The investment case for the insurance-linked securities (ILS) asset class remains strong due to the diversification benefits ILS offers to a portfolio, despite the lower returns available throughout the reinsurance market, according to Mercer.
Consultants at global investment service provider and advisory Mercer continue to push ILS and reinsurance linked investments as an asset class that can benefit portfolio diversification for institutional investors, with the attraction due to ILS’ low correlation with wider financial market factors as strong as ever.
“Sophisticated investors should investigate the use of ILS to gain exposure to an alternative source of risk premia,” consultants from Mercer explained in a recent report.
The consultants explain that ILS can be “particularly interesting” to sophisticated investors due to the fact that “natural catastrophe risk has shown very low correlation with traditional financial risk.”
As a result, for large, sophisticated institutional investors, an allocation to ILS, such as into an ILS fund, or instruments such as catastrophe bonds, remains attractive according to Mercer, which is encouraging to note given the lower rates now generally achievable.
Returns on ILS investments and catastrophe bonds have been affected by the slide in global reinsurance rates-on-line in recent years, resulting in as much as a 40% decline in some ILS fund returns over three years.
Attractive returns can still be achieved from some ILS strategies, but due to the decline in available reinsurance rate this often requires taking on a greater degree of risk than an investment would have three years ago.
With average ILS fund returns tracking at 4.11% up to the end of November, according to the ILS Advisers Index of 32 constituent ILS funds, returns are undeniably down as the ILS market adjusts to the softened reinsurance market environment.
ILS returns have been impacted by multiple factors; the low catastrophe loss environment, the build up of excess traditional reinsurance capacity, the growth of its own alternative reinsurance capital, the greater retention by large insurers and the resulting high-level of competition this has all stimulated.
Hence achieving the returns of three years ago, at the same level of risk assumption, just isn’t possible anymore. But even at these lower returns the asset class has a strong case for investment and inflows continue to be seen from large investors, like pension funds.
Mercer states that with the reinsurance market cycle driving down available returns, despite this reduction the “diversification benefits” that ILS offers are “still attractive.”
It’s important for investors to understand that when investing in ILS they can face “rare but possible extreme drawdowns,” Mercer notes. It also cautions that investors need to be prepared to embrace ILS as a longer-term asset class allocation and that they need to be prepared to ride out the re/insurance market cycle.
Investors also need to be “prepared potentially to increase exposure after experiencing significant losses, as pricing can be very attractive following major events.”