Insurance-linked strategies, the lowest volatility hedge fund segment

The insurance-linked securities (ILS) asset class, of funds featuring catastrophe bonds, collateralised reinsurance contracts, quota share and sidecar investments, industry loss warranties (ILW’s) and other private ILS, displays the lowest volatility of any hedge fund strategy.

According to a recent report from alternative investment and hedge fund asset information service Preqin, across over 100 hedge fund strategy segments the insurance-linked strategies asset class displayed the lowest volatility on either a 3 or 5 year basis.

In 2015 insurance-linked strategies were among the only hedge fund strategies to not face a single negative month in the year, according to Preqin’s data, testament to the relatively stable long-term returns that the asset classes offers.

While ILS as an asset class has seen its returns decline sharply, as it mirrors pricing across the reinsurance markets and the novelty factor has diminished as investors became more confident in ILS, on an annualised basis the returns are still attractive, versus other hedge fund segments, particularly so when you consider the much lower volatility.

Preqin reports that the insurance-linked strategies segment of the hedge fund universe, which it categorises within “niche strategies”, has a three-year volatility of just 1.01% and a five-year volatility of 1.61%.

The figures are the lowest out of Preqin’s over 100 hedge fund strategy sub-segments, in most cases significantly lower than the other seemingly much more volatile asset classes.

Testament to the low volatility of the insurance-linked strategies asset class is the fact that not a single month in 2015 saw a negative return, when much of the hedge fund world was suffering consecutive negative months.

While ILS returns, averaged across the sector, have fallen, the asset class continues to provide largely stable, relatively uncorrelated returns, with long-term investors benefiting from the lower volatility as well.

Of course, when it comes to volatile investments ILS can be one. A major catastrophe event could wipe out a significant percentage of the ILS markets assets in one fell swoop, but of course that would have to be exactly the kind of impactful event that ILS capital is designed to pay out for, which is why returns are available.

But that volatility of large catastrophic events, when viewed over the longer-term, becomes low as the asset class is typically only highly exposed to the types of events that occur once every 30 to 100 years.

Preqin reports an average return from insurance-linked strategies of 3.14% in 2015, lower than the Eurkekahedge ILS Advisers Index’s 4.24% average across its constituent ILS funds. But when you look at the broader range of opportunities in ILS investing, 10% and higher returns were possible in 2015 from higher risk/return strategies, which still benefit from lower volatility than the majority of other hedge fund strategies.

Indeed if you ramp up the risk profile of most hedge fund asset classes you get significant volatility, while ILS and reinsurance remains a much lower volatility investment overall.

This is another of the key reasons that major institutional investors continue to discover the insurance-linked strategies (ILS) market and allocate capital to it for the first time.

While losses may happen, and volatility can spike, it’s typically only a short-term event after which the stable, returns with low-correlation to the broader financial markets continue, and of course at that point the returns may increase too, making the asset class even more attractive to be invested in.