Correlation between insurance-linked securities returns and S&P500 returns declines

We like to bring you interesting data points about the catastrophe bond and insurance-linked security market here on Artemis. Today we have a really interesting chart showing the correlation of ILS returns with the S&P500 from the latest quarterly ILS market report published yesterday by Lane Financial LLC, a consulting firm and broker-dealer focused on the ILS and associated sectors.

From an investor perspective, how the returns of the outstanding cat bond and ILS market tracks versus key market indicators such as the S&P500 is important. Investors in the ILS and cat bond space are looking for a diversifying source of returns, often allocating as much as 2% to 6% of their assets into ILS. So it is important for them to see less correlation between the returns of an ILS indicator versus the S&P500 as this helps to demonstrate the diversification opportunity. Of course, just because the correlation is low doesn’t necessarily mean that ILS is the right investment opportunity. There is the actual return profile to consider as well.

Lane Financial’s report shows that the rolling 24 month correlation between insurance total returns (as measured using the Lane Financial Insurance Return Index) versus the total return of the stock market (as measured by the S&P500) has dropped down to just 19%, the lowest point since before the Lehman Brothers collapse and the financial crisis.

Before the crisis ILS and stock correlations were in the single digit range, then during the crisis they peaked at around 60% showing the strong correlation that appeared in the market after Lehman collapsed and the total-return swap was exposed as a less than desirable method of collateral. Now, the correlation level is gradually subsiding back below 20%, something Lane Financial had expected to happen and forecast in earlier reports.

The chart also shows the correlation of an investment grade index and a high yield bond index versus the S&P500 as well. Both of these measures have risen in recent months up to mid-2012, which Lane Financial was surprised to see and puts down to the risk appetite in the financial markets at the moment.

Also interesting is how low the long-term volatility of the Lane Financial index is when compared to the other indices and the S&P500. The LFIRI shows a volatility of just 0.79% compared to 4.44% for the S&P500, 1.52% for an investment grade index and 3.91% for a high yield index.

For ILS, Lane Financial say the data is satisfying as it clearly shows that they are a diversifying asset class. You can see the chart below.

Correlation of insurance-linked securities returns versus stock market returns

We’ll cover some more details from the latest quarterly Lane Financial report soon. You can find the report on their website where you’ll need to register to download a copy.