Don’t diversify for diversification’s sake in ILS investing: Experts

Diversification is often considered key to a successful investment strategy, but for institutional investors targeting the insurance-linked securities (ILS) space diversifying for the sake of diversification isn’t necessarily an optimal approach, according to Dirk Lohmann and Todor Todorov.

The expanding base of institutional investors that operate in the ILS space typically only allocate a small portion, maybe 1% – 3%, of their investment portfolio to the ILS asset class.

While investing in insurance and reinsurance-linked business through ILS funds and managers adds diversification to an overall risk portfolio, diversifying within the actual ILS segment itself might not be a necessary, or optimal approach according to industry experts.

This is according to Dirk Lohmann, Head of Insurance Linked Strategies at Schroders and Todor Todorov, Investment Consultant, Hedge Funds Research at Towers Watson, who both discussed the diversification within the ILS space in a recent interview with Clear Path Analysis.

“There is no need to look for ILS that are diversifying simply for the sake of diversification because diversification can be very expensive and not really bring much value to the investor,” said Lohmann.

Increased diversification within the ILS section of an overall investment portfolio can be costly. Investing in multiple perils could involve increased transactional costs, which, despite adding a mix of perils, regions and potentially counterparties, might not actually bring any additional value to an investor, as highlighted by Lohmann.

Furthermore, taking on a range of perils and regions is an area where sizeable reinsurance companies play, and, owing to their sheer size when compared to ILS funds and managers they can often underwrite at significantly lower rates than perhaps ILS players are able to.

This could create a situation where an ILS investor, owing to a strong desire to diversify, simply ends up taking on a broad range of perils that perhaps they don’t properly understand, and at lower rates in order to compete with the reinsurers just for the sake of diversification.

One of the key benefits of investing in ILS is its extremely low correlation with the wider financial markets, underlined by the steady returns the asset class achieved during the U.S. financial crisis in 2008, one of the very few alternative investments to do so.

Owing to this, and the fact that it’s a diversifying asset class in itself without the need for multiple peril region exposures under various collateralized reinsurance contracts, for example, Todorov explains that diversification isn’t of significant importance for the institutional investors that allocate a small percentage of their investment capital to ILS.

“Diversification for the sake of diversification within ILS is not necessarily the top priority within institutional investors, but indeed focusing on risk perils where capital is truly needed and that can play a role in that portfolio is more than welcome,” said Todorov.

ILS investors like concentrated risk because they understand this is where they are likely going to make the most profit, and their increased understanding and sophistication is reflected in the realisation that they might lose, or not make as much by diversifying within ILS.

“The key point is that you don’t just buy diversification for its own sake and get painted into a corner of writing very expensive and low returning risks geographies where there is excessive capacity, chasing a limited amount of demand,” said Lohmann.

Increased diversification within ILS heightens the risk of overexposure and also investors would likely take on a lower return for the sake of diversification, and, again, in an effort to compete with the wealth of reinsurers.

“Where institutional investors have expressed interest, but there hasn’t been that many available products is targeting different parts of the insurance industry and return drivers.

“This could be on the life side or in other lines of business but these would bring something truly different and interesting to their portfolio,” said Todorov.

The desire for institutional investors to access insurance and reinsurance risks through the structures of the growing ILS space is evident, and their willingness and increased understanding of the benefits and limitations of the space will likely support the growth of the market in the future.

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