For investors looking at insurance-linked securities (ILS), in order to gain the full diversifying benefits of an allocation to the asset class, it is important to look to the private ILS and collateralised reinsurance segment as well as catastrophe bonds, Zeba Ahmad, Alternatives Director at Schroders has said.
While catastrophe bonds provide a clear way to gain access to insurance and reinsurance linked returns in a well-structured and documented, largely liquid manner, the private ILS segment also comes with benefits, Ahmad explained in an article.
Catastrophe bonds tend to sit towards the upper-end of reinsurance towers, but with private ILS investors can gain access to returns from across more layers of the risk tower, matching their return requirements more closely to their appetites for risk.
Ahmad explained, “Investors are typically most familiar with cat bonds as the most liquid portion of ILS markets. However, private ILS, the largest portion of the ILS market, can also be an important tool for sophisticated investors seeking diversification. Their structure is similar to cat bonds, but private ILS – such as collateralised reinsurance – can provide access to a broader range of covered events and the ability to harvest “illiquidity premia”.”
She went on to write that, private ILS and collateralised reinsurance, because of the ability to structure deals throughout the risk tower, “provide investors with the opportunity to earn higher returns by attaching at other points.”
As a result, investors benefit from an illiquidity premium with the more private ILS deals, which typically are not traded and so are held by sophisticated investment managers that have the ability to model and understand the ceding companies risks.
We’d also add that investors therefore benefit from the expertise of the originators and managers of these ILS portfolios, who in many cases cultivate their own relationships with ceding companies in order to gain access to the layers of reinsurance risk that their investors and fund strategies are attracted to.
Ahmad also explained that ILS offer investors a source of “dependable diversification.”
Diversification is a hot topic in investment markets and even among the alternative segment, insurance-linked securities (ILS) stand alongside few others, as one of the most diversifying asset classes available.
“Returns that are less dependent on the economic cycle are now increasingly sought after. This is because the current economic cycle is increasingly long in the tooth and many investors are eyeing it with some caution. In particular, the credit cycle is being closely monitored, given its impacts on interest rates, company earnings and default rates,” Ahmad said.
She also explained that investors have been forced to look up the risk spectrum in some traditional asset classes, as while at the same time stock markets are increasingly expensive. All of which makes ILS look even more attractive at this time.
Investors typically look to analyse the possible downside, when exploring asset classes that are said to be diversifying and that exhibit a lack of correlation with broader financial markets.
The biggest drawdowns for the catastrophe bond market always come with major natural catastrophe events, unsurprisingly.
However, Ahmad noted that, “Arguably, cat bonds did show some mark-to-market losses during the pandemic led sell-off, but losing less than 2% vs double digit losses in other asset classes seems quite uneventful.”
Also highlighting that, “This liquidity driven sell-off impacted cat bonds, but private transactions – which generally have a 12-month maturity and do not trade – were not at all impacted.”
While it is possible that a major catastrophe event could derail financial markets to a degree, Ahmad further explained that typically this is a market dip that bounces back very quickly, as seen after the Tohoku earthquake in 2011.
Which only serves to further demonstrate the case for building dependable diversification with ILS in an investors portfolio.
Ahmad concluded, “The traditional approach of diversifying within the boundaries of bonds, equities, and possibly real estate does not adequately address the issue of diversification. In times of elevated market stress, correlations for these assets can draw towards 1.
“ILS introduces genuine diversification by isolating risks that are not related to the economic cycle.”
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