ILS and cat bond investors. Yield hungry? Or seeking asset qualities?

For many investors a high return is not the only reason for looking at alternative asset classes and hedge funds. Research shows many only seek a 4% to 6% return, information that will comfort the insurance linked investment market at a time of softer prices.

Catastrophe bond yields and broader reinsurance rates and pricing are down significantly over the last two years, largely due to the over-capitalised nature of the market, lack of major losses and the influence of a growing institutional capital base in insurance-linked securities (ILS) and reinsurance investments. As a result the expected return of ILS funds, cat bond funds and other insurance linked investment opportunities are also down this year.

Despite this lower yield, the mainstream press continues to portray investors in catastrophe bonds, reinsurance and insurance linked securities as ‘yield-hungry’, a mob of rabid investors chasing an asset class down. But there’s more to investors motivations for entering a new alternative asset class, like the insurance linked sector.

Research from Preqin, a provider of information and analysis for the alternative asset management marketplace, shows that investors are not simply looking for higher returns, they often tap alternative asset classes such as reinsurance and ILS for the qualities they offer to an overall investment portfolio.

That means qualities such as the low levels of correlation that ILS and investments in reinsurance display with wider economic indicators, such as the return of equity markets, are a major factor in investors allocating to alternative assets. Note, we say ‘low’ correlation as nothing is ever completely uncorrelated (in our opinion).

In a survey of over 100 large, institutional investors Preqin found that motivations for allocating to alternative asset classes are not purely driven by higher potential returns. Respondents indicated that they are looking for hedge fund allocations to produce returns uncorrelated to equity markets (59% of investors cited this), produce robust risk-adjusted returns (53% of investors) and dampen portfolio volatility (46% of investors).

Interestingly, of the surveyed institutional investors, 67% said they look for returns of between 4% and 6% from their alternative hedge fund allocations, while only 6% of investors seek returns over 10%. This perhaps allays the fear (to a degree) that investors would run a mile as soon as average catastrophe bond yields dropped below 6%, a concern that has been cited more than once this year.

It also helps to explain the continued attractiveness of the insurance and reinsurance linked asset class, which can provide a 4% to 6% return with a relatively low volatility portfolio of risk. Higher returns are of course possible, particularly if looking to a retrocession investment, or to participate in lower layers of reinsurance, but for institutional investors it seems that the qualities an alternative asset class adds to the portfolio can outweigh the attraction of outsized returns.

“Investors are looking for hedge funds to do more than produce high returns; in fact, it is their ability to produce risk-adjusted absolute returns which are uncorrelated to equity markets that appeals to these institutions,” explained Amy Bensted, Head of Hedge Funds Products at Preqin.

Preqin believe that investment managers need to focus on the features that their asset classes or strategies offer which will appeal to these investors. This is an area that ILS has been particularly good at, given the asset class has long been extolling the virtues of its low-level of correlation to equities, its relatively high sharpe ratio and the impressive track record of many managers.

Bensted continued; “Investors are the most satisfied with returns they have ever been, with hedge funds having largely lived up to investors’ expectations on an absolute and risk-adjusted basis over the short, medium and longer term. The amount of money they invest in hedge funds has increased over recent years and is likely to grow significantly in the years to come. Hedge fund managers looking to raise capital from these investors need to market the positive impact that their vehicle can have on an investor’s portfolio outside of returns in order to attract an increasingly sophisticated investor base.”

For insurance linked investment managers, ILS funds and reinsurers looking to raise new capital from institutional sources, the survey will provide encouragement that investors will not simply lose interest as the average return of the asset class declined inline with pricing.

The survey results show that many investors are happy with a lower return, particularly if the asset class provides the benefits to their overall portfolio that they seek. In that respect, ILS, catastrophe bonds and reinsurance linked investments are very well positioned to continue to attract capital from these large institutional investors.

Combine the fact that many investors in ILS and catastrophe bonds have come to terms with their lower cost of capital, enabling them to compete at lower returns with traditional reinsurers, with the fact that the lower returns still remain acceptable for an asset class bringing them other portfolio benefits, and it’s easy to see why reinsurers have rushed to establish units to manage this capital as well.

Perhaps the stories in the press about yield starved, or yield hungry, institutional investors rushing head first into the ILS, catastrophe bond and reinsurance market without a thought for the risks, aren’t as warranted as some would like you to believe.