The most attractive proposition of the Cat Bonds is that their performance is mainly driven by factors that have little to no connection to the factors impacting the more traditional assets. As such, Cat Bonds exhibit low to zero correlation to the traditional investment products, although they are not completely immune to the impact of extreme market downturns.
But there are also some significant limitations. First of all, the size of the Cat Bonds market is fairly small and they are concentrated in just a handful of perils (a fancy insurance world word for risks), with bias towards US Wind (hurricanes), so diversification is difficult. Also, the issuance is seasonal. The majority of the cat bonds are being issued before the hurricane season in the US (June) and at the year-end (Europe wind, Japan wind). The US and Japan quake are less seasonal, but also harder to find. So, allocating investor money effectively is difficult through much of the year.
One way to diversify is to go into reinsurance products. They are much more diverse, but less liquid, a typical contract duration being 1 year. But both Cat Bonds and reinsurance products are issued only in the quantity that insurance companies are willing to sell into the market. The total size of these two product types outstanding is around $30 billion (estimates vary widely), which may look like a fair amount, but is actually minuscule if you compare it even to a small cap stocks. Also, re-insurance's profitability is subject to influence of the insurance industry business
cycle, and may be unprofitable at times.
Given the size of the market, it is not surprising that there is only a handful of established investment managers out there, and they tend to be very small.
All this poses challenges to making the ILS (insurance-linked products) a viable investment. However, given the pent-up demand for thid type of demand, there may be some interesting developments, both good and bad. It will be interesting to watch the developments over this year, as it may become a turning point in the asset class's path into investment portfolios.
FYR
Hedge fund joins high-risk insurance arena
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