Tail-risks can “differ tremendously” across cat bond funds: Plenum

While catastrophe bond funds might have similar return expectation metrics, the tail-risk inherent in a cat bond fund strategy can “differ tremendously,” depending on the underlying portfolio construction, a new study from Plenum Investments shows.

Plenum Investments, the Zurich based specialist catastrophe bond and insurance-linked securities (ILS) investment manager, has published a new market study that looks at the make-up of UCITS cat bond funds at the end of 2022.

The study looks to further build on a range of initiatives Plenum Investments has been investing in over the last year or so, seeking to drive greater cat bond market transparency.

These include its launch of a set of UCITS cat bond fund indices, that provide a new benchmark for the industry and its investors.

Plenum’s updated study of UCITS cat bond funds looks at the risk-yield positioning of strategies and makes them more comparable using a uniform strategy.

It once again shows that there are differences in how funds diversify and the exposures they carry, while also demonstrating that tail-risk exposure varies between them.

“The expected loss has a positively linear correlation with the ROI outlook,” Plenum explained. “But the Tail-risks of the funds with similar return expectations can differ tremendously.”

Plenum adds that, “This suggests that some funds manage their risks more efficiently than others, as evidenced by the ratio of VaR (99%) and discount margin.”

On average, the UCITS cat bond fund cohort has over 75% exposure to US wind and quake risks, in terms of the contribution to expected loss, while European wind and quake only makes up on average 5.64% and Japanese risks 6.03%.

Concentration to US wind and quake differs across the group, with the highest US wind expected loss contribution 63.33%, the lowest 44.94%, while the highest US earthquake concentration of risk is 26.71% and the lowest 15.74%.

While the US perils are the main contributor to expected losses, as you’d imagine, there are other perils outside of the main classification groups as well.

Other risk peril categories make up an average of almost 13% of the risk concentration across the group of cat bond funds, but here there is a significant difference across the group, from as low as 6.24% other perils, to as high as 26.10%.

Plenum said that its study implies that, “Funds with a relatively greater commitment to US wind risks are affected by higher tail risks.”

“The tail risk of a fund is linked to its positioning profile and the diversification of the fund. In particular, the higher than average allocations into US wind risks describe this high tail-risk nature,” Plenum continued to explain.

The investment manager also noted that there is uncertainty in the results, caused by timing of reporting, the maturity profile and timing of assets held in cat bond funds, plus the fact some funds contain more private placement assets than others.

Plenum said that greater standardisation in reporting and transparency would help here, enabling cat bond investors to better compare strategies.

Stating that, “Our study also aims to encourage the CAT Bond fund industry to clearly identify the assets in their annual reports. We also propose to establish the Expected Loss and the VaR (99%) as the standard risk metrics for CAT Bond Funds and that funds disclose the calculation basis (modeling software) or point out the limited comparability.”

Plenum Investments invites interested parties to contact the manager for a copy of the full study by email, at: [email protected]

Analyse interactive charts for this UCITS catastrophe bond fund index.