"Nature doesn’t read stock prices": the evolution of insurance-linked securities
In a recent podcast, Flavio Matter, Head of ILS at Schroders Capital, explained why demand for the asset class has grown, how it reached its "Goldilocks" moment in 2023 through to 2025, and why he believes it remains an attractive option for a modern investment portfolio.
In recent years, the insurance-linked securities (ILS) market has undergone a structural coming-of-age. Today it is a large global market – estimated at some $120 billion, with catastrophe bonds alone accounting for half that figure – that has decisively shed its reputation as a mere niche curiosity.
In fact, in the eyes of many investors, the ILS market has been recast as a structural engine of performance. So, how did we reach this point?
The making of a "Goldilocks" moment
Speaking on a recent podcast with Professionelles Investieren, Flavio Matter, Head of Insurance-Linked Securities at Schroders Capital, reflected on the market’s evolution and maturation.
He noted that the favourable yield environment driving higher returns in recent years is no mere statistical outlier. Rather, the "Goldilocks" conditions defining 2023 through to 2025 in particular were the product of a grueling, multi-year sequence of events that recast pricing mechanics.
The inflection point for the trends that followed arrived in September 2022 with Hurricane Ian’s landfall in Southwest Florida. One of the costliest hurricanes in US history, Ian struck at the core of ILS market exposure and resulted in the worst single month in the asset class’s history, resulting in short-term losses of nearly 9%.
“The reinsurance market is very cyclical,” Matter observed. “After major events, capital is removed from the market. That also means that prices then rise accordingly, because the reinsurance market, the cat bond market, is ultimately driven by supply and demand.”
"Currently we're seeing a 2.8 percentage point additional spread in cat bonds over high-yield. That is quite attractive when one considers that the default probabilities of cat bonds and high-yield are probably in the same order of magnitude.”
Cat bond characteristics
The takeaway is that, for those who weathered the 2022 volatility, the rewards were immediate: most ILS strategies have since delivered double-digit returns.
Perceptions of the asset class come in different forms. To the rookie, it has been curiosity - a way to earn a spread by taking on the risk of Florida hurricanes or Japanese earthquakes. To the seasoned allocator, however, it is seen as a diversification tool that is uncorrelated, and just as likely to perform when traditional markets, such as the S&P 500, struggle as when they flourish.
“Nature doesn’t read stock prices,” Matter succinctly explained.
Setting out the growing attractions of the asset class to allocators, he noted that cat bonds have delivered annualised returns in the 7-8% range over the long term, with annualised volatility in the 3-4% range – a level of volatility which is significantly lower than both equities and high-yield credit. Meanwhile, more than 90% of months in the last 20 years have posted positive performance.
Addressing the concerns of investors regarding climate change and its impact on weather-exposed cat bonds, Matter is pragmatic.
“Climate change plays a role, but it is not the only factor,” he said. Because cat bonds have relatively short durations, typically three to five years, and undergo annual resets, managers can "permanently recalibrate" their models to reflect the latest science and adjust pricing accordingly.
From "stress test" to capital outlet
To understand where the market is going, one must go back to where it began: August 1992, Florida. Hurricane Andrew, a Category 5 monster, struck with wind speeds exceeding 250 km/h. It caused $27 billion in insured losses (equivalent to about $60 billion today).
"Hurricane Andrew was an effective stress test," Matter said. “You could say the impact was ultimately systemic... There were many insolvencies, especially among local primary insurers. But the key point was not just the destruction caused by the storm, but the realisation that traditional reinsurance balance sheets were not sufficient to permanently carry peak risks from large hurricanes or events such as earthquakes.”
That disaster forced the insurance industry to seek supplemental risk-bearing capital – which it found through the capital markets, and the risk transfer inherent in ILS.
While the 1990s saw the birth of these "prototypes", it was 2005’s Hurricane Katrina that served as the catalyst for the market to grow, mature and enter mainstream. Since Katrina, the cat bond market has grown from roughly $10 billion to approximately $60 billion today.
A unique market
As we have explained in a recent white paper, the ILS market is split between two distinct structures: public ILS and private ILS.
Matter explained: “Cat bonds are the public part of ILS – more standardised, more transparent, and generally tradable. There is a secondary market for cat bonds, often with a focus on peak risks such as US hurricanes or Japanese earthquakes.
“On the private ILS side, these are more customised, less standardised, and less liquid, but more flexible. Through private ILS, risks can be transferred to the capital market that are not suitable for cat bonds.”
Having access to a broader range of risk, liquidity and return profiles can help to enhance efficiency of returns – and maximise the potential portfolio advantages of ILS. It also ensures that reinsurers can transfer and backstop a range of risks, ultimately helping to strengthen their ability to withstand shocks.
“Fundamentally, I believe ILS and cat bonds in particular can provide real added value to portfolios. We have seen it through attractive risk-adjusted returns and diversification within portfolios,” said Matter.
He continued: “ILS investments also have a real impact. On the one hand they strengthen the insurance sector, but they also increase broader risk-bearing capacity after natural catastrophes. This is relevant from a social perspective, especially if one goes beyond the established markets and thinks of developing regions of the world.”
“So, I believe the asset class is really attractive in a modern investment portfolio.”
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