The devastation caused by Hurricanes Harvey and Irma has led to renewed interest in Insurance-Linked Securities (ILS), which include catastrophe bonds (also known as “cat bonds”). These major meteorological disasters have prompted a sharp correction in the ILS market. The total extent of the fall is not yet known, but it could provide a good entry point at a time when investors are seeking maximum diversification in terms of both returns and risk. This asset class has seen steadily increasing inflows in the last few years, and remains attractive today.
ILSs are insurance contracts that allow firms, including insurance and reinsurance companies, to protect themselves against high-severity, low-probability natural events such as hurricanes, earthquakes and tornadoes. That protection is achieved by transferring the insurance risk to the financial markets. To compensate for that risk, ILS investors receive coupons, which are generally paid quarterly.
ILS comprise two types of products. The first, cat bonds, are listed securities with maturities of 3–5 years. The second consists of private contracts, which often have a 1-year term. Within an ILS portfolio, each of these instrument types adds value. The existence of a secondary market for cat bonds means that they have greater liquidity than private contracts, while the latter deliver additional diversification because of the variety of risks they cover.
Because an ILS provides protection against a predefined natural catastrophe, it may lose some or all of its value if an extreme event occurs. That loss corresponds to the compensation paid to the insured party, and in that case the cat bond or private contract is said to be “triggered”. The trigger is subject to various predefined conditions, such as the amount of the loss suffered and/or physical parameters such as wind speed in the case of a major hurricane.
As current weather events show, it is vital for an ILS portfolio to be highly diversified in terms of the number of positions held, the nature of the perils covered, exposed regions and trigger types. However, it should be borne in mind that since they first appeared in the 1990s, the default rate on cat bonds has been less than 1%.
The main appeal of the ILS market is that its driving forces differ from those of other investments. They show almost complete decorrelation with respect to other assets in a portfolio, and along with higher returns than traditional bonds and low volatility, this is drawing in increasing numbers of investors.
Since 2002, the Swiss Re Cat Bond Total Return index has delivered an annualised return of 7.9% with annualised volatility of just under 3%, which represents an unrivalled risk/return profile. Over the same period, the four largest “drawdowns” – resulting from Hurricane Katrina in 2005, Hurricane Ike in 2008, Hurricane Sandy in 2012 and the Tohoku earthquake, which caused the Japanese tsunami in 2011 – ended up having a limited impact on the industry as a whole, amounting to 3-5%.
As with any asset class, achieving alpha depends on rigorous selection by the asset manager. With ILS, technical expertise and assets under management are two critical factors. The first criterion does not just involve expertise in sourcing and selecting investments, but above all the ability to model insurance risks and the quality of the tools used by the investment team. As regards the second criterion, the outperformance achieved by active managers compared with a passive benchmark – which is often riskier and more volatile – will be especially great with medium-sized players.
On average, ILS investors devote 3-4% of their overall portfolio to these instruments, as a way of complementing traditional bond investments. Although returns and diversification are the two most common reasons for investing in ILS, a third advantage should also be highlighted, which is their social impact. As well as their financial appeal for end-investors, ILS play a key role in supporting post-catastrophe reconstruction, thereby supporting the viability of the current reinsurance system.
Source of data: Bloomberg Finance L.P. Data as at 31/08/2017
Olivier Marion
Senior Investment Specialist, Alternatives