Diversification drives ILS adoption on both sides of the trade

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Adoption of insurance-linked securities (ILS) by both investors and cedants continues to be driven by their desire for diversification, on both sides of the ILS trade, a recent survey found.

diversificationThe survey undertaken by insurance and reinsurance broker Willis Towers Watson (WTW) asked both sides of the market what drives them to adopt ILS, as an asset class for investing in or a source of reinsurance protection.

Diversification is king, the brokers’ recent survey report says, as once you examine the motivations of both investors and cedants, it becomes clear why the ILS asset class remains attractive even after the recent period of catastrophe losses.

“End investors are primarily driven by ILS’ portfolio diversification opportunities and their non-correlation with other financial asset classes,” WTW explained.

For institutional investors, memories of the financial crisis, when the limited diversification between traditional asset classes became abundantly clear, are still fresh.

As a result, 96% of the ILS survey responses from end-investors said that the fact ILS is generally uncorrelated with traditional markets such as equities and fixed income was a key driver for their allocations, while 64% cited portfolio diversification generally as a driver.

“Interest in diversification is also likely to correlate with investors’ cost of capital, suggesting that ILS investments are typically consistent with needs,” WTW continued.

Other key drivers for investing in ILS among the institutional investors surveyed included, the relatively low-cost of accessing the ILS asset class, the high yield potential of ILS investing, the fact the asset class is seen as relatively easy to understand and monitor, that ILS can be relatively liquid compared to other alternatives (especially catastrophe bonds) and that the ILS investments on offer are relatively institutional friendly.

Those other drivers are all positive for the ILS sector, as having a positive view on cost and ease of accessing an asset class, as well as how easy it is to understand, monitor and trade into or out of, are all vital in encouraging further institutional interest in insurance and reinsurance as an investment opportunity.

Summarising investor appetite, WTW explained, “Even though real returns on other asset classes may increase further if interest rates rise, the diversification and real return objectives of pension funds invested in ILS suggest that a significant shift out of ILS would be unlikely.”

On the other side of the trade in ILS, the cedants, generally insurance and reinsurance firms, are also seeing diversification as their key driver for embracing the asset class as an alternative source of protection.

The majority (58%) of cedants surveyed utilise ILS capacity in some form or another, WTW’s survey found, while almost a quarter derive more than 30% of their capacity limit from ILS sources.

Hence the survey sample were clearly the type of cedants more predisposed to ILS as a form of protection, so it’s interesting to learn why this is.

“Cedants also value diversification,” WTW explained. Adding that diversification was, “Ranked as a primary attraction by nearly three-quarters of organizations, followed in importance by pricing and credit quality.”

74% of the cedants responding to the survey said that diversification of their capacity was a key driver, while 58% cited pricing, 47% cited credit quality, so the fully collateralized nature of ILS products, and impressively 32% said they came to the ILS market for protection due to the innovation on offer.

Other drivers included the speed of claim payment that is possible with ILS, the generally multi-year term of the coverage on offer, as well as improved support for aggregate drop structures.

Overall, the survey positions ILS in a positive light, for both investors and cedants, and while there are still loss impacts to deal with, WTW feels these will be overcome and growth of ILS will continue.

“The long-term interest in ILS, particularly from pension fund managers seeking diversification, remains strong,” WTW said.

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