Higher risk-free rate boosts ILS investment returns

The steady rise in interest rates of instruments such as U.S. Treasuries, that are typically used as collateral for insurance-linked securities (ILS) and collateralized reinsurance investments, have now served to boost returns for ILS investors in 2019.

U.S. Treasuries have seen their interest rates rise steadily over the last two years, which supports better returns for ILS investors given the floating nature of ILS instruments such as catastrophe bonds and other reinsurance-linked assets.

U.S. Treasuries fell to as low as a 0.20% return back in 2016, but steady increases helped by U.S. interest rate rises mean that they currently stand at around 2.07% for a 90-day Treasury instrument.

It actually stood at 2.40% in early May, but since then as readers will know there has been a slow decline.

The overall rate of increase had slowed in 2019, but as the effect of rising Treasury rates takes some time to flow through to collateralised asset classes, this is now seen to be boosting returns materially for ILS investors.

Hence it will also take some time for the recent decline, if it continues, to impact ILS market returns.

The risk-free component of catastrophe bonds and other Treasury bill backed ILS or reinsurance investments had been negligible in recent years, but is now contributing a significant benefit to some investors.

Other asset classes which are not collateralised in this way do not offer the benefit of this risk-free component to their returns, which is another factor that can make ILS particularly attractive as an asset class at this time.

While many catastrophe bonds have in recent years changed to using IBRD notes for their collateral assets, these have also seen their returns rising steadily.

Typically these IBRD notes pay a minimal spread around LIBOR rates, which had been on the rise from 2016 as well.

In fact, the interest rates for these IBRD notes for use as collateral had risen before Treasuries, making them particularly attractive and winning over new business in the catastrophe bond market.

But now Treasuries have caught up and so this is benefiting ILS fund managers who tend to use the 90-day Treasury as a collateral tool for their collateralized reinsurance and private ILS transactions.

Being a fully collateralized asset class, in the main, ILS investors are all benefiting from this and the boost from underlying collateral returns is welcomed and also a differentiator for the class, compared to many other assets.

Recent research by ILS consultancy Lane Financial showed that taking the floating rate of return from Treasuries and combining it with a market-weighted portfolio of ILS securities provided a running loss-free total return of 7.89% and an expected total return of 5.59%.

That’s for a market-weighted portfolio of catastrophe bonds, a relatively low volatility, beta style investment product, which now thanks to the risen rates can offer a very attractive total return.

With the catastrophe bond, ILS and collateralized reinsurance asset class seeing contract renewal pricing rise by anywhere from 5% to 25%, sometimes more in certain loss-affected cases, the potential returns from the ILS asset class now stand much higher than they did a couple of years ago.

As we’ve noted before, that makes right now a very good time to allocate to the sector and enter the ILS market as an investor.

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