It takes confidence to invest in a firm named after Aeolus, the Greek god of the winds — particularly when the firm is in the business of underwriting the risks of hurricanes, typhoons, and wildfires.
Paul Singer has confidence.
For four years leading up to 2016, Singer’s Elliott Management had been putting capital into the funds of Aeolus Capital Management, which gives institutions the ability to offer reinsurance for natural disasters. With so-called insurance-linked securities, investors earn a yield for locking up their money for a certain amount of time. Those funds are then used to pay claims if a catastrophe hits. Investors are either hoping for calm weather — in which case there are no claims — or betting that their ILS asset manager has done a good job of pricing the insurance against, and assessing the risk of, catastrophes.
In 2016, Elliott decided to put money in Aeolus itself in the form of a majority ownership stake.
Then, both literally and figuratively, disaster struck.
Starting in 2017 both the global reinsurance market and Elliott’s strategy got hit by two years of unrelenting hurricanes, earthquakes, and wildfires. In 2018 the world saw Hurricane Michael, Typhoon Jebi, and raging wildfires in California that ravaged parts of the state, including the sadly named town — at least in retrospect — of Paradise. Claims over the two-year period were among the largest ever.
And yet Aeolus has emerged as a winner.
Following recent disasters, pensions and other institutional investors have come to realize that there is indeed risk in reinsuring disasters. After many years of easy returns, investors are learning that the quality and expertise of their asset manager matters — a win for firms like Aeolus. And yet these investors are largely sticking with the insurance investments, which promise to be uncorrelated: You don’t have to be a mathematician to understand that the frequency and deadliness of natural disasters are not tied to any economic factor at all, unlike stocks or bonds.
In 2017 “investors ran toward [the asset class] in an indiscriminate way. Anybody in this space got money thrown at them,” says Mark Cicirelli, U.S. head of insurance at Elliott, speaking for the first time about the activist investment firm’s stake in Aeolus. “Then there was a second year of meaningful catastrophic losses, and a different picture emerged as investors became more disciplined.”
Reinsurance is not the first thing that comes to mind when investors think of Elliott Management.
Long known as one of the most pugilistic investors in the world, Elliott made its name going after management at companies such as AT&T and Athenahealth. But Cicirelli, a 14-year veteran of Elliott who has a healthy sense of humor about his passion for the arcane details of insurance, argues that Elliott’s investing philosophy is a mirror image of Aeolus’s approach to insurance-linked securities and reinsurance.
Cicirelli describes the philosophy as “effort-driven returns” and remembers telling his boss, Paul Singer, in 2012 — when the firm was first investing in insurance funds — that Aeolus does reinsurance the way “we would do reinsurance if that was the business we were in.” When a reporter pressed him on what that meant, he said, “Elliott adds value through doing excruciating, complex, mind-numbing processes over and over again.”
Andrew Bernstein, now managing partner and co-head of portfolio management of Aeolus, sees the mind-numbing process from a different angle. “When Elliott first came in as an LP, they did massive, irritating amounts of due diligence, as you might expect,” he says.
But, he adds, “there was real cultural affinity. They watched us sweat it out.”
Elliott witnessed Aeolus in action when it provided reinsurance to a company Elliott bought in 2009 called iCat, which underwrites property and casualty risk. It was the first time under Cicirelli’s leadership that Elliott got involved in the P&C sector. “Elliott has seen us from both sides,” notes Bernstein. “They saw the margins that we got on the risks. They saw the secret sauce: that we could obtain risk at more attractive pricing levels than the standard market, with it still making sense for the counterparty. They lived through that.”
Insurance-linked securities are a product of changes that took place in the aftermath of 2005’s Hurricane Katrina.
“The hurricane season of ’05 brought an incredible secular change to the property and casualty industry,” says Bernstein. Spooked by two years of hurricanes and other disasters on the scale of 2017 and 2018, ratings agencies became much more conservative in how they modeled catastrophes. As a result, reinsurance companies needed to hold more capital to cover their risks. The industry was thus desperate for a new source of money, and institutional investors — lured by attractive yields and diversification — ponied up.
Yet there was a structural problem. The industry needed capital, but not every firm could overcome the barriers — even with the potential for high profits —to starting a traditional insurance company from scratch. What’s more, few wanted to pour money into an existing insurance company after Katrina because of the uncertainty over claims that could still come in. “Someone would have had to put good money next to possible bad money,” says Bernstein. Insurance-linked securities solved that problem by offering stand-alone reinsurance in a new vehicle funded by institutions. “Now the market has evolved. The day after Hurricane Irma [in 2017], you could — and Aeolus did — open up a new reinsurance vehicle that had no exposure to the event that happened the day before.”
Industry observers were surprised that investors didn’t abandon the sector once the recent pain started. After all, institutions got their first taste of the new asset class during a decade that had been spared the worst natural disasters. A few years of collecting attractive yields while not having to pay any claims out of the collateral they had put up lulled some institutions into carelessness.
“Much of the last ten years, though, coincided with a benign period. No hurricanes made landfall for a decade,” says Cicirelli. “That was unprecedented. That led traditional rated reinsurers to say that the upstarts wouldn’t survive once they were confronted with actual losses. Investors only commit for one year — and sure, they’re told there is risk. But the reinsurers said they’ll scatter once there is a catastrophe, and this non-rated reinsurance backed by investors’ capital will fail.”
There have been hiccups.
In 2017 and 2018 some investors’ money was stuck in funds to pay potential claims from Hurricane Irma, the Camp fires in California, and other catastrophes.
Others realized their managers had been investing in risks they didn’t understand and, as a result, did a poor job of underwriting.
There were some bad returns and losses at certain firms, including Markel Catco Investment management, an ILS manager. In July, Markel Catco announced it would wind up the portfolio and return capital to investors while also launching a new ILS platform.
Some investors also backed off, conceding that their expectations for the asset class were too high. “There was also a bit of fatigue,” says an executive at another ILS manager. “Investors said, ‘Hey, we don’t need the headache of worrying about disasters.’”
Aeolus, which was started in 2006 as a private equity–backed reinsurance company, believes there is great opportunity now for investors. The firm, which raised capital in 2018 as others were shrinking, is in the market taking advantage of higher reinsurance rates and other dislocations.
“We’re all facing the same cycle and headwind,” explains Bernstein. “This is what causes a hard market. This is a year where risks are incredibly well priced because capital is hard to come by. It leaves our investors in an unusual position: If there are no further events in 2019, they’ll make good returns and they will benefit from big price increases for next year.” He adds that the firm, which is an asset manager with a fully functioning reinsurance company inside, is getting some of the best pricing in a decade.
There has been a radical transformation in this niche industry — but the industry, according to Elliott’s Cicirelli, is still “in the adolescent stage.”
Yet some argue that the model could be used for other risks. Although insurance is one of the largest global industries, there’s still a shortage of it when it comes to insuring businesses in emerging markets or certain risks, such as cybersecurity.
The structure could work for climate-related risk, even if it is very unpredictable. Insurance-linked securities get repriced every year, with investors having to bear the risk only over the following 12 months, explains Cicirelli. At the same time, quantitative hedge funds and other investors have become more adept at using data and new techniques to predict the likelihood of certain events. Institutional investors could earn a competitive return by providing capital and taking on new risks in a world beset by climate change, cyberthugs, and autocrats.
“Outside P&C it’s being noted what happened here in ILS and how well a capital markets format has worked,” says Cicirelli. “Are there other applications? We’re beginning to see some work in life insurance and with certain other weather events, such as rain in the Midwest. There is a lot of interest in replicating the success that has been proven out here.”