John Wells, chairman at Leadenhall Capital Partners, answers SCI's questions

Q: How and when did Leadenhall Capital Partners become involved in the insurance-linked securities (ILS) market?
A: Leadenhall Capital Partners was established in May 2008, when Luca Albertini and I formed an investment management partnership with Amlin - the first such venture to be backed by a Lloyd's insurer. We were both previously involved with insurance-linked securities at Swiss Re.

We manage funds in the insurance-linked investments area. Unlike mortgage securitisations where losses are expected to be fairly consistent and the range of outcomes is expected to be narrow, catastrophe investments have long periods where they earn full returns as they are only exposed to the loss of significant principal as the result of a rare major event. When we look at opportunities, we target investments where over a 100-year period we would expect income to be a multiple of any losses that might be incurred.

At present, the highest return for a given level of risk can be found in cat bonds exposed to US hurricanes or earthquakes, which currently pay a much higher return for a given level of risk than those cat bonds exposed to European wind storms or Japanese earthquakes for example. Currently around 60%-70% of cat bonds are exposed to US risks and, if return is the only requirement, a portfolio would have just US risk. However, most investors do not want to have all their capital exposed to one event, so the challenge is to structure portfolios that have some diversification without giving up too much yield.

Other investors want more diversification and are prepared to give up some yield in order to lower their exposure to losses from a major insurance event. We manage funds that cater to both types of appetite.

We've had a lot of interest in the funds from Japanese investors. Mortality risk is attractive to pension funds because they typically have longevity exposure. Mortality assets aren't understood as well as natural catastrophe, which is one area where Leadenhall differentiates itself as an ILS manager.

Since the beginning of the year we have received around US$400m of new subscription/mandates, taking our assets under management beyond US$650m for the first time.

When an institution is looking at the impact of putting cat risk in their portfolios, they will look at the maximum likely downside, say with a 99.5% probability, and what they are likely to earn in a best-case year. If, for example, 5% of a pension fund's portfolio is in ILS and 30% of this may be lost due to a major insurance event, that represents a potential 1.5% loss to the pension fund's overall portfolio in that year. However, if this is expected to happen only once every 200 years and the ILS portfolio has a 12% annual return in years without losses, the investors may be happy that the contribution from the insurance assets to the overall portfolio of 60bp per annum in good years is sufficient to outweigh the downside risk.

Q: How else do you differentiate yourself from your competitors?
A: The first differentiation is our joint venture partner: Amlin has a 50% share in the Leadenhall management company and provided US$100m seed capital for our two funds. Teaming up with an insurance company is a significant advantage for investors as it means that, while Amlin benefits from access to capital markets expertise, we and our investors gain from Amlin's top-class reinsurance expertise.

The feedback loop between our portfolio managers and Amlin's reinsurance underwriters works well. This is a huge differentiator - no other ILS funds have this capability. Access to origination opportunities, underwriting skills, modelling and actuarial services and feedback on pricing and demand for traditional reinsurance transactions ensures that we can offer the best service to our investors.

The second differentiator is that we can use underwriting skills rather than just models to analyse opportunities, while a number of ILS managers rely only on the specialist models that produce risk numbers for cat bonds. While ILS models are useful tools and will likely improve going forward, there remains a high degree of variability between modelling firms for the same perils. We prefer to rely on underwriting skills that include unmodellable factors to assess risks and rewards.

Our third advantage flows from the first two. At any point in time, particular risks may come in cat bond, swap or private placement format, with different risk/return and liquidity characteristics.

As we have the tools and access to the infrastructure to analyse all of these, we are able to choose which asset and in which instrument format will best fit our investors' requirements. We can put together portfolios that present the best risk/reward for a given set of objectives.

Q: What are your key areas of focus today?
A: We employ a granular approach to investing. About US$330m is deployed across the two funds, representing about 100 different investments, while US$320m is in managed account format.

We wouldn't typically hold more than 5%-10% of an individual cat bond. We have a broad range of potential origination contacts, meaning that the business is scalable in terms of making larger investments in the future.

When we first started investing in 2008, most cat bonds were trading at a discount to par in the mid- to low-90s after the collapse of Lehman Brothers, with multi-strategy funds under pressure to sell due to redemptions. At first, 100% of our portfolio was cat bond investments, as these offered the best value.

But within a year, cat bond prices relative to private placement prices switched around. While the majority of our investments are now in private placements, we maintain some exposure to cat bonds to ensure that we have the right liquidity to meet quarterly redemptions and where they represent good value.

Liquidity in the secondary cat bond market remains pretty good and we will always try to capture any associated relative value opportunities either when there are sellers of bonds or when we have new subscriptions in the funds.

Q: What is your strategy going forward?
A: The ILS market will continue to grow and we will respond to investor demand to structure portfolios that meet their requirements. We're seeing significant interest on a managed account basis from major pension schemes around the world and expect that this will continue where funds have particular investment criteria. But we're also keen to continue growing the two funds for those who need a fund environment to make investments

Q: What major development do you need/expect from the market in the future?
A: Pension fund interest around the world in catastrophe bonds and other ILS is gaining momentum as pension funds search for investments that match their long-term horizons with the correct risk/reward criteria in a volatile world. ILS provide income, diversification and independence from equities and other fixed income assets.

As part of the ILS universe, cat bonds have remained liquid, even during stress periods. But many pension funds are only just beginning to get to grips with the ILS sector and what the different investment strategies within ILS have to offer.

While the record first-quarter cat bond issuance of US$1.49bn is positive, overall volume outstanding is unlikely to go past US$17bn at the end of the year. Even if we continue to see high issuance volumes until year-end, the cat bond sector still wouldn't represent more than 40% of the overall ILS market, which includes private placements and swaps as well. So we always try and ensure that investors include these in their permissible investments.

The private placement insurance-linked note market, which now stands at US$20bn-US$30bn, has been the success story of recent years. Private placements involve looking at the underlying insurance dynamics and the claims-paying ability of the counterparty. They tend to be one-year transactions, where liquidity is foregone in return for higher yields.

Pension funds, in particular, like private placements because they like getting paid for their ability to be longer-term investors. Assuming a nat cat event hasn't occurred, private placements are automatically redeemed at par, thus side-stepping the possibility of having to sell in adverse market conditions.

Cat swap volumes are also growing. The attraction of that product is that they're based on an index and benefit from standardised language, so are easier to put in place than private placements.

Until recently, most of those deals were done on US risk because of the lack of a reliable index elsewhere. Now, however, in Europe the PERILS index has been introduced with the aim of creating ILWs on European risks. We expect more deals to be done on this basis in the future.

CS