Have lower yields blown away the opportunity in insurance-linked securities?
The recent fall in yields on insurance-linked securities (ILS) has been widely interpreted as closing off the opportunity for investors. We disagree. In this short paper we argue that the strategic case for investment in ILS still stands.
The recent fall in yields on insurance-linked securities (ILS) has been widely interpreted as closing off the opportunity for investors. We disagree. In this short paper we argue that the strategic case for investment in ILS still stands. We find that:
- Over the long term valuations are not particularly expensive, and yields not particularly low
- Widening ILS mandates from catastrophe bonds to include private transactions can help
- increase yield
- The supply and demand outlook remains healthy, with future supply likely to outstrip demand.
What are insurance-linked securities?
Catastrophe bonds: Like conventional bonds, these are tradable instruments that repay the
holder’s capital at maturity, together with a regular coupon over the life of the bond.
The issuer is an insurer (or reinsurer) passing risks on to the capital markets. This is usually done to reduce the capital that (re)insurers need to hold against risks on their balance sheet.
If a defined catastrophe occurs such as a hurricane, earthquake, or wind storm, the holder of the catastrophe bond may as a result forgo all or part of their coupon and capital.
Private transactions: Unlike catastrophe bonds, these are not tradable. They are bespoke reinsurance agreements agreed directly between a reinsurer and investor. They are often cheaper to issue than a catastrophe bond and can provide higher returns.
They can also provide diversification across a wider set of risks such as aviation, marine, motor and mortality. The private transactions market is estimated to be roughly twice the size of the catastrophe bond market, but due to its nature there is less data available on this segment.
For further information on ILS please click here.
It is certainly true that current yields of around 5% are below where they were six years ago (Figure 1). This is consistent with years when there are few catastrophes.
In these years insurers cut their premiums as they compete for business and need less capital to payout claims. This in turn reduces the yield on ILS. When larger events do hit, such as Hurricane Katrina in New Orleans, Hurricane Ike or the 2011 tsunami in Japan, market prices rise as reinsurers need to rebuild their balance sheets after having paid out large claims, and investors require a higher risk premium. This is reflected in the sharply rising lines on the chart after major disasters.