MAY 2016

Examining the risk diversification potential of ILS investments for asset owners and the headwinds new investors face

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INSURANCE LINKED SECURITIES FOR INSTITUTIONAL INVESTORS

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Noel Hillmann: Is an investment in ILS still attractive for institutional investors in the current market environment?

Greg Hagood: Our position is that ILS is still attractive as the asset class has a positive expected return and is not correlated to the broader financial markets. This is our 18th year in the business and we have lived through several disruptions in the broader capital markets, such as Long Term Capital, the 9/11 terrorist attacks, the tech bubble and more recently the 2008 financial crisis. In each of these dislocations, our returns held up and the integrity of the non-correlation story was demonstrated. The traits of the asset class are both rare and valuable.

Noel: Should investors wait to enter the market – perhaps after a large catastrophe event when pricing may have improved?

Greg: Each investor will take their own view of market timing, but obviously post a catastrophe, spreads should widen and we have seen this historically. After hurricanes Katrina, Rita and Wilma in 2005, spreads in the reinsurance market approximately doubled. If a similar event were to happen today, we believe spreads would not widen nearly as much, simply because new capital could flow to the opportunity so much quicker now that fund managers, side cars and cat bonds are so much more developed.

In terms of whether investors should wait to enter the market post-event, many of our investors think about their

allocation with us as a core strategic weight for the diversification benefit, with the ability and plan to tactically adjust up or down based on market conditions.

Investors might have a core strategic weight of 2% and the ability to dial the weight up to 4% post event or take it down to 1% if market conditions were tight. Given current market conditions, most of our investors are at strategic weight and post event our expectations are that most investors would dial that up to above weight as you would do in any other asset class.

We do have some purely opportunistic investors who only enter post event and it is nice to have that “accordion capital” in dislocated markets.

Noel: Is there a particular environment that is opportune to be entering into the ILS sector?

Greg: If you take at face value that the asset class has a positive expected return and is non-correlated, that is a benefit in and of itself.

The perfect environment would likely be after a series of large catastrophes where the market is quite dislocated and there is a shortage of capital in the broader market.

Noel: How do managers add value to this market?

Greg: Reinsurance is not an exchange traded risk. Therefore, strong and deep origination capabilities are very important for optimal portfolio construction. In all markets, a larger

investible universe is better to choose from than a smaller one.

Investors also need to find out how strong a manager’s research and risk analysis teams are. The best managers will have a deep and experienced research team, primarily focused on making the baseline catastrophe models more robust and fully understanding the market landscape.

Another advantage investors should consider is the benefits of scale with their manager. Post the financial crisis in 2008, insurance companies became more focused on the creditworthiness of their trading partners. This led to much more reinsurance business being placed with larger, better rated, more strategic trading partners. This development has been termed “tiering” in the reinsurance market and it basically means the larger, more strategic managers are receiving better pricing and better signings than the smaller players who trade only in the broader syndicated reinsurance markets.

Currently, in the syndicated market, if you want 100 dollars of a particular transaction, you are only able to get 50.

If you are a manager in the top tier of the market, not only do you get better pricing for the risk, but if you want 100 dollars you are more likely to get that 100 dollars which is helpful for investors.

Noel: What is it that investors need to be looking for and what questions do they need to be asking managers to determine the best fit for them?

1.4 INTERVIEW

How should investors view the ILS opportunity today?

Interviewer Interviewee

Noel HillmannManaging Director, Clear Path Analysis

Greg HagoodCo-Founder and Managing Partner, Nephila Capital

How should investors view the ILS opportunity today?

Greg: They need to see what value that manager adds, how big their staff is, what is the experience of their team, have they been through a series of losses with investors alongside and if so, how did they manage risk?

They also need to focus on all-in fees and not just the headline fees. Many times the headline fees might seem to be lower for one manager over another, but investors need to dig deeper to see what the hidden fees are.

There are many places where fees might not be as transparent. For example, is the manager investing in side cars or quota shares and if so, what fees do they pay to the sponsor for sourcing risk on the manager’s behalf? Do they use a fronting company and do they use leverage? If so, what are the fees for these services? Do they source risk or obtain modelling services from a parent company and if so, what fees are paid to the parent for these capabilities? Is the manager large enough to negotiate lower brokerage fees on behalf of investors?

Investors need to ask questions relating to the fees coming out of the entire proposition as opposed to just the management and incentive fees to help differentiate the value a manager provides.

There are also potential conflicts of interests that arise, whether perceived or real, that can occur when the manager is part of a larger organisation and these should be explored as well.

Noel: Nephila has recently begun to source risk in the insurance market as well as the reinsurance market. What are the main reasons for doing that?

Greg: Portfolio construction benefits from having as large an investible universe as possible from which to choose.

We have 150 people at our firm and certainly have the capability to see the

risk in the insurance market and be closer to the original point of sale.

For investors, we started down this path about 3 1⁄2 years ago and have built out a platform to see and analyse risk in the market and we feel that one of the biggest benefits to investors is just having a larger investible universe.

For example, there are times when reinsurance pricing is better than insurance pricing and vice versa. Thus, if we access the risk in both markets, we can tilt the portfolio accordingly and this will be of benefit to investors’ expected returns over time.

The other big benefit is by being closer to the original point of sale, there are some cost efficiencies that can be gained and this is something that

we are also focused on to benefit our investors’ returns.

Noel: How has the market changed in recent years and what can investors expect in the medium term from this asset class?

Greg: The biggest change in the last 10 years is that the capital markets have gone from taking no reinsurance risk to being about a 20-25% market share of the world’s catastrophe risk today. As premiums have come down in the last 5 -10 years, we would argue that is somewhat due to a lack of catastrophe losses, but some of it is also because of the type of capital that is financing the risk.

There is a more efficient cost of capital financing the risks from the capital markets and the natural clearing price for this risk has come down.

So, part of the decline in premiums over the last 5 years in our view is secular in nature and will most likely not return, and part of it is cyclical because there hasn't been a lot catastrophe loss activity.

In terms of what the future holds, technology will likely play a larger role in our market down the road.

We also feel that efficiencies will be brought to the distribution chain for risk and more of the original premium dollar will go to the people who assume the catastrophe risk.

Noel: In terms of new investors who are coming to the market, do you see a shift in the investor profile that still hasn't tucked into this market place who really should be giving it greater consideration?

Greg: In the first 8-10 years of our business, our investor base was more fund of funds, family offices and hedge funds.

In the more recent 5-10 years it has transitioned primarily to pension funds and university endowments etc. and we expect this trend to continue.

One channel that hadn't come into the market until recently was retail investors.

“Investors need to ask questions relating to the fees coming out of the entire proposition as opposed to just the management and incentive fees to help differentiate the value a manager provides.”

How should investors view the ILS opportunity today?

There have been some products in Europe and more recently in the U.S. that are bringing retail customers to the market and we are still evaluating the market impact.

Noel: Do you feel that the term of insurance linked securities is one that has an inherently risky attitude associated with it?

Greg: One of the issues that we run into a lot is that people don't have a natural bucket for it in their strategic asset allocation or policy.

They have a bucket for equity, private equity and even hedge funds and many times ILS ends up in another bucket like absolute return or core fixed income.

This said, the attributes of the asset class are so powerful that people try to find a home for it.

More broadly, the acceptance of the asset class is light years ahead of where it was even 10 years ago. Education on the space is much higher and the conversation now is more about differentiation amongst fund managers and approaches than it is what is re insurance or insurance, so we have come a long way.

Noel: Can the asset class continue to grow?

Greg: It will continue to grow as it is just too powerful a story. Investors are looking for diversifiers and the world’s global capital market assets are becoming more correlated due to the global interconnectivity, so something

that is truly not correlated that has a positive expected return will continue to attract capital.

Noel: How do you decide when you can take in more investor money?

Greg: It is very simple, as we have different funds with different objectives and we take the amount of capital that we feel that we can to make those stated objectives.

As an example, we have not taken capital as a firm for the last 2.5 years and we believe this is the right thing to do as a fiduciary of investors’ capital.

We have recently reopened our funds for a limited amount of capital for certain funds as we thought we could accept this additional capital while still meeting their required return/risk metrics

Noel: Thank you for sharing your views on this topic.

“When the market pricing gets better, it may be that we can take more but right now we have been very judicious in our capital approach and doing the right thing for investors will serve both them and us in the longer term quite well.”

Colin Browne: To start with, since this is an introduction to the asset class, how do you define weather risk?

Barney Schauble: Catastrophe is really risk of damage and buildings being knocked down by natural hazards like winds, earthquakes and other storms.

When we talk about weather what we mean is more of a physical manifestation of normal weather so how much rainfall do you get in the course of a year for a hydro electric plant, how much snow do you get for a ski resort, what is the temperature for an energy company etc.

There is even a wind component, which is related to how much wind blows for your wind farm rather than the level of wind with respect to an actual windstorm.

It is still a natural variable, objective and measurable, but driven by Mother Nature, not human behaviours necessarily.

It retains that non-correlation component to broader financial markets but it is a different variable than catastrophe risk.

Colin: Is this an area that is going to become more difficult to predict going into the future or are the changes that are happening more gradual?

Barney: You have to look very carefully at the exposure that you have and how that is changing.

The implications for snowfall in the next 10 years, relative to the last 50,

years is very different than for the temperature in Arizona.

The way we think about weather and catastrophe risk as a variable is that it is a physical system and you can model it and you are not trying to predict the psychology of the stock or bond markets.

How you model it is different as when you are thinking about earthquake modelling you are thinking about historical fault activity and the underlying physics of that.

Whereas when you are thinking about modelling temperature you are looking at 50 years of information at say, Heathrow and you can look at the trend over the course of that time period to see a gradual warming trend, a stable trend, more frequent but less severe rain or snow storms, etc.

There is a huge amount of information you can use to make that determination and that is the advantage.

You certainly have to look at trends and changes but that is going to manifest itself differently in different places and you have to be aware of that as a buyer or seller of that kind of protection.

Colin: Is weather risk a more stable investment choice than catastrophe or are they just different animals?

Barney: I feel they are different animals and it is a much smaller sector.

Businesses and individual people have been buying property catastrophe risk protection for hundreds of years.

Weather risk is a little different in that way and really that is a question of pricing as if you had two risks, one of which you were extremely confident in the modelling but you got paid very little and the other you were less confident but got paid a much higher price, which is the most prudent investment? So it is not just a function of risk analysis.

We do believe that with weather risk analysis, both as a buyer and a seller, you can have some meaningful confidence that you know how this system behaves and you aren't going to have a day that is 0 and then the next day is 20.

You aren't going to have wind speed that goes from 0 to 100 miles per hour for an entire year at a wind farm so there is some fundamental stability built into the system in a way that is not for financial markets.

Colin: What are the factors that people need to know about this area to give them some insider knowledge?

Barney: There has always been some basic component of weather risk transfer in insurance as people would buy protection against low snowfall etc., but the weather market as we know it today came about with the growing popularity of energy trading in the late 1990s.

When you look at the trading of coal, natural gas, and power, people realised that this was really just being driven by the weather.

2.2 INTERVIEW

An introduction to weather risk as an ILS asset class

Interviewer Interviewee

Colin BrownePublisher, Clear Path Analysis

Barney SchaubleManaging Partner, Nephila Capital

An introduction to weather risk as an ILS asset class

You then had this development of a market, which initially started as weather derivatives where people would try and come up with a way to match each other’s exposure, which is where you come up with a standardised product that would be bought and sold through an exchange.

I was involved personally in some of those early transactions in my banking days and the idea made sense as there are a lot of companies out there with an exposure to weather. If you Google weather and earnings there are a shocking number of companies who either blame or credit a fluctuation in their earnings on the weather.

The idea of developing a risk transfer product to deal with that made sense.

I joined Nephila in 2004, having spent the prior part of my career largely in banking and thinking about risk management products. Our view as a firm was that if this market were going to grow then it wouldn’t be so much as an exchange-traded product.

This is because if we took someone who benefits from rain, like a hydroelectric facility, and someone who doesn't, like a nearby golf course, it is very unlikely that their exposure is exactly the same and that an exchange traded product is going to meet their requirements.

Our view was that this market would develop in a way which was similar to the catastrophe risk market meaning that you would want more customised coverage as a buyer, and as a seller you could assemble a portfolio of customised coverage and there would be investor interest in this idea of some 0 beta, positive return, natural statistically driven asset class.

This is what has happened over the course of the period that we started in 2005 in a dedicated fund for this product and it isn't particularly well known.

Part of this is that there is still a low level of awareness in most sectors about the availability of these tools, so we have spent a lot of time working with partners like KKR and Allianz as well as insurance brokers, banks and risk consultants, informing them that they should be aware that this is available.

We are letting them know that if there is a transportation, agricultural or renewable energy problem that is largely driven by the weather, they do have an alternative rather than saying that the weather was good or bad.

It isn't well known from either an investor or user standpoint right now but that is starting to change.

Part of what is changing this is the growing importance in renewable energy in a variety of power markets.

There is awareness that weather is driving earnings for companies and some sensitivity to that. The SEC and the Bank of England are asking for more information on the implication of weather or climate exposure to your company.

The message we are trying to get across is that there is a potential risk transfer solution for these kinds of exposures and if that results in an investable product, it may be of interest to investors.

Colin: Are these very long-term investments and are there tactical approaches to these types of risks or is this something that would factor into an existing product?

Barney: There are some periodic, climatic issues that you have to factor in and this is true for hurricane risk as well. An El Niño versus a La Niña year gives different implications for what you might see in terms of storm formation and that is something that we feel is important.

You may be operating a hydroelectric plant and you know that over a five year period, there will be at least one year where rainfall is going to be very low and you will have to go and buy power from somewhere else to supply it to your customers.

You don't know what year that is going to be and whether it will be driven by an El Niño or La Niña, but it is unexpected and you have a difficult time planning for it.

In this case you could say that you would like to buy protection over the course of the next 5 years for 1 or 2 of those years and you are willing to accept that when that happens, it costs you a certain amount of money and you are willing to pay from premium against that downside.

It is different than catastrophe risk as you are not saying a 1 in 100 year earthquake is going to impact me but rather a 1 in 10 year probability but you want to buy protection over the next 5 years.

This is a risk smoothing and risk transfer exercise that makes sense as you now have more predictable cash flows.

Where it doesn't work is where you may have a hydroelectric plant in a place where you know that when there is a La Niña there you get very low rainfall.

When you get in a situation like we are in today, where there is an increasing probability of moving into a La Niña at the end of 2016, and somebody calls up

“Part of what is changing this is the growing importance in renewable energy in a variety of power markets.”

An introduction to weather risk as an ILS asset class

looking to buy protection for 2016 that is where it doesn't work.

There are situations where that will drive more demand and if you look at the impact of El Niño over the course of the last year and a half, all around the world, it clearly drives people risk awareness.

There are however the issues where the cyclical nature or the ability to forecast means that it starts to become less of an insurable risk.

Colin: With the move toward more weather-sensitive renewable energy sources, do you think this sector will become more mainstream?

Barney: We think so because in the development of renewable energy for a long time period, you often have early issues that have to do with technology; are the turbines and solar panels going to work; what is the local regulatory regime; do people want this, etc.

20 years ago in the early days of the weather market, renewable energy was facing those types of issues. But

now many of those changes have been met or well understood and growth of renewable energy is continuing in a pretty dramatic way.

If you are in the renewable energy business, then you are effectively in the weather business.

If you are financing that business or thinking about the variable cash flows from that business, looking at weather risk transfer makes a ton of sense.

We have a meaningful history and experience in hydro, wind and solar so we do feel that this is going to cause a real demand in uptake from these sectors in these kinds of products.

This is one of the factors that is causing growth in the weather market and by extension growth in the opportunity to invest in weather.

We did six transactions last year protecting against wind in one form or another and that includes not just protection for people who own a wind farm and want the wind to be high, but also includes someone who competes

with the wind farm and wants the wind to be low.

If you are in Texas and are operating something that is not a wind farm, the pricing in that market is driven by the overall level of wind in the grid, so there are many other people who are exposed to the impact of that natural phenomenon.

If we sell protection to one English wind farm and 10 others say they want exactly the same sort of transaction, that is obviously going to lead to an opportunity for us to raise more capital and for investors to say that they can now invest in this portfolio of wind alone.

We feel that this is a huge driver of potential growth in this space.

Colin: Although you aren't in the business of infrastructure, do you have conversations with energy clients and firms about potential opportunity areas for growth?

Barney: Absolutely. Some of your readers are going to be pension funds that do invest in infrastructure and are looking for projects and although it is true that we aren't going to go build hydro plants ourselves, there are many people who will.

Where this can be helpful is when an investor decides they want to put capital into a new project, but they are concerned that although they are good at building a certain type of operation and can raise the finance to build it, if they don’t get the rain they need, they won't recover the cost of that investment.

“Absolutely. Some of your readers are going to be pension funds that do invest in infrastructure and are looking for projects and although it is true that we aren't going to go build hydro plants ourselves, there are many people who will.”

An introduction to weather risk as an ILS asset class

We have seen this is even at a greenfield stage, where the sponsor of a new project wants to buy protection to de-risk their weather exposure, so that if they build a dam and don't get rainfall, they will get a payment in the interim to allow them to service the debt on the project.

This removes that fairly large risk factor and allows them to get the financing that they need and complete their project.

Colin: Looking to the broader ILS space, there is still a perception that it is too new or too under- tested for it to be a smart investment choice. How do you counter that perception?

Barney: It depends on your perspective: personally, I don’t think of ILS as a new market. I wrote my undergraduate thesis on the idea of a catastrophe bond in 1994.

I then worked on the first catastrophe bond, which was executed in 1996 and this bond ended up paying some claims to its sponsor, though it ultimately did make money for its investors. So 20 years have now passed since that landmark transaction.

Having been at Nephila in 2004, 2005 and 2011 and seen market testing both from natural catastrophe events and financial market events, on the one hand it is new in that many people are unfamiliar or not invested in it, but on the other hand it is not new at all when you compare to peer to peer lending.

It is new in that its penetration is not like credit where everyone owns equities and credit and has some commodity exposure.

As a firm we don't think of it as new and untested in that we feel that both through financial and environmental catastrophes, the asset class has done exactly what it was supposed to do.

I would say the same about weather. We set up a dedicated fund to invest in weather in 2005 and that fund has had years of good weather and not so good weather, investors have come and gone from it and people who buy protection have been paid or have not needed protection etc., but it is still something of which many investors

and companies are not aware.

It is new to many people as an asset class in that they haven't invested in it but in terms of concern about whether it will work properly or the legal or regulatory environment for it, or what happens when there is a loss, we feel that we can point to a lot of factors that would give both buyers and investors comfort.

A question might be whether it is a good investment for your underlying pension constituents, in terms of: do you feel that you can quantify the risk and return relative to other things?

We feel that this is the case as we can show the underlying exposures and a realistic range of probabilities of

payouts and individual contracts on the overall portfolio.

This relies upon some stable, natural systems. We feel that a portfolio of wind, temperature and rainfall contracts is more quantifiable than a portfolio of technology stocks in terms of what its potential behaviour might be.

From this standpoint, we feel that there is a risk and return that an investor can point to as a prudent investment and can get an understanding of the upside and downside and make a judgement accordingly.

It won't necessarily be for everybody, just like other parts of ILS, but you can at least make that determination.

A second question might be whether it is a good investment to make from an ESG standpoint.

This isn't about selling firearms to another country but helping to provide a risk transfer buffer to sensitive businesses.

To the extent that you are losing money, you aren't doing so because someone made a bad loan or sold something undesirable, but rather that your money is being transferred to someone who has been impacted by a weather exposure and needs this capital to weather that volatility in their business.

Unlike the global financial crisis where you may have ended up saying we invested in products that were built upon some questionable underlying risk metrics, with ILS and weather it can be about people losing their homes, businesses, buildings and some of the money goes to repay them and transfer that risk to you.

This is an outcome that feels on a fundamental level to be a prudent thing to invest in relative to some other investment opportunities that are out there.

“This relies upon some stable, natural systems. We feel that a portfolio of wind, temperature and rainfall contracts is more quantifiable than a portfolio of technology stocks in terms of what its potential behaviour might be.”

9

An introduction to weather risk as an ILS asset class

It is a positive contribution to society in the same way that a pension fund itself is a risk buffer for society in providing businesses and individuals with another form of risk buffer.

It is a non zero sum type of investing and not something where you might have one stock and I have a view on the same stock and one of us will be right.

Colin: Thank you for sharing your views on this topic.

Contact us at info@nephila.com or Visit us at www.nephila.com

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Markets Change.Weather Changes.Nephila’s focus remains the same.

Nephila Capital Ltd is the largest and most experienced investment manager dedicated to reinsurance and weather risk. Nephila offers a broad range of investment products focusing on instruments such as insurance-linked securities, catastrophe bonds, insurance swaps, and weather derivatives.

Nephila has assets under management of approximately $9.5 billion as of April 1 2016 and has been managing institutional assets in this space since it was founded in 1998. The firm has 150 employees globally based in Bermuda (headquarters), San Francisco, CA, Nashville, TN and London.