Reducing portfolio volatility with non-Cat ILS

Insurance linked securities (ILS) offer institutional investors two novel ways of diversifying their portfolios by using an asset class that does not move in tandem with the rest of the financial market.
June 27, 2023
Reducing portfolio volatility with non-Cat ILS
Reducing portfolio volatility with non-Cat ILS

Insurance-linked securities (ILS) offer institutional investors two novel ways of diversifying their portfolios by using an asset class that does not move in tandem with the rest of the financial market.  

Many institutional investors, family offices and corporate treasurers value non-correlation because it reduces risk and the chance of making significant losses across the portfolio.  

But generating true diversification is difficult and finding asset classes that are not tied to the swings in economic and monetary cycles is harder still.  

This is where ILS can complement institutional investor strategies whether seeking true diversification or a way of enhancing yields on high-quality investment-grade bonds. 

“One of the most appealing aspects of ILS is their potential diversification properties. ILS are outcome-oriented investments with low correlation to financial markets as their performance is related to non-financial events,” Amundi Asset Management, a leading European asset manager, recently wrote in a note.   

And within the ILS space, investors can benefit from two types of risk - both of which are not correlated with the mainstream asset classes. Catastrophe ILS (Cat-ILS), which is already well established, is about providing cover for infrequent, but high impact events such as hurricanes and earthquakes where damage claims can run into billions of dollars.   

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The newer segment of this market, which is developing rapidly, is known as non-Catastrophe ILS (non-Cat ILS) or even casualty ILS and bundles together millions of insurance policies related to providing cover for cars, intellectual property and so on.  

The big difference between the two types of ILS, is that non-Cat is subject to more frequent, but much smaller claims, which provide a wealth of data that can be used to build accurate risk models. 

Non-Cat ILS returns are based on the actual value of claims made versus forecasts carried out by an actuary. If they are less than predicted, investors enjoy higher returns. In the event forecasts under-estimate claims, any losses that accrue to investors are capped.  

In many respects, the smoother nature of the returns achievable on non-Cat ILS versus Cat ILS makes the former more attractive to institutional investors seeking steady returns. 

Source: Capital IQ, Federal Reserve Economic Data, AM Best, Expert interviews, Vesttoo analysis
Source: Capital IQ, Federal Reserve Economic Data, AM Best, Expert interviews, Vesttoo analysis

In terms of ILS’ unique characteristics: “The risks are different, they're uncorrelated. Counterparty risk doesn't drive returns, how the debt and equity of an insurance company trades should not drive returns in ILS either,” says Thomas Rose, Head of Capital Markets, North America at Vesttoo, a platform linking insurance exposures with capital markets. In other words, ILS is a way to invest in pure insurance risk.  

Boosting yields 

The mechanism for investors to access ILS is to place funds in a ‘cell’, which is similar to an escrow account. The investor funds are held by a third party to cover insurance risks. That capital is typically parked in money market funds or US Treasuries with the coupons paid to investors. These are the same types of assets that are widely held by institutional investors. 

 “They don't need to change their asset allocation. They’re just picking up extra yield by using that fixed income as collateral,” says Rose adding that: “non-Cat ILS is a sound investment strategy to boost returns on an existing fixed income portfolio.”  

ILS products are packaged as securitisations, which are familiar to most institutional investors and underpinned by solid legal and regulatory foundations.  

“From a standpoint of investors getting these (non-Cat ILS) diversifying assets on the balance sheet, which are less binary in nature, could only be even more attractive,” says Erik Manning, a Director at BMS Re, a broker focused on insurance and capital markets. “This (ILS) is the only genuinely non correlating asset that exists in the world as far as I'm concerned.” Manning explains that investors can improve their Sharpe ratio performance (a measure of risk-adjusted return) of their portfolio with the use of non-Cat ILS. “So, their overall return is exponentially improved as a result of holding these assets,” says Manning.  

Each non-Cat ILS transaction is unique. Also, they tend to be tranched into different categories of risk as is typical with securitisations. That means lower credit rated tranches absorb claims first to protect those further up the credit stack. Returns of 200-300 basis points above The Secured Overnight Financing Rate or SOFR are achievable from the lower risk tranches. 

Institutional investors can also take comfort that one of the world’s most successful investors is deeply involved in the insurance and reinsurance markets. Warren Buffett, through the conglomerate Berkshire Hathaway that he presides over, has been immersed in insurance for over 50 years, underwriting policies for his own insurers and those of others. ILS is merely a conduit giving institutional investors access to insurance risk without exposure to the insurance companies that underwrite these policies. Currently, the market is dominated by specialist ILS funds. But it has the potential to grow in size and sophistication as more institutional investors become involved.  

Traditional approaches  

However, ILS isn’t the only way for institutional investors to reduce portfolio volatility.  Traditional approaches to achieving non-correlation include investing in hedge funds. Many have strategies that are designed to take full advantage of market conditions regardless of what they are. That would include shorting markets when they are in a tailspin or even investing in unconventional assets. Though this approach can be successful - and indeed provide a degree of non-correlation - it is heavily reliant on the fund manager’s skills to correctly judge market direction.  

Institutional investors can deploy a range of strategies involving derivatives in a bid to make their portfolios perform more predictably. But this too can come at a price in terms of sacrificing outperformance when market conditions are very favorable and it often involves leverage, which harbours its own risks.  

Then there are various esoteric assets, such as rare paintings. This asset comes with very practical issues around storage and security, valuation challenges and can even be subject to changing fashions in the art world. They are not practical investments for most institutional investors.  

Non-Cat ILS is not a strategy; rather, it is an asset class based on reliable income streams and modellable risks generated by a well-established traditional industry. It is therefore well suited for playing a role in institutional investor portfolios.  

“In my opinion, non-Cat ILS is a great opportunity for the industry to grow while for many investors - whether pension funds, annuity providers, fixed income investors, defined benefits pension plans or family offices - they will see value in having non-correlating diversifying assets within their portfolio,” says Manning.  

Read more in our previous article on "Reimagining Diversification: a New Asset Class Providing Investors With Non-correlated Returns"

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