Equity investing can be as risky as catastrophe reinsurance investing

For large institutional investors with diversified portfolios of investments across multiple asset classes, the addition of a small allocation to catastrophe risks and reinsurance linked investments can actually be no more risky than their allocations to equities.

One of the more misunderstood, or perhaps overlooked, aspects of the insurance-linked securities (ILS) and reinsurance linked investments strategy is that, typically, investors only allocate a small amount of their capital to this asset class.

In fact it is typical for investors allocations to ILS to range from just 1% of their total assets up to perhaps 5%, but that is high. For an institutional investor like a large pension fund it is likely to make up no more than 2% of the funds overall investment portfolio.

For these broadly diversified investors, who learn to understand and appreciate the benefits of an allocation to reinsurance or ILS, it is likely that they have much larger allocations to international equity markets.

Equities, so stocks and share investments in companies or perhaps in an exchange traded fund that tracks equity markets, can make up 20% or even as much as 40% of a pension funds overall investment allocations, meaning that volatility of the holdings can have a significant effect on the fund performance.

ILS is a low volatility asset class, over the longer term. Yes, a single event can be severe, market changing and create enormous losses, but they typically only happen rarely. More typical in insurance and reinsurance markets are the kind of attritional losses which rarely hit the layers of risk covered in ILS transactions and invested in by large institutional investors.

So, while an investor can lose its whole allocation to ILS from a single large catastrophe event, that is likely to be an infrequent thing and, even when it does happen, being a small piece of the overall portfolio means it is not unmanageable.

On the other hand equities can move massively on a day-to-day basis and as they often make up such a large component of an investors portfolio the impact can be huge.

This is another reason that many investment consultants recommend their pension fund clients look to reinsurance and ILS as a more stable source of return to add, as a small overall component, to their investment portfolios.

When treated in this way, as part of a diversified approach to investing, these large pension fund-type investors can manage a loss from their ILS allocations, due to a major catastrophe event, much more easily than they can manage those caused by volatile equity markets.

A real-world example of this has been provided by a recent article regarding the pension fund allocations of the Linde Group, an international gas and engineering company.

Linde has around $6 billion of assets in its pension funds and currently allocates around 4% of its strategic asset allocation to catastrophe reinsurance risks.

Christian Schlegel, the head of pension investments at Linde, told Investment & Pensions Europe in the article that the exposure to natural catastrophe risks is based on “sound structural arguments.”

Schlegel told IPE that he appreciates that returns are depressed in the sector, as there haven’t been any major catastrophe losses in recent years, but the investment still delivers a return that is higher than other fixed income assets and also offers the added benefit of having a low correlation to other economic factors.

When asked how he would react when there are major catastrophe losses, Schlegel explained; “If the reinsurance portfolio loses 30% in a disaster year, it’s a 1% loss in the overall portfolio. That can happen in a week with the equity portfolio.”

This is how large institutional investors, such as pension funds, think about their investments in ILS, catastrophe bonds and reinsurance. They invest in a diversified portfolio of catastrophe risk, mostly some do prefer more exposure, but at a level where it only makes up a small percent of the overall portfolio.

With the kind of catastrophe events that would total a diversified investment in ILS or reinsurance being the 1-in-30 to 1-in-100 year type events, that means over the longer-term an investment in catastrophe reinsurance could be significantly less volatile in terms of impact to the pension fund’s overall portfolio as its investments in equities.

That is a very important factor to large investors. Pension funds are looking for asset classes like ILS, which provide a source of return that beats many equivalents, with lower volatility as a component of the portfolio and with the added low-correlation benefits that catastrophe risk has.

This is no ‘bet on disaster’ as the traditional media might have you believe. Investors are attracted to insurance and reinsurance risks for real and tangible reasons, as they do add benefits to their overall portfolio which cannot be found in many other asset classes.

Hence the attraction is expected to continue, with more large investors like pension funds becoming interested in the ILS space every day. It’s also why it’s not anticipated that these investors will leave the sector in droves at the first sign of catastrophe losses. They understand what they can lose and as a small part of their portfolio it’s manageable and, while clearly undesirable to lose any money, it’s not going to come as a huge surprise when it does happen.