Since the fourth quarter of last year many investors have been de-risking their portfolios, in particular shedding the most heavily owned segments of the global equity market. At the same time however, we have not seen a corresponding increase in allocations to ‘safe haven’ or other assets. It seems cash is king. Investors know what they want less of, but are uncertain about where to reallocate investments. This behaviour is consistent with a new paradigm in markets – post-peak. We believe such an environment requires renewed emphasis on portfolio construction and, in particular, on non-directional strategies.
Insurance-linked securities (ILS) are tied to a risk that has nothing to do with the economic cycle, interest rate movements, the political environment or currency fluctuations. Instead, the returns of these investments are driven by large insurance and reinsurance1 loss events connected primarily to natural phenomena, such as earthquakes and hurricanes. Movements in the equity or bond markets will not cause a cyclone or an earthquake to occur and while these catastrophic natural disasters do happen – and drawdowns will happen with time – when they do they are independent of the ongoing activity in the traditional financial markets.
This means ILS returns have a different set of drivers and can benefit from being fundamentally uncorrelated with the broader market, unlike other asset classes where correlations can significantly increase during times of market stress. Consequently, the addition of ILS into a portfolio can deliver on the promise of non-directional strategies: the potential to enhance portfolio construction by reducing volatility and providing more stability of returns.
ILS are uncorrelated with other major asset classes
Past performance is not an indicator of future performance and current or future trends.
So what differentiates this asset class from typical equities and bonds and how does that impact portfolio construction? ILS allow investors to access a structural source of return from the insurance and reinsurance markets by focusing the risk exposure on a narrow, well-modelled and well-understood aspect of the insurance activity – eg the risk that an earthquake or a hurricane will happen – without the general market or operational risks associated with investing directly in an insurance or reinsurance company.
The most straightforward way of incorporating these instruments when building portfolios is to consider them as an alternative to traditional fixed income investments. There is a strong argument that a portion of an investor’s corporate bond exposure, for example, could be replaced with catastrophe (cat) bonds, one of the most well-known types of ILS.2
Yet there is more to ILS than just their portfolio-enhancing qualities. By providing structural capital to the global (re)insurance industry to set against the possibility of rare but damaging catastrophes, ILS arguably have a measurable beneficial impact on society and the quality of people’s lives. Investors are increasingly considering the positive environmental, social and governance (ESG) qualities of ILS, particularly when they are used by public institutions as tools to help manage risk and to support better disaster preparedness and response to communities at risk of natural disasters. An interesting example of this is a cat bond sponsored by the global Pandemic Emergency Facility (PEF) – a World Bank facility, set up with the support of the World Health Organisation. This innovative cat bond provides pre-emptive relief to catastrophic breakouts of viral pandemics such as Ebola and influenza. From a narrow financial perspective, the beneficial impact of this bond is considerable because early action funding has a multiplier effect: one US dollar spent on containment early in the stages of a breaking pandemic is worth over one hundred US dollars of treatment later, when traditional, international aid tends to arrive.
The ILS market is also at the forefront of monitoring for the impact of climate change on economies. Climate change has not yet manifested itself in an increased frequency of hurricanes – this has been acknowledged by the Intergovernmental Panel on Climate Change (IPCC)3 , which provides the official global scientific view on climate change impact on weather – although investors in this market continue to monitor events and check their models for any potential change in activity. Changes that could impact in the underlying (re)insurance risks could be due to an uptick in frequency or severity of weather-related catastrophes, but are more likely due to more powerful underlying issues that can exacerbate losses – namely, increasing concentrations of property and wealth in areas more prone to natural disasters, like coastlines and wildland-urban interfaces.
Events, such as last year’s wildfires in California, while devastating to those communities and those affected, have often only impacted portfolios to a minor degree. Yet, more recent wildfire occurrences have provided vital data points to test prevailing models and might lead to attractive investment opportunities. Initial evaluations provisionally indicate that California wildfire models likely need to double the risk in some areas of the state, primarily due to climate-related, increased flammability of forested areas.
Finally, we believe the ILS market has reached an exciting inflection point. Although the asset class may still be relatively under the radar, it has been around for 20 years and in 2019 is set to top a key milestone: a market size that exceeds the USD 100 billion mark, providing around 20% of total available global reinsurance capacity4. Last year saw large landmark cat bond issuances from The World Bank, transferring earthquake risk to the market on behalf of the Pacific Alliance countries Chile, Columbia, Mexico and Peru; and the US Federal government, transferring flood risk to the market on behalf of the US National Flood Insurance Program.
These are exciting developments for the market which underscore that demand for capital in this asset class has not been invented as a solution for investors; rather it is responding to critical and growing need from the (re)insurance industry and from society as a whole. In our view, as the market becomes more supply driven over the coming years, the investor base should widen further. And for providing this structural capital solution to support the growth and the efficient functioning of the global (re)insurance marketplace, and therefore the world’s economies and societies, ILS investors could be rewarded with attractive and uncorrelated risk-adjusted returns.
ILS market growth