Underpinned by innovative catastrophe bond transactions and increased awareness and understanding of sustainable and ethical investing, the insurance-linked securities (ILS) space is more than just a portfolio-enhancing asset class.
This is according to John Seo, the Co-founder and Managing Director of specialist ILS manager Fermat Capital Management. In a recent article for GAM Investments, Seo explains that while the ILS space benefits from being fundamentally uncorrelated with the broader market, as an asset class, it brings more than just portfolio-enhancing qualities.
“By providing structural capital to the global re/insurance industry to set against the possibility of rare but damaging catastrophes, ILS arguably have a measurable beneficial impact on society and the quality of people’s lives.
“Investors are increasingly considering the positive environmental, social and governance (ESG) qualities of ILS, particularly when they are used by public institutions as tools to help manage risk and to support better disaster preparedness and response to communities at risk of natural disasters,” said Seo.
Catastrophe bonds, one of the largest sub-sectors of the ILS space, were introduced to cover very peak exposures, often sitting at the top of reinsurance towers to mitigate the impacts of the most extreme natural catastrophe events.
Over time, and assisted by the increased sophistication and maturity of the ILS community, cat bonds have started to move further down the tower, supplementing traditional reinsurance coverage in a different way than before and ultimately being more widely leveraged across both the traditional reinsurance, and primary insurance space.
The ILS asset class has grown rapidly over the last five or six years and continues to reach new heights, something that’s supported by innovative cat bond transactions that not only provide diversification and uncorrelation benefits for investors, but that also play a very important role in the ability of societies and economies to both prepare for and recover from natural disasters.
As an example, Seo discusses the $320 million IBRD CAR 111-112 catastrophe bond transaction, that provides financial backing and insurance protection to the World Bank’s Pandemic Emergency Financing Facility (PEF).
The bond provides parametric protection tied to the occurrence of specific pandemics, such as Ebola and influenza, providing liquidity and capital to assist stricken countries or regions in their response and recovery efforts.
“From a narrow financial perspective, the beneficial impact of this bond is considerable because early action funding has a multiplier effect: one US dollar spent on containment early in the stages of a breaking pandemic is worth over one hundred US dollars of treatment later, when traditional, international aid tends to arrive,” says Seo.
Investing in a sustainable, responsible and ethical manner is becoming of increased importance for investors in the ILS space, a trend supported by the fact the Bermuda Stock Exchange (BSX) is pushing the ILS asset class as one that has ESG investment qualities.
At the same time, investors in the space are reportedly asking about climate change and ESG investing more and more.
“Climate change has not yet manifested itself in an increased frequency of hurricanes – this has been acknowledged by the Intergovernmental Panel on Climate Change (IPCC)3 , which provides the official global scientific view on climate change impact on weather – although investors in this market continue to monitor events and check their models for any potential change in activity.
“Changes that could impact in the underlying (re)insurance risks could be due to an uptick in frequency or severity of weather-related catastrophes, but are more likely due to more powerful underlying issues that can exacerbate losses – namely, increasing concentrations of property and wealth in areas more prone to natural disasters, like coastlines and wildland-urban interfaces,” explains Seo.
He continues to explain that while events like the 2018 California wildfires were devastating to those communities affected, they often only have a minimal impact on portfolios. However, more recent wildfire events have provided important data points to test prevailing models, which might well result in attractive investment opportunities.
“Initial evaluations provisionally indicate that California wildfire models likely need to double the risk in some areas of the state, primarily due to climate-related, increased flammability of forested areas,” says Seo.
ILS are becoming an increasingly important source of risk transfer and risk funding, assisting organisations and in some instances governments’ efforts to remove natural catastrophe risk from their balance sheets, while freeing up their own funds for resilience and response needs.