How to build dependable diversification with insurance-linked securities


Diversification, properly implemented, can achieve lower risk with improved returns, or higher returns with constant risk. But it’s harder to do than many investors think. We explain here that insurance linked securities (ILS) can not only offer a compelling income stream, but why they represent genuine diversification.

Making diversification meaningful

Diversification is a hot topic at the moment. Corporate bonds, equities, and governments bonds have all had a long, strong run. However, these assets have historically had a strong correlation with how the economy is performing.

Returns that are less dependent on the economic cycle are now increasingly sought after. This is because the current economic cycle is increasingly long in the tooth and many investors are eyeing it with some caution. In particular, the credit cycle is being closely monitored, given its impacts on interest rates, company earnings and default rates.

Investors in search of income in traditional asset classes have been forced to reach further up on the risk spectrum. Similarly, stock markets are ever more expensive, with the link between headline valuations and earnings weakening.

How does ILS work?

The income stream from ILS is driven by insurance risks, such as major earthquakes or land falling hurricanes, and therefore uncorrelated with financial markets. The below highlights the low correlation with more traditional asset types.

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The ILS market is estimated at about $120 billion in size and comprises both liquid and illiquid segments. The liquid portion consists of catastrophe, or “cat bonds”, and represents approximately 40% of the total ILS market. Cat bonds have an active secondary market that facilitates trading.

Investors are typically most familiar with cat bonds as the most liquid portion of ILS markets. However, private ILS, the largest portion of the ILS market, can also be an important tool for sophisticated investors seeking diversification. Their structure is similar to cat bonds, but private ILS - such as collateralised reinsurance - can provide access to a broader range of covered events and the ability to harvest “illiquidity premia”.

Cat bonds typically attach at the most remote level of risk. This means that investors only experience losses once a company’s own loss-retention and other layers of reinsurance have been exhausted. They are compensated with lower yields as a result. Private ILS, such as collateralised reinsurance, provide investors with the opportunity to earn higher returns by attaching at other points.

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ILS are generally fully collateralized transactions and, as a “contingent liability”, the invested cash will only be used to pay claims if there is a natural catastrophe as designated by that contract. This could be the extent of damages or severity of event, the region or peril type.  As long as there is no such event the investor’s cash will remain invested in money market funds via a trust account.

The investor, therefore, not only receives a risk premium for the insurance exposure, but also has an interest rate component to the returns which is reset regularly. In the event that the next market correction is linked to higher rates, not only will ILS continue to do its own thing, but it will also see higher interest rates come through via the reset. The very low interest rate sensitivity of these securities adds another diversifying quality.

When all about you are losing…

When investors look for the diversification offered by an asset class, it is usually the downside correlation they focus on. The chart below plots market drawdowns over the past 10 years and compares to those observed with the Swiss Re Cat Bond Index. In most instances when the MSCI World or SP500 had a negative return period, the Swiss Re Cat Bond Index posted positive returns. The worst drawdown for cat bonds took place in the in third and fourth quarters of 2017, caused by some Atlantic hurricanes making land fall, as well as California wildfires and an earthquake in Mexico.

Arguably, cat bonds did show some mark-to-market losses during the pandemic led sell-off, but losing less than 2% vs double digit losses in other asset classes seems quite uneventful. This liquidity driven sell-off impacted cat bonds, but private transactions - which generally have a 12-month maturity and do not trade - were not at all impacted.

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That the credit cycle does not impact natural catastrophes is easy enough to understand, but would natural catastrophes ever have the scope to derail markets? Thankfully, no such events have - as yet - come to pass. Katrina in 2005 had almost no impact – the S&P 500 lost 1.3%  at the worst point during the week and ended flat after a few days. The Tōhoku earthquake and tsunami,  which occurred on 11 March 2011, had a bigger market impact with the Nikkei falling 15% in the aftermath. Within a few days the losses were at -4%.

A large hurricane in the Gulf of Mexico or a strong earthquake in California may cause markets to react but some mitigating factors are:

  1. Production sites for most industries are global, such that only a fraction of capacity would be hit
  2. Any large scale damage from a natural catastrophe would likely be met with stimulus/aid and the fallout would likely be short lived. 
  3. Shift to a more digital economy with remote servers

Thinking outside the box

The traditional approach of diversifying within the boundaries of bonds, equities, and possibly real estate does not adequately address the issue of diversification. In times of elevated market stress, correlations for these assets can draw towards 1. ILS introduces genuine diversification by isolating risks that are not related to the economic cycle.


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Topics:

  • Alternatives
  • Private Assets
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