The Hedgeweek Interview: Diego Wauters, Chairman & CEO, Coriolis Capital Limited, London.
Coriolis Capital Limited is the London-based hedge fund manager focusing on both natural catastrophe bonds and weather derivatives. Diego Wauters explains the rationale behind the company's cutting edge investment products.
HW: When was Coriolis Capital founded and what are its investment strategies?
DW: Coriolis Capital was founded in June 2003, following a management buy-out from Société Générale.
Over the last seven years, a number of new hedging and investment instruments have appeared in the financial markets. Among them, insurance-related derivatives such as natural catastrophe bonds (CAT Bonds) and Weather Derivatives have quickly grown to reach a size of more than USD 12 billion in notional value for each category.
Coriolis Capital has pioneered a range of hedge funds specialising in these new asset classes. With over six years of expertise in this field, the Coriolis Capital team based in London has a strong track record in these highly specialised markets.
Our funds invest either in CAT bonds and Weather Derivatives (via our Horizon Fund) or in CAT Bonds only (via our CaTpricorn Fund). They have attracted a number of professional investors because of their lack of correlation with the financial markets, their low volatility and good returns. They represent an ideal defensive alternative strategy.
We have achieved positive returns for the past four years for our clients and currently have USD 350 million in assets under management.
HW: What is a CAT Bond?
DW: CAT Bonds are financial instruments that turn reinsurance contracts into securities and derivatives structures (an alternative to traditional reinsurance). They constitute an exchange of principal for periodic coupon payments.
The payment of the coupon and/or the return of the principal of the bond is linked to the occurrence of a specific Catastrophic event.
CAT Bonds tend to cover earthquakes, hurricanes, typhoons and winter storms.
HW: When and how did the CAT Bonds market begin and how large is it?
DW: The market for CAT Bonds emerged in 1997 as a complement to the capacity available from the reinsurance market. It resulted mainly from dramatic price spikes post Hurricane Andrew (Sept.1992), the Northridge Earthquake (Jan.1994), and more recently from the events of September 11th.
It had a record issuance of USD 1.6 billion in 2002, which also saw the first corporate-sponsored transaction.
The average size of CAT Bonds is USD 200 million and growth of the market is expected as more and more investors are looking at this new asset class.
HW: How is a CAT Bond priced and rated?
DW: In general, the "price" of an insurance-linked security is the spread over and above (a) the risk-free rate and (b) the loss expected from the insurance (physical probability). This "excess spread" is a function of, and reward for, the risk assumed and its value in a diversified portfolio.
The CAT Bond's coupon is defined upfront. The investor must post the notional amount of the bond in an account, or trust, which invests in high grade securities (thus eliminating credit risk) and earns LIBOR.
CAT Bonds are issued at spreads over LIBOR. Investors view the spread over LIBOR as the "premium" they are paid for taking on the natural catastrophe risk.
CAT Bonds are uncorrelated with the typical financial risks of a fixed income or equity investment portfolio. They are an innovative way to simultaneously enhance investment portfolio returns while reducing the volatility of those returns (providing a better Efficient Frontier).
All major CAT Bond transactions have been rated by at least one of the rating agencies - Moody's, Standard & Poor's or Fitch. Typically, two ratings are associated with a CAT Bond transaction.
The Rating Agencies subject CAT Bonds to the same rigorous ratings methodology as traditional fixed income securities (i.e Default Rate, Recovery and Stress Testing all apply).
Most CAT Bonds have been rated in the BB/BB+ range, however a limited number of bonds have received A, B and BBB ratings.
Thanks to an active secondary market, it is now possible to analyse prices and to compare them with other investor alternatives.
HW: Who are the main risk consultants in the CAT Bonds market?
DW: There are several - insurers, reinsurers, brokers, financial markets, and corporations have all recognised the need to synthesise available scientific research with quantitative techniques to evaluate the physical probability of financial loss.
Analysis of CAT Bond risk is typically done by independent third party modelling firms such as Risk Management Solutions, Inc., EQE International and Applied Insurance Research.
Necessity for stochastic modelling arises from the infrequent occurrence of catastrophic events and the inability to rely solely on historical records. Models are robust, incorporate the historical record along with the most recent scientific data and are subject to rigorous peer review.
Investors rely primarily on the output of the models disclosed in the Offering Circular in assessing the risk of the CAT Bond.
HW: Who are the main CAT Bond arrangers?
DW: They are all large global players - Swiss Re Capital Markets, Goldman Sachs, Aon, Lehman Brothers and Merrill Lynch.
HW: What is a Weather Derivative?
DW: A Weather Derivative is a financial product where two parties agree to exchange cash-flows determined by reference to a Weather Index. It can be used as hedging and trading tools by any company whose business is impacted by the weather.
The Weather Index is calculated by reference to official Weather Data as published by the National Met Offices across the world.
Weather Data can be : Temperature, Precipitation, Snowfall, Snowdepth, Windspeed, Sunshine.…it is a long list and we monitor all of it.
The main industries exposed to weather variations are the following: Energy, Government and Municipalities, Retail, Construction, Leisure, Travel, Sport, Insurance and Reinsurance, Agriculture, Food and Beverage.
HW: How are Weather Derivatives packaged and how large is the market for these products?
DW: Weather Derivatives are packaged under different structures: Swaps, Calls, Puts, Collars and Exotic Derivative Products are all available.
Most Weather Derivatives are traded on the OTC market and have less than 6 months maturity. Since mid-1997 more than 10,000 weather contracts worth around USD 13 billion have been traded. Many market participants are very optimistic about the potential of weather derivatives.
To date, most transactions have been temperature-based but precipitation hedges are becoming increasingly common. The market outside North America is growing rapidly.
Also, the volume of weather derivatives traded on the CME is growing rapidly.
HW: Can you summarise the benefits and also the downside of CAT Bonds and Weather Derivatives?
DW: I would summarise these as follows. Both Weather Derivatives and Cat Bonds:
- Have little or no correlation with the financial markets
- Are easy to diversify from a geographical point of view
- Show a high expected return relative to risk.
However these products are:
- Difficult to price, as traditional financial models do not apply
- Based on historical weather data which can be difficult to obtain
- Relatively illiquid instruments as this market started around 1996.
HW: How can investors tap into these complex products?
DW: One of the funds managed by Coriolis, the Dublin-listed Horizon Fund, allows professional investors (excluding private and US clients) to participate for a minimum subscription of USD 0.5 million to a fund investing in both Cat Bonds and Weather Derivatives.
Horizon offers quarterly windows of entry and exit (on 1 February, 1 May, 1 August and 1 November). It has proved popular with European financial institutions and currently has USD 110 million under management,
We also offer our investors the ability to invest in CAT Bond-only funds such as our new CaTpricorn fund. Obviously a fund invested solely in CAT Bonds offers less diversification.
Finally, we can create dedicated funds for those institutional investors who want to create their own funds with a minimum equity of USD 30 million.
HW: What are your targets for Coriolis Capital and how will you achieve them?
DW: In terms of growing the amount of money we manage, we are seeking to increase our assets under management, currently USD 350 million, to over USD 500 million over the next eighteen months.
We intend to achieve this with our new and innovative funds such as CaTpricorn but also by educating a growing number of interested investors as to the benefits of these new and innovative investment products.
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