ILS “particularly suitable for reducing tail risks” for investors: BAI

Despite the fact insurance-linked securities (ILS) themselves have the tail-risk of major global natural catastrophe events firmly embedded in the asset class, as part of a broader alternatives allocation ILS are “particularly suitable for reducing tail risks” in investor portfolios, according to the BAI.

The German association for alternative investments, the BAI or the Bundesverband Alternative Investments e.V., recently undertook a study of alternative asset classes, looking at which can play a positive role in investor diversification and reducing correlation with major global events that can swing financial markets.

With the ILS asset class composed of largely natural catastrophe reinsurance risks, through instruments such as catastrophe bonds, collateralised reinsurance and other structures, it does harbor an inherent tail risk, the BAI notes, which manifests when major disasters occur and has driven down values.

“However, these inherent tail risks (given the randomness and severity of natural disasters) of cat bonds play a subordinate role in the overall portfolio of most institutional investors,” the BAI explained.

In fact, “In times of increased market volatility (e.g. financial crisis and corona crisis), ILS did not have the higher volatility levels that were observed in other asset classes,” the BAI also explained.

ILS can offer consistent returns with very little volatility, while the asset class exhibits extremely low correlations with traditional investments as well as other alternative investment classes, the BAI said, which it believes “underlines the important portfolio diversification that this asset class can offer.”

It’s also notable that during the peak of the COVID-19 coronavirus crisis, the ILS market continued to run at near full speed, with new issues coming to market and investment activity continuing apace, unlike many other investment categories.

The BAI believes that “Insurance-linked securities are therefore one of the most alternative asset classes,” in the context of its study, adding that because of their exceptional risk-return profile, they are “particularly suitable for reducing tail risks in the overall portfolio.”

Importantly, the “low correlation of ILS to other asset classes and thus diversification advantages persist even in times of greater market volatility,” the BAI continued.

The diversification effect of ILS and catastrophe bonds was most evident during the last financial crisis and around March 2020, when the coronavirus outbreak was spreading rapidly around the world and markets dropped, but ILS remained largely stable.

“The ILS market remained orderly during the turbulent pandemic phases, and bid and ask prices remained appropriate. Much like during the financial crisis, the ILS market has been largely isolated from the general financial market disruption and has once again proven to be resilient,” the BAI explained.

Of course, there can be correlation in the ILS market, like any other asset class there are tail-risk elements that could correlate across markets and asset classes, when the biggest global events occur.

But even under the peak of coronavirus spread, it was only certain life ILS and the World Bank’s pandemic bonds that exhibited correlation. Similarly, even after really significant natural catastrophes, where markets can move more in tandem, the ILS market tends to recover and resume its normal trajectory rapidly.

Finally, the BAI makes a comment on the regulation of investments into ILS in Germany, where sometimes it can be challenging for institutional allocators to access the market.

Saying, “The comparatively high interest rate and the independence of underwriting risks from other financial market risks will continue to provide a high incentive to invest in the reinsurance market.

“A clear positioning by BaFin would be desirable, which clarifies the permissibility of acquiring ILS funds for investors who are subject to the investment ordinance.

“Because the previous statements show: Cat bonds can make an important contribution to the diversification of the institutional portfolio.”

A glowing summary of the benefits of ILS investing and one that should garner the attention of regulators and investors in Germany alike.