Combining cat bonds with insurance bonds a hidden source of alpha: Twelve Capital

The combination of catastrophe bonds alongside insurance bonds within an investment portfolio can generate a “hidden source of alpha” for investors, offering them an “untapped source of risk premium”, specialist ILS investment manager Twelve Capital has said.

Twelve Capital, the Zurich headquartered catastrophe bond, insurance-linked securities (ILS) and reinsurance linked investment fund manager, explained in a recent paper that investors often pay dearly in order to access sources of investment return that display hidden alpha and are an untapped source of risk premium.

But in the ILS market and with another fixed income asset from the insurance and reinsurance sector, insurance bonds, “there is a previously overlooked solution that is more cost effective and delivers a desirable result.”

The two types of fixed income assets, catastrophe bonds and insurance bonds, which are typically liquid and investment grade bond dominated, come with very different exposures, but complement each other and as a result a source of risk premium can be accessed that can be extremely valuable for portfolio diversification, Twelve Capital believes.

“When two very different asset classes are blended together, it is possible to create more balanced and stable returns and mitigate undesirable risks that do not reward,” the investment manager explains.

Taking the example of the COVID-19 coronavirus pandemic and the volatility this created in financial markets, Twelve Capital notes that catastrophe bonds and insurance bonds performed well, with cat bonds having a lower level of beta with the broader markets, while issuers of insurance bonds did not appear to experience solvency issues from the rising claims experienced.

As a result, both of these distinct but insurance and reinsurance linked fixed income assets demonstrated their lack of correlation, offering investors all-important diversified sources of returns during the pandemic related financial market crisis.

As regulatory type investment bonds that help to ensure the capital adequacy of insurers, insurance bonds are often considered relatively stable in their delivery of returns and remote from default risk.

While they often have less attractive yields than catastrophe bonds, when blended with them in a portfolio strategy, insurance bonds can help to mitigate some of the tail-risk that cat bonds are exposed to, Twelve Capital notes.

Historically, the insurance industry has experienced lower default rates on these insurance bonds versus other sectors and Twelve Capital explains that “their yield is less connected with the credit risk that they are exposed to and more related to their complexity.”

As a result, investors can be rewarded for having the patience to understand how these insurance bonds work. But Twelve Capital notes expertise in the insurance and reinsurance industry is required to make proper, informed investment decisions on them.

Twelve Capital notes that, “Combining Insurance Bonds and Cat Bonds in an efficient asset allocation mix, by taking advantage of the US Wind season, reduces volatility and improves potential returns,” and that “By dynamically allocating between Cat Bonds and Insurance Bonds, investors can create a strong insurance focused strategy that forms part of their investment portfolio.”

Part of this dynamic allocation means adjusting the portfolio mix to capitalise on risk premiums during the U.S. wind season, for example.

Given their return potential, features and lack of correlation, Twelve Capital notes that this blended approach remains attractive even after the pandemic related volatility has subsided.

These assets have something positive to add to large investment portfolios across the financial and reinsurance cycle, providing investors with “an attractive risk-return profile that bears a lower correlation to other parts of an investment portfolio.”

“Ultimately, this is an investment strategy that offers investors a very high degree of flexibility. Firstly, from a portfolio construction perspective. And secondly, in the form of defensive income that can be either drawn or reinvested, depending on the investor’s objective. It is a source of risk-premium that can form part of any well- diversified investment portfolio,” Twelve Capital concludes