Understanding the true nature of insurance-linked securities correlation

The correlation of insurance-linked securities to other asset classes and the financial markets in general is always a topic of much discussion among investors and market participants alike. Ever since the collapse of Lehman Brothers and the resulting fallout on a number of catastrophe bonds which used a Lehman subsidiary as swap counterparty, the market has been keen to increase its understanding of the level of correlation between ILS and other instruments or financial market volatility.

Lane Financial LLC, a well known registered broker-dealer with a focus on the ILS markets, has published some interesting insight into the ILS correlation conundrum today. Their Quarterly Market Performance Report for Q2 2011 contains an article on the topic of correlation and is well worth a read, particularly if you are aware of the authors longstanding participation in the ILS market.

The article should be read in full as it’s fairly technical and needs to be understood in context however here’s a few of their conclusions.

They conclude; that ILS correlation fluctuates depending on market conditions and events. That the correlation of ILS to equity returns is in the 18% – 28% range. That there are investment grade returns available which have a lower percentage correlation to equity than ILS, but that ILS total returns can far outperform those investment grade bond returns, which suggests to us that ILS would be a better diversifier for many investors.

The article concludes with this paragraph:

A final note on correlations is in order. We have used the conventional measure of correlation in coming to the conclusions above. But it is a measure that fails to take account of the special nature of correlations – results are not all linear. As we now are vividly aware, big events may correlate; small events might not. Statistical devices like copulas have been designed to take account of this possibility. There is, however, no standard copula that is accepted for all comparisons. As one emerges we believe better correlation measures will also emerge as will better understanding of the place of ILS in general portfolios of assets.

From our discussions with investors we see an increasing understanding of the correlation conundrum and acceptance that nothing is truly non-correlated. This realisation is typical of a market that is maturing and becoming more sophisticated.

We highly recommend you visit the Lane Financial LLC website and register for free access to this report and their other insightful papers.