A look at why insurance-linked securities are largely immune to the Covid-19 volatility

The outbreak of Covid-19 has triggered, in anticipation of a global recession, major corrections in the listed equity, commodity and debt markets. For re-insurers, the wider market volatility means their balance sheets will be impacted on both the “asset” and also on the “liability” sides. That is to say, they will be facing virus-related claims, and their stock holdings will have traded down significantly.

Insurance-linked securities (ILS), however, have been resilient. ILS, simply put, are instruments that transfer insurance risks to the capital markets. The structure of ILS diversifies away from most financial market risks, and the asset class is subsequently uncorrelated to interest rates, stocks or currencies. This can be valuable, because all of these often move similarly to each other during crises. The performance of ILS largely depends on the occurrence of a loss event, mainly related to natural catastrophes.

During the Global Financial Crisis in 2008, ILS were comparatively stable, and so far has behaved similarly.

Why do ILS behave differently?

ILS have been around for about three decades, during which time the market has grown to approximately $90-100 billion. A third of the market comprises tradeable catastrophe or “cat” bonds, while the other two thirds are illiquid, privately traded, collateralised reinsurance transactions. ILS are largely immune to Covid-19 as the majority of the risks transferred via ILS cover natural perils such as hurricanes or earthquakes.

There have been questions relating to life-related risks, given the Covid-19 outbreak. While there is life component to ILS markets, it constitutes a relative small - albeit growing - fraction of the whole. The impact of the virus on even those deals is currently expected to be limited.

As transactions covering pandemic risks specifically are difficult to model and price, the current virus will not trigger a substantial growth of such deals. We see more potential for extreme mortality structures, for which sufficient data is available.

When and how is performance affected?

Compared to other asset classes, ILS have also historically offered investors lower volatility and less drawdown while still delivering attractive returns.

That is not to say there are no risks involved in ILS, only that they clearly differ from those faced by traditional asset classes like equities and corporate bonds.

As outlined above, performance of ILS is mainly driven by the occurrence of natural catastrophe or “nat cat” events. Up to 2017, ILS investors profited from benign years of catastrophe activity. However, the following two years were characterised by frequent and severe activity. Hurricanes Harvey, Irma and Maria, and the wildfires in California all occurred in 2017. Hurricanes Florence and Michael, typhoon Jebi and more California wildfires hit in 2018. Indeed, these formed the largest and fourth largest years of insured losses on record, respectively. Consequently, the debate around climate change and its potential impact on "nat cat" events have recently heated up.

Climate change

Climate change has undeniably had an influence on the frequency and severity of certain natural catastrophes[1]. That said, even here the impact on insurance-linked instruments is more limited than one might expect.

With ILS performance primarily driven by the occurrence or absence of natural catastrophes, it seems logical that the global warming trend represents a growing risk. However, the key here is the word “trend”. Climate change is a gradual and long-term phenomenon. ILS are typically short-term instruments. Most catastrophe bonds have a term of three to five years, and private transactions linked to natural catastrophe risk typically provide cover for 12 months. Over such periods, climate change should not have a discernible influence on the risk level of an insurance-linked security as modelled by a third party vendor at the inception of the instrument.

Although these models are regularly updated to take into account the latest scientific findings and reflect the effects of climate change, good ILS asset managers continually adapt their own view of risks. They stay abreast of a changing risk and exposure environment and do not simply wait for the next model update.

As with any investment decision, it is important that ILS investors work with a specialised and experienced manager. Insurance risks are complex in nature. The ILS manager must be able to understand those risks, able to model and adequately price them. Next to the necessary academic and professional background of the team, the manager should have an above-average track record through the cycles.

[1] Only weather-related risks, but not earthquakes or volcanic eruptions, are affected by climate change