How chasing storms can generate uncorrelated returns

Many institutional investors use alternative asset classes as a complement to their equity and bond holdings to increase diversification and manage risk. Since the mid-1990s, this stable of alternative assets has increasingly included insurance-linked  securities (ILS). The reasons why are easy to see. 

29 May 2014

Many institutional investors use alternative asset classes as a complement to their equity and bond holdings to increase diversification and manage risk. Since the mid-1990s, this stable of alternative assets has increasingly included insurance-linked securities (ILS). The reasons why are easy to see. Being linked to insurance ‘events’, such as natural catastrophes or exceptionally high claims, the returns from ILS are almost completely uncorrelated with traditional investment influences, such as interest rates, economic growth or issuer covenants. As a result, they provide excellent diversification benefits for most traditional portfolios, as well as strong expected returns for long-term investors.

As an asset class, ILS have grown substantially in size and breadth over the last decade,
meaning more opportunities for investors and more diversification within portfolios. It is
now relatively straightforward for investors to gain efficient access to ILS via pooled funds
and we expect the ILS market to continue to grow as demand increases, both from issuers
and investors. Against that background, this article aims to provide an introduction to ILS
and how they can be used by institutional investors.

How do they work?

To protect themselves against the impact of rare but expensive outsize claims, insurers often pass on some of the risks to third parties, such as other insurance companies or reinsurers. Since the mid-1990s, ILS have emerged as an alternative to this traditional reinsurance. These securities give insurers (and reinsurers themselves) access to a large additional source of capital, while transferring risk to investors.

ILS are often considered as bond investments. A bond’s characteristics, however, are determined by the ability of the issuing country or company to repay the debt. With ILS,  the factor determining whether the principal is at risk is not default, but the incidence of insurance claims (or some other event). The risks adopted by a buyer are more like those of pure insurance and often very specific to the contracts being covered. Therefore, the risk premium embedded in an ILS contract is different from the usual equity, duration and credit premia embedded in most institutional investment portfolios. As a result, the main drivers of returns from an ILS investment are distinct from those of most other financial market instruments.

There are a variety of different ILS products available. Catastrophe bonds (commonly referred to as cat bonds) are the best known. These transfer the financial impact of a specified, large natural catastrophe from a reinsurer to the capital markets. Using a simple cat bond as an example (see Figure 1), the cashflows are typically as follows:

  1. The issuer of a cat bond is contracted by insurers and/or reinsurers to provide capitalto cover certain insurance risks. An ILS investor buys part of the contract.
  2. The investor’s principal is invested in a ring-fenced collateral account, typically money-market funds or other low-risk investment.
  3. The reinsurer pays periodic premiums for the insurance cover.
  4. The issuer pays regular coupons to the investor, made up of the reinsurance premiums and returns on the invested collateral.
  5. If the insured event occurs, the reinsurer makes a claim against the ILS collateral pool and the principal available for return is reduced or lost. If the insured event does not occur, then the principal is returned in full to the investor.

The return an investor receives from investing in ILS is therefore linked to the incidence of a predetermined event within a specified time period. The occurrence of this event triggers the loss of all or part of the investor’s principal, which passes to the insurance company and helps them pay the relevant claims. If the insured event does not happen (a far more likely scenario), the investor receives all the regular payments on the bond, plus the return of their principal.

Many traded ILS bonds use ‘parametric triggers’. This means that the insured event is not linked to actual claims made, but rather to the occurrence of a specific and measurable incident, such as wind-speed reaching a certain level in a specific location, or the occurrence of an earthquake of particular strength in a given area. These are ‘cleaner’ than bonds linked to real claims experience, given that the event is better defined and the consequent loss more clear-cut.

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