This interview with Niklaus Hilti, Head of Insurance-Linked Securities Strategies at Credit Suisse Asset Management, discusses the return potential of the insurance-linked securities (ILS) asset class and how to compare this across different strategies.
This interview, fully titled ‘Comparing risk-adjusted returns in insurance-linked strategies‘ is taken from the recently published report by specialist financial services, pensions and investments publisher Clear Path Analysis, titled ‘Insurance-Linked Securities for Institutional Investors 2014.’ Clear Path Analysis have kindly allowed Artemis to republish it here in full.
– Niklaus Hilti, Head of Insurance-Linked Securities Strategies, Credit Suisse Asset Management.
– Jessica McGhie, Senior Publisher, Clear Path Analysis.
Jessica McGhie: In a diversified portfolio with single insurance-linked positions what level of risk should asset owners expect in their fixed income instruments and derivative transactions?
Niklaus Hilti: It strongly depends on the risk appetite and diversification of the investor. It’s fair to assume that most investors tapping into the insurance-linked strategies (ILS) space are already quite diversified on the more traditional side of investments. However, there are two schools of thought on how much risk an investor should take. The first argues that because an investor is already diversified when entering the ILS marketplace they are able to take on a significant concentration risk within their ILS allocation.
The second argues that whilst adding an ILS allocation diversifies the portfolio, if the investor wants to maximise that allocation and its low correlated portfolio position, they will be limited on the amount of risk that they can take. In such instances investors want a more diversified strategy rather than a concentrated strategy.
Jessica: Does that risk depend on the other assets within their portfolio or are there other factors that influence it?
Niklaus: ILS is usually considered as an independent asset class, not comparable to other assets. Moreover, because of this general assumption that ILS has low correlation with other asset classes, the risk question typically becomes a function of how much they wish to allocate and what their target returns are. Some investors have very ambitious target returns and therefore are prepared to take on higher risk. They typically go for a concentrated ILS product whilst investors, who are happy with a 4% or 5% return, tend to opt for a more diversified ILS investment approach. For them it is important that while achieving this target return they are equally maximising their position of low correlated investments. This is very hard to achieve and ILS are one of the very few asset classes that are able to do so.
Jessica: Do you think asset owners struggle to accurately compare premiums of different ILS instruments and their risks?
Niklaus: The main problem is that investors, and consultants, tend to compare premiums rather than the risk adjusted margins. They simply look at the yield even though this is very dangerous, particularly in ILS. Even in a softening market you can achieve stable premium income by taking on more risk. The question is therefore how much risk you are taking on with the specific instrument. And these risks, unfortunately, are more complex and difficult to understand for many “traditional” investors/consultants as they significantly differ from say, typical equity risks.
ILS risks are usually low frequency and high severity event risks; this means that you can easily have 10 years of excellent premium returns but in the 11th year lose everything. As an investor or consultant this isn’t easy to see because typically they don’t put enough emphasis on analysing how much concentration risk there is within ILS. ILS returns mostly look great if there are no big catastrophes; so simply comparing yields or premiums without taking into account the underlying risk that investors are taking on is dangerous.
Jessica: What steps would you advise asset owners take to ensure a truly comparative study?
Niklaus: It is about asking for high transparency and meaningful risk information to ensure that the investor, consultant or analyst can really see how much concentration and downside risk there is. It’s always hidden in the product or strategy and so, of course, getting that transparency with meaningful figures is key.
Jessica: Do asset owners struggle to get the right level of data and the right transparency? Is there still quite a lot of work to be done within that area?
Niklaus: The ILS space is generally a bit more transparent than the reinsurance space as whole. However, there is a lot transparency in less meaningful information yet consequently investors are not seeing what the downside is, how much concentration risk they are running and how much they could lose in specific scenarios.
Jessica: Should the risks be assessed separate to the premiums or in conjunction with each other?
Niklaus: It’s always in conjunction with each. You can always achieve a certain premium in reinsurance and therefore, the important question is around what your risk adjusted margin is. Obviously the combination of premium and risk helps you identify the risk adjusted return or margin, that’s key.
Jessica: Which ILS instruments are presently delivering the best risk- adjusted returns and enhancing asset owners’ strategic objectives?
Niklaus: Historically catastrophe (CAT) bonds have delivered an excess risk adjusted return but since 2013 all ILS instruments have pretty much converged. At the moment I would say instruments like private transactions are slightly better given that there is a higher entry barrier for additional capital than in the CAT bond market. All of the market’s participants are aware of the different instruments and subsequently are much more efficient in using those instruments. Going forward though pricing will be pretty tight because this increased market efficiency is here to stay; there’s more information and more people looking.
Jessica: Thank you Niklaus.
Read our other articles and transcripts taken from this report:
Visit the Clear Path Analysis website to register to download a full copy of the report ‘Insurance-Linked Securities for Institutional Investors 2014‘ including all of the interviews and roundtables.