Interest rate rise won’t reduce allocation to ILS market: Morgan Stanley

After the U.S. Federal Reserve hiked interest rates in December of 2016 analysts at Morgan Stanley have said that the move wouldn’t result in a reduction in the allocation of capital to the alternative reinsurance market, as investors favour the sector’s diversification over its returns.

Some risk transfer market analysts and observers warned that any rise in interest rates could result in investors leaving the insurance-linked securities (ILS) market in hope of better returns in other alternative assets. But analysts at Morgan Stanley have said that this simply isn’t the case.

“Recent rise in interest rate is not expected to impact allocation of alternative capital to the industry as pension funds and asset managers view them more from diversification benefit vs. pure returns,” said Morgan Stanley analysts in a market research report.

Despite returns in the global reinsurance and ILS market coming under increasing pressure and continuing to fall in the soft market landscape, investors and sponsors of ILS transactions continue to be attracted to the space.

For the most part, ILS investments are uncorrelated to broader financial market volatility, highlighted by the sector’s solid performance throughout the 2007 financial crisis when compared to other alternatives, and investors can take advantage of steady, albeit currently reduced returns.

The ILS asset class also provides capital market investors with valuable and welcomed diversification within their portfolio, and the expanding reach of the asset class suggests that further diversification of the actual ILS investment itself is increasing for investors.

Alternative reinsurance capital continues to grow its share of dedicated, total reinsurance capacity, and this was again the case at the recent January 1^st 2017 renewal season, seemingly regardless of the rise in interest rates.

Furthermore, it’s important to note that the majority of ILS business floats above the interest rate return anyway as it’s tied to the return of the collateral, which is equal to a money market reference rate, such as the U.S. Treasury bill rate, or LIBOR.

“Reinsurers continue to grow AUM within their 3rd party capital structures enabling them to retain gross exposure and earn stable fee income.

“Companies see continued interest from asset managers and pension funds to gain exposure to reinsurance market as <1% of industry AUM is allocated to this asset class,” said Morgan Stanley.

The permanence of ILS capital and its investor base has been questioned numerous times since the asset class grew to a size that really started to have an influence on the global reinsurance market. Ranging from the belief that much of the market’s capacity would disappear after a large event, to investors fleeing the space once interest rates rise again.

But the broader risk transfer market should not underestimate the diversification benefits the asset class provides for capital markets investors.

Investors are becoming more and more comfortable with the space and the marketplace continues to show a willingness to expand its remit, even at times of broader re/insurance market turmoil.