spread over LIBOR (bps)

Est. Loss Cost (bps)

At 9-30-08 87 issues paid spreads above LIBOR >5x the expected loss costs ……


ILS as Reinsurance

The current bid pricing can be used to calculate an expected loss ratio – the portion of the spread over LIBOR that will ultimately be returned as indemnification for losses. The average ILS is priced to an expected loss ratio as follows:

Priced and traded as a bond, an ILS is also a limited duration, specified and remote risk reinsurance policy. Thinking of it as reinsurance, this is hard market pricing, and exactly the pricing environment where successful companies get created.


ILS as Reinsurance – Lower Operating Costs

Assembling a portfolio of cat bonds can be done without broker commissions, the high overhead of a Bermuda office, or the risk of adverse development in old accident years. Compared to operating an insurance company, both loss costs and expenses are lower :

Lower operating costs lead to higher profits with less risk….


ILS as Reinsurance – Higher Profits, Lower Risk

ILS pay a much higher return per quanta of risk. The profitability of the spread over LIBOR is analogous to reinsurance premium, and can be used in measures of underwriting profitability:

ILS investing is low leverage – $1 invested is $1 at risk. Reinsurers take on over $2 of risk for every $1 of capital. Debt and “side cars” both increase leverage and present risk returns as service fee income. The ILS Funds will be deploying capital over the course of 2009, and will be only 30% deployed on average. Even after this leverage, higher returns come from a portfolio of ILS holdings:

A $1 of risk pays ILS investors $6.32 while reinsurers get $1.11.


Operations expertise manages the risk

  • Example – Cat Bonds
  • Accurate measurement of the risk of loss costs requires insights that come from operating insurance companies.
    • Understanding and using geo-coded data
      • Adjusting for the use of “centroid” data
    • Timely and accurate “insurance-to-value”
      • Correcting for historical errors
    • Monitoring aggregate exposures
      • A second 1000 Cape Coral residences has a different risk-return profile than does the first
    • Changes in the underlying risk portfolios
  • Example – Model Selection
  • Issuers can game model selection, so successful investing requires mastery of the detailed data.

A real world example follows: one company’s insured exposures and the 1938 hurricane.


One model predicts losses of $21 mm

  • RMS losses concentrated on right side of storm track.

A second model says $235 mm

  • AIR distributes loss to both sides of storm track.

Issuers can “game” model selection, so investors

must master and model the detailed data

  • Both RMS and AIR say they are providing the right answer
    • Long Island Express footprints accurately reflects reported wind speeds and damage.
    • Industry aggregates are within 5%, yet distribution of loss varies considerably between models.
  • Sample Co. versus industry
    • Sample has no MA exposure, where RMS is higher for industry.
    • Sample has peak exposures in NJ where RMS assigns no loss.

Experienced insurance operators, we insist on closing with the data. This produces better ILS investment decisions.


Black Swans

  • Insurance linked securities are subject to model risks:
    • Data integrity
    • Model selection
    • Scope and currency of the model
    • Timeliness of the results
    • Bias to action by the model user
  • Ignorance of the model limitations guarantees model risk, while close attention to data and model issues minimizes the risks.
  • The insurance industry’s broader problems with coverage definition, regulatory and rating agency risk, et al are not transferred in the securities. Counterparty risks, systemic risks, et al are present, but minimized by the structure of the securities.
  • ILS have one-way non-correlation – the ILS loss triggers are not caused by other events in the capital markets. Capital market events have effected the collateral of four of the outstanding cat bonds. The last 3 months dropped corporate bond prices 23%, and dropped ILS prices 2.5% .

ILS are complex securities, but simpler than MBS.

Portfolio results are largely driven by non-correlated risks.


Best Choice for Your ILS Manager

  • No channel conflicts
    • Of the 10 funds active or forming, 7 are sponsored by brokers or reinsurers. The parent organizations make a greater margin from traditional reinsurance, so the funds have to make decisions accommodating unrelated business interests, and investor money is put into sidecars and “special situations”. The ILS Funds are focused on ILS.
  • Appropriate fee structure
    • 6 of the 10 funds have PE / hedge fund style “2 and 20” management fees. The ILS Funds charge fees appropriate to a bond fund: a 25 b.p. management fee until the money is deployed into ILS, and 60 b.p. management fee on ILS invested funds.
  • Closer to the data
    • Only The ILS Funds have been formed by actuaries and accountants skilled in insurance company management, rather than brokers and consultants. The ILS Funds have the tools and inclination to “trust, but verify”.
  • Better Risk Management
    • 8 of the 10 funds operate or will operate without systems for aggregating exposures across securities. The ILS Funds have adapted an enterprise risk management model to the ILS investment business, and are able to aggregate exposure information.
  • Access
    • Broker and reinsurer funds have proprietary access to only their own transactions. The ILS Funds are an investor attractiveto all originators.

Significant supply of new investment opportunities

Sources of New Business

Assuming future growth at half the historical rate, the new originations increase from the current $14b to $119b per year.

  • Bankers
  • Goldman
  • Lehman
  • UBS
  • Brokers
  • Benfield
  • Aon
  • Guy Carpenter
  • Reinsurers
  • Swiss Re
  • Munich Re
  • AIG
  • Pvt Placements
  • Bankers
  • Brokers
  • Direct
  • Swiss Re has indicated they will provide to The ILS Funds 6-8 investment opportunities of $5-10 mm each every 6 months.
  • The total pipeline of The ILS Funds is estimated at 2x the Swiss Re offer, or over $200 mm per year.

Total volume outstanding is projected to grow to over $300b, again assuming growth at half the historical rate.


Structure of The ILS Funds

  • Terms
  • Structured as a closed end bond fund
  • Qualifying investments limited to ILS – no sidecars or “special situations”
  • Investors elect life / non-life allocation
  • 10 year life
  • Qualifying investments have a maximum term of 7 years, expect 3 yr avg
  • Management fee of 25 bp on uninvested funds, 60 bp on ILS invested

The ILS Funds

$125 mm

$125 mm

  • Non-Life Fund
  • Cat Bonds
  • ILWs
  • Other
  • Life Fund
  • XXX Bonds
  • Other


  • Non-Life Fund
  • MA, Partner
  • DB, Associate
  • Life Fund
  • NB, Partner
  • AA, Associate
  • Shared Resources
  • PK, Partner
  • PC, Associate
  • GW, Analyst
  • AS, Controller

Investment Process

  • Small, Disciplined Group
  • Independent risk of loss analysis using multiple models and the same or proxy data
  • Comparison of returns to target LIBOR + 500 bps
  • Proforma effect on aggregate exposure models
  • Investment committee presentation and decision
  • Call and funding
  • Daily monitoring of any developing risk issues
  • Quarterly reviews of all individual positions and aggregate portfolio
  • Quarterly reviews of price targets
  • Daily calls to discuss any open trading orders

18-24 investment

opportunities per year













Background of the Professionals

NB, Partner, FSA

Responsible for management of the life fund, NB is a senior actuarial partner with a Big 4 accounting firm. His background includes 20 years of actuarial consulting and 5 years of operating life, credit life and annuity insurance companies. He has been involved in structuring and purchasing reinsurance for the bulk of his career, and is currently responsible for the life securitizations of the nation’s largest insurer. He will devote full time to The ILS Funds.

Preston Kavanagh, Partner, CPA

Responsible for overall management of the funds, Preston is an experienced insurance entrepreneur who also has 10 years of experience in the operation and management of investment funds targeting the insurance industry. His background includes 10 years with KPMG (8 years in actuarial consulting), 10 years as a partner managing the Conning Capital Funds, and 5 years operating property-casualty insurance companies. He has been involved in structuring and purchasing reinsurance in workers compensation, homeowners insurance, commercial specialty lines and excess and surplus lines, including membership on the Reinsurance Security Committee of Alleghany Corporation. He contributed to the development of the risk based capital models used by the NAIC and AM Best, and is familiar with the risk capitalization models used by the major rating agencies. CPA, CMA, CLU, ChFC. He will devote full time to The ILS Funds.

MA, Partner, FCAS

Responsible for management of the non-life fund, MA is the risk and reinsurance officer of a property insurance company with 400,000 insured locations. He has been involved with insurance and reinsurance of property risks for the bulk of his 25 year career, including 2 years spent developing one of the leading cat models and 5 years steering the development of the other model as that company’s beta user. He will devote full time to The ILS Funds.


Background of the Professionals

DB, Associate

[Support for cat bond modeling, out of cat modeling firm].

AA, Associate

[Support for mortality / morbidity modeling, out of actuarial consulting firm].

GW, Analyst

[Utility infielder for investment cash flow analysis and modeling, out of NY group focused on ILS].

PC, Associate

[Support for IT and communications technology].

AS, Controller

Responsible for the day to day cash operations and reporting of The ILS Funds, AS has 8 years of experience as the controller of the Conning Capital Funds. This involved accounting and reporting for 20 entities and 120 limited partner interests.

Investing in ILS requires expertise in insurance company data and operations, catastrophe models, and acting on the relevant insights. Only The ILS Funds brings the expertise without conflicts. The best choice for your ILS manager is The ILS Funds.


Associated Professional Firms


Actuarial Consulting, Non-Life

Towers Perrin

Actuarial Consulting, Life

Goodwin Procter




Innovative Computer Systems






Next Steps

The ILS Funds are now seeking expressions of interest. If you would like to receive additional information, please contact [fund raising agent], at the following:

To schedule a meeting with the fund managers, please contact the following: