Cat Bond Management: A peek Into the Entropics Office
Cat bond investment management is somewhat different from the management of other asset classes as it is slow frequency trading and much more portfolio risk management. Entropics’ portfolio collects risk premiums by holding a globally diversified portfolio of natural catastrophe risk, with little or no correlation with traditional assets classes like equity and bonds. I am often asked by people I meet where cat bond management differs from traditional asset management, and I would like to use the opportunity to briefly explain some of the differences.
The guiding principle of our management is to deliver good returns with a controlled risk by investing responsibly in insurance linked securities (ILS). The basis for our approach to risk control is our view of cat bonds and ILS primarily as a carrier of insurance risks. This may seem obvious at first glance, but it is, of course, equally possible to focus on traditional financial risk analysis and thus to not, in our view, pay enough attention to the underlying insurance risk.
Portfolio Modelling: More Than Stress Testing
Catastrophe modelling provides our portfolio managers with scientific results that can be applied to controlling the risk. Catastrophe modelling is performed by our actuaries, by means of catastrophe modelling software and proprietary models. The results provide the managers with a measure of probability for losses. This is a difference to managers of traditional asset classes who often perform extensive stress tests on the effect of potential capital market crashes, but not necessarily on how probable a crash is.
The basis for our modelling work is a combination of mathematical models of natural catastrophes and insured values, building construction types et cetera.
A crucial property of a portfolio is the structure of the Exceedance Probability curve, EP(x), measuring the probability that a loss of a given size x (or greater) will occur. The corresponding x for a certain probability is called the Value at Risk (VaR). EP is usually annualized and is presented as a curve for the whole spectrum of potential losses. The EP(x) curve provides the managers with a tool to handle concentration risks. In our Monthly Report you will find selected key figures and explanations.
The portfolio turnover is low, as we pursue a buy and hold strategy in the liquid part of the ILS market i.e. listed cat bonds. The portfolio is built up by transactions in the primary and secondary markets. At any given time, we have a short list of 3-5 potential portfolio transactions, which are evaluated at managers’ meetings or whenever deemed as necessary. Upcoming maturities, inflows, outflows and currency hedging are continuously managed from an aggregate portfolio perspective.
In practice, this means that our daily management is very much focused on portfolio risk management and by underwriting discipline combined with modelling capabilities.
One thing that makes Entropics different even from other ILS managers is our investment style, and our focus on responsible investments (RI). Again, RI for cat bonds is, in our view, quite different from RI for other asset classes. While we check the commonly used ESG (environmental, social and governance) indicators, the most important aspect of a cat bond is really the nature of the insurance obligation. We thus primarily look at this aspect and rule out bonds that are not beneficial to society.
Aiming for Risk Adjusted Returns
The total natural catastrophe bond investment spectrum encompasses almost 200 outstanding bonds, with a total volume of approximately $26 billion. It is thus still feasible to have a fairly comprehensive view of the entire spectrum when generating investment ideas. We do, of course, look at every prospect for new bonds in the primary market, but we also keep a close watch of the secondary market. Given the risk metrics and the expected return of the portfolio, the managers, together with the actuaries, generate investment ideas.. These ideas are then tested in simulated portfolios and new risk metrics and expected returns are analysed before an actual investment decision is taken. In between managers’ meetings, the actuaries carry out the orders decided at the meeting.
I hope this gives an impression of what our daily and weekly routines look like. Our operations have a lot in common with any insurance operation, with a strong emphasis on underwriting and actuarial analysis, rather than more frequent trading. I am convinced that Entropics is, based on this approach and the uncorrelated nature of an ILS portfolio, advantageously positioned to deliver good risk-adjusted returns on responsible investments.