ILS investors still looking for risk-adjusted returns and diversification

Capital market investors with an interest in the insurance-linked securities (ILS) space continue to invest in the asset class owing to its diversification benefits, low correlation with the wider financial markets, and the return per unit of risk, according to ILS market experts.

The ILS market has witnessed significant growth in recent times, underlined by continued strong issuance in the catastrophe bond market, the rise of collateralized reinsurance ventures, reinsurance sidecars, and more recently a spike in cat bond lite issuance.

Although a reduction in pricing has occurred across the global reinsurance landscape due to an influx of capacity, intense competition and a benign loss environment, resulting in reduced returns in the ILS sector, new investors continue to enter the market just as existing ones continue to return.

The reason for this, comes down to the diversification and low correlation benefits the asset class offers investors, along with the ability to continue to generate adequate returns per unit of risk, explained industry experts and executives speaking at the SIFMA IRLS 2016 conference in New York recently.

Steve Sutinen, Senior Portfolio Manager, Fixed Interest, at Challenger Investment Partners, highlighted that ILS has been a very important, and successful element of the firm’s multi-strategy portfolio for the best part of nine years now, “and there are two reasons for that.”

“The return it generated per unit of risk, and the low correlation with the risk portfolio,” explained Sutinen.

And he certainly wasn’t alone with his thinking. Fellow panel member Todor Todorov, Senior Investment Consultant, Hedge Fund Research, Willis Towers Watson, explained that the investors his firm speaks to are really attracted to the asset classes diversification benefits, and also the low correlation of the risk compared to what else they have in their risk portfolio.

Adding that “ILS has got investor interest in terms of its per unit of risk return, and also its diversification benefits.”

A view that was also held by Dr. Dan Bergman, Head of Investment Research & ILS at the Third Swedish National Pension Fund, a company that invests in the asset class with a long-term, and patient view.

Bergman stressed that the company began investing in the asset class really for its diversification benefits, but hastened to add that it also needs to be a sound investment from a risk-adjusted return, so again, the same elements noted by Sutinen and Todorov.

As mentioned previously in the piece pressures from the global reinsurance landscape have filtered down and compressed margins across the majority business lines in the insurance and also ILS landscape, and the SIFMA panelists highlighted that investors aren’t receiving the returns of years gone by.

“If we look at the past ten years we clearly see less attractive risk reward in this market now than five years ago,” said Bergman.

Todorov underlined that what is important in the ILS space is the spreads, particularly when compared to other asset classes, and while spreads in the majority of asset classes have tightened in recent months, he doesn’t feel ILS is yet at a stage where “investors start looking to take money out of ILS and put it to work elsewhere.”

Importantly, despite the return per unit of risk being substantially reduced from what it was four or five years ago, Todorov highlights that when you look at the space with a view to what it can offer an investor, and how it can benefit their investment portfolio, then it clearly still has a role to play.

And this has to do with its diversifying nature and low correlation to broader financial markets. Returns are reduced, and there is a possibility of further declines as the market moves further into 2016, but investors are compensated for this via ILS’ diversification benefits, and the fact that when the wider financial markets are experiencing volatility, ILS still has the ability to generate adequate returns.

SIFMA panelist Jonathan Malawer, Managing Director, Senior Investment Analyst, K2 Advisors, LLC, highlighted the low correlation aspect of the ILS asset class.

“I think it (ILS) surprised people in terms of its uncorrelated nature again, especially the investors. If you look at last summer with the volatility in the marketplace, ILS delivered as promised, given its uncorrelated nature and its very unique risk profile,” explained Malawer, adding that he feels investors are in the space for the long-term.

With this mind, financial markets remain volatile as we head further into 2016, and the insurance and reinsurance industries are expected to experience a similar, if not an intensified continuation of market challenges seen in 2015.

However, as evidenced and debated by executives at the recent SIFMA event, ILS has the ability to generate adequate returns per unit of risk when compared to other asset classes, particularly at times of financial market turmoil.

And while the yield might not be as desirable as investors perhaps hope for or are used to, the diversification offered and low correlating nature of ILS investments is likely to keep investors interested in the space for the foreseeable future.