Trends – Institutional Monthly
Insurance-linked strategies – independent by nature
In terms of attractiveness to investors, ILS are gaining popularity thanks to their low correlation to other asset classes and their attractive yield potential, especially in the current low interest rate environment.
Insurance-linked strategies (ILS) are an innovative niche asset class that allows investors to take on the role of a reinsurance company. ILS provide capital to the reinsurance industry by transferring the risk of high-severity, low-probability natural and man-made catastrophic events from insurance and reinsurance companies to the capital market. In exchange for bearing the catastrophe risk, the capital providers are reimbursed by earning a risk premium.
Even though ILS are very much tied to the reinsurance industry, the asset class nowadays is still considered to be young and innovative, which is a contrast to the traditional reinsurance business. Historically, ILS as an asset class emerged in the mid–1990s as a consequence of major catastrophic events in the United States, namely Hurricane Andrew and the earthquake in Northridge, California. The large insured losses emerging from these events exposed large gaps in the underlying capital base of insurance and reinsurance companies and raised the question of capital adequacy within the industry. It was apparent that a new source of capital with a higher capability of absorbing large losses was required. The capital market fulfilled this requirement due to its size and depth.
As a result, the first securities with standardized terms and conditions, known as catastrophe bonds (cat bonds), were issued in 1994 and transferred a specified set of risks from a sponsor to investors. Ever since, the cat bond market, excluding life and private cat bonds, has grown to a size of approximately USD 22.0 bn and 118 bonds outstanding as of 30 March 2016.
A true alternative investment strategy
In term of the risk transfer, ILS investments can be structured as cat bonds or as private ILS transactions negotiated directly with insurance and reinsurance counterparties, known as collateralized reinsurance. We estimate the collateralized reinsurance market for natural and man-made catastrophes to have a size of approximately USD 400 bn and therefore to have much more depth and to offer more opportunities than the cat bond market.
In terms of attractiveness to investors, ILS are gaining popularity thanks to their low correlation to other asset classes and their attractive yield potential, especially in the current low interest rate environment. The low correlation stems from the fact that the return of an ILS portfolio solely depends on the occurrence or non-occurrence of catastrophic events such as hurricanes, floods, bushfires or man-made catastrophes like plane crashes or maritime disasters. Therefore, ILS remain largely independent of events in the financial market, even in times of market stress, which undoubtedly is a desirable property for an investment. This is a key driver for the significant fund inflows that the asset class has seen in recent years. We see that more and more investors are appreciating this fact and recognize ILS as a true alternative investment strategy. Investors deciding to invest in ILS because of the uncorrelated source of returns are generally more longer-term-oriented than, for example, investors who are investing in order to tackle the current low interest rates. The first quarter of 2016 has demonstrated how challenging, volatile and highly correlated global financial markets can be. We expect that, in 2016 and 2017, new investors will invest in ILS – and for the right reasons.
Attractive return potential despite lower margins
Naturally, there is a downside to large asset inflows. Yields, especially in the cat bond market, are not as attractive as they used to be. The industry is therefore currently experiencing a so-called “soft market” environment. The ILS market has seen a significant reduction in margins between 2011 and 2014 followed by a phase of stable margins since the end of 2014 until the first quarter of 2016. It seems that cat bond investors are disciplined and do not invest below a certain minimum margin over expected loss. It will be very interesting to see if reinsurers follow the example of ILS investors and stop the margin compression and not only slow it down. If that happens, it will be a sign that the market has truly converged and does not fall into old reinsurance patterns anymore. Regardless of the outcome, in a world of zero or even negative interest rate policy, ILS remain an attractive investment opportunity.
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