Catastrophe bonds a useful source of diversification for investors

Catastrophe bonds and insurance-linked securities seem to be in the news at least once a week with respect to their use as a diversifier for investment portfolios. A fortnight ago we wrote about the Australian investment advisor Ibbotson who suggested that insurance-linked securities were an ‘investment asset to withstand recession‘. Now Australian investment research house van Eyk Research has come out in favour of cat bonds as well.

van Eyk Research are a leading Australian provider of investment research, providing advice to both investors and financial advisers. This suggests that their target audience are not solely institutional investors, rather their research helps advisers inform retail clients on good investment options to take.

According to their research, catastrophe bonds are a useful source of diversification for investors. Interestingly, they also say that investors are overpaid for taking on peak catastrophe risks, a comment that will interest sponsors looking to make cat bonds more affordable.

As the investment landscape for cat bonds and ILS expands and opportunities begin to appear for smaller, retail investors to access the market, such as the efforts by GAM, perhaps the premiums paid will begin to shrink slightly. Institutional investors have received large premiums for cat bond investments historically as they are willing to take on such large, and sometimes concentrated, risks. If the risks are broken down into smaller chunks perhaps investors will accept a lower risk premium? An interesting thought for where the ILS market could go if it really tries to access the retail market, a sometimes controversial point with some ILS market participants who believe they are too sophisticated an asset for the average investor.

van Eyk warns investors against over-concentration of their portfolios to U.S. hurricane risks, thus highlighting the need to diversify this diversifying asset. They expect the market to grow over the next decade, primarily driven by population density, inflation in building costs, growing concentration risk and of course growing interest from investors.