Insurance-linked securities: diversification and returns
The first half of 2022 has shown that conventional diversification strategies don’t always work in times of stress. We explain why ILS is a truly uncorrelated asset class.
Insurance-linked securities (ILS) have served as a valuable tool for investors seeking portfolio diversification since the asset class was created in the 1990s. They have demonstrated little to no correlation with traditional asset classes over multiple-decades. Additionally they have provided stable returns.
Here we look at how ILS have performed in recent months, explain the factors driving returns and outline how to integrate ILS as a diversifying tool.
How ILS behaved during the recent market declines
Before Covid-19 interest rates had been making progress towards “normalisation”. However, as the pandemic shut economies, central banks moved quickly to keep bond markets open and moving. This supported price stability and jobs, stabilised the economy, and indeed, the recovery from the demand shock was rapid.
However, supply bottlenecks created by lockdowns and travel restrictions added to inflationary pressures. Many risk markets started the year at relative high valuations, vulnerable to any bad news.
Russia’s invasion of Ukraine provided the catalyst. Concerns over growth have risen, inflation has spiked and rates are rising. The market selloff has affected many asset types.
Long-duration assets, like 10-year US Treasuries, and companies with valuations tied to future cash flows have been especially hard-hit. ILS have not.
Figure 1: ILS correlations
Source: Past performance is not a guide to future performance and may not be repeated. Schroders Capital, Bloomberg, as at 30 April 2022. Worst monthly drawdowns in equity markets since inception of Swiss Re Global Cat Bond Total Return Index in January 2002. Equities: S&P500 Composite Index, High Yield Bonds: BofA Merrill Lynch Global HY Index. 1Markets refers to S&P500 Composite Index
Why ILS behave differently
ILS behave differently for several reasons.
As a floating rate instrument, an ILS has little interest rate duration to speak of, leaving it relatively unscathed by the latest bond market rout.
If inflationary pressures persist – as the Federal Reserve (Fed) and other central banks believe they will – higher rates may be with us for a while. More interest rate rises will feed through to ILS investors as part of their coupon.
This recent resilience is not a one-off. As the chart above shows, periods of major drawdowns in high yields and equities do not coincide with periods of major drawdowns in ILS. When drawdowns in ILS do occur they are mainly driven by the occurrence of large natural catastrophes (abbreviated to “nat cat”).
The ILS market‘s low correlation has remained true during severe declining markets, including through market turmoil driven by the war in Ukraine. Indeed, the SwissRe Cat Bond Index is showing positive performance year-to-date.
The negative correlation between the two major asset classes of equities and bonds has been a practical attribute over the past two decades. It is one investors have long made use of in traditional 60:40 equity/bond portfolios. But signs are emerging that the correlation is breaking down.
ILS are truly uncorrelated because their unique income streams are driven by insurance risks predominantly linked to natural catastrophes.
Because insurance risks – such as the risk of a hurricane making landfall in Florida, or an earthquake striking California – are not correlated with financial assets, ILS represent a stable and consistently uncorrelated source of income.
Beyond diversification – the drivers of ILS return
ILS markets are driven by the fundamentals of the insurance cycle and serve as an important tool for insurance, and reinsurance companies, as they underwrite and transfer risks. In the simplest terms, when there are no nat cat events, capacity increases, driving prices lower. In the event of a large nat cat event, collateral is used to pay claims, shrinking supply, which drives prices higher.
The insurance market prior to 2017 was characterized by falling rates and narrowing margins for risk transfer. Because the south-eastern US had not seen a major hurricane make landfall since 2008, spreads on catastrophe bonds fell steadily. Starting at over 1,200 bps in mid-2009, they fell to near 400 bps in 2015. Rates trended lower or remained range-bound through 2017.
2017 saw a gradual shift in the market, one which has since accelerated. Driven by large losses from Hurricanes Harvey, Irma and Maria, along with the devastating California wildfires and other global events, the insurance industry saw over $140 billion in insured losses in 2017 alone.
In 2018, the insurance industry was impacted by disasters including Hurricanes Florence and Michael, additional wildfires in California, and Typhoon Jebi in Japan. All of these contributed to another $80 billion in insured losses (Figure 2, below).
Taken together, the $220 billion in combined losses resulted in market dislocations. Investors absorbed losses, and some made the decision to exit the asst class. The yields available to ILS investors began increasing as a result.
Figure 2: Global annual insured losses (US$ billion and 2021 values)
Insured losses outside the US added to the momentum of increasing rates in 2019, and Covid-19 has created additional losses arising across several lines of business including event cancellation, mortality risk, and business interruption insurance. 2021 did not provide respite.
Winter storm Uri hit Texas, European floods created unimaginable damage and Hurricane Ida not only hit the coast of Louisiana - which is hurricane-prone - but caused flooding in areas as far flung as New York, unlike any previously recorded in the region.
At the same time, recent financial market upheavals have created pressures on assets. Growing economic uncertainty and active central bank policies of the last decade resulted in yield curves falling and flattening globally. This has put pressure on insurance company asset portfolios for years, which may now be unable to provide similar levels of investment income going forward.
Taken together, the volatility in the assets and liabilities of insurance company balance sheets has resulted in a diminished capacity to absorb risk. As a result, we believe insurance companies are likely to seek additional reinsurance capacity over the coming months.
Increased demand for protection can lead to an increase in the risk transfer price in the insurance market. If that increased demand is on top of a period of poor underwriting results, then it is much more likely that risk transfer pricing will increase.
This is what we are seeing at the moment. Figure 3 below shows that year on year price increases for property insurance, per quarter, have been substantial and continuous since 2017, and are still increasing.
Figure 3: Primary property insurance market rate increases year-on-year per quarter
Source: Past performance is not a guide to future performance and may not be repeated. Marsh – Global Insurance market Index Q4 2021 (Feb 2022) 604248
Whilst not necessarily in lock-step, where the primary insurance market goes, the reinsurance and ILS markets typically follow.
In the ILS market we are now seeing an increase in risk transfer pricing in both the catastrophe bond and the collateralised reinsurance markets.
What type of risk and return can investors expect?
ILS are investable both through tradable catastrophe or “cat” bonds as well private contracts which are generally “buy-and- hold” for a 12-month period. In simple terms, riskiness of ILS contracts depends on the expected frequency and severity of the losses they cover. Contracts which are more remote from the risk they cover (i.e. have a lower probability of being triggered) will pay lower yields, all else being equal. It follows that investors can choose ILS funds with varying degrees of liquidity and riskiness.
Investors favouring liquidity and a lower risk appetite may see yields in the 4-6% range. For those who can afford quarterly or bi-annual liquidity a blended product of bonds and private contracts may offer yields between 8-12%. Other strategies can be higher octane, but given the potentially extreme negative outcomes, we would encourage investors to scrutinise how sound these are.
New environment, new tools
We believe investors would be wise to consider diversification through a new lens. Rising yields may mean the diversification benefits provided by government bonds are materially different in the future. At the same time, risk assets may carry hazards that require new understanding as a result of central bank actions and weaker connection to fundamentals.
For these reasons, we think investors should not overlook insurance-linked securities when seeking a solution for diversification with low interest rate duration. Current insurance market dynamics also mean that ILS investors can benefit from the highest yields in a decade.
It is, however, an asset class that requires unique skills and, tools and networks. Partnering with an ILS manager can help quantify and balance risks, while incorporating diversification and return.
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