The Current Crash is a Clear Signal: You Should Diversify With Insurance-Linked Assets

Uncorrelated, diversified assets
February 10, 2022
The Current Crash is a Clear Signal: You Should Diversify With Insurance-Linked Assets
The Current Crash is a Clear Signal: You Should Diversify With Insurance-Linked Assets

The market is experiencing high volatility and a sharp downward movement in multiple asset classes at the same time. Portfolio returns are suffering a very difficult start to the year and managers are frantically trying to adjust their exposures to limit the downside across entire holdings. Many would be thrilled to own an asset class that behaves with little or no correlation to market and economic trends.

Diversifying a portfolio to the point that it can show reasonable returns even in a bearish market is highly complex and what makes investing an art and a science at the same time. Even amateur investors are told to combine different financial instruments with good variance between them so they don’t put all their eggs in one basket. But to nullify systemic risk - the whole market spiraling down - means diversifying on a whole other level. 

Conventional wisdom considers systemic risk to be generally unavoidable. It would be more accurate to say that assets that aren’t affected by systemic risk are often too volatile or too low-yielding to satisfy investors’ appetites. But right within easy reach there is a class of assets that are entirely non-correlated to the capital market, non-volatile, and have attractive yields: Insurance-linked assets.

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Insurance-linked assets are a type of financial instrument that represents a set of insurance policies, providing insurers with reinsurance coverage for their portfolios. Since they are tied to insurance policies, they are unaffected by the bearish trends of the market, thus allowing for true diversification of portfolios. The global reinsurance market is enormous. But as of yet, only a small percent of its estimated $400 trillion in liabilities is covered by reinsurance transactions.

Most capital market investors are familiar with Catastrophe (CAT) bonds, which hedge risk associated with exogenic events such as hurricanes, tornados, floods, and earthquakes. While CAT bonds are non-correlated to broader market trends and provide diversification benefits, natural disasters are difficult to predict and performance is very volatile, deterring investors. The outcome investors are actually seeking: low volatility, predictable uncorrelated returns, is seen when diversifying exposures within an ILS portfolio, outside of CAT bonds. 

There is a wide variety of low severity, low volatility insurance-linked assets. More traditional insurance-linked assets such as life, auto, D&O, general liabilities, and more, also have zero or negative beta, eliminating systemic risk and providing strong portfolio diversification. As opposed to catastrophe risks, non-CAT insurance liabilities are higher in frequency, lower in volatility, and contain large amounts of available historical portfolio data; allowing for accurate risk projections and highly predictable, stable investment returns.  

Companies such as Vesttoo structure these liabilities into a new asset class made accessible to the broader, non-insurance savvy investors. Vesttoo utilizes machine learning algorithms and AI-based risk modeling to accurately predict investment returns, monitor performance, and facilitate risk transfer between insurance companies and investors through a dedicated fund - Vesttoo’s Insurance-Linked Program (ILP). The technology further enables the global rating agencies to apply rating methodologies and actually rate these liabilities backed by debt (securities), facilitating the investment process as much as possible. These are enabled by diligent, objective, and accurate risk modeling.

Insurance-linked investments have the advantage of a standardized investment structure and low tail risk, but most importantly no correlation to the capital market, meaning they can eliminate systemic risk.

For decades, talented, experienced investors had little knowledge of the insurance markets or lacked a platform to access them in a safe, diversified way. Providing access to insurance-linked assets in a digital, efficient way is another thing companies like Vesttoo tackle: creating a marketplace where these investments can be found, compared, and placed securely.

The result is mutually-beneficial as insurers move risk off their balance sheets to the capital markets, while investors gain access to non-correlated, stable investments that genuinely diversify their portfolios. Just like any other traditional fixed-income investment, but free from market and systemic risk.

Furthermore, investors have the ability to pledge existing collateral and assets instead of cash. In other words, by pledging an existing bond, investors can enhance their yields by multiplying returns -  both from the existing bond and the reinsurance portfolio.

The current crisis may be short-lived or leave a lasting impact on part of the tech industry, but either way, it serves as a stark reminder that investors should always be on the lookout for ways to diversify and mitigate systemic risk. Insurance-linked assets, with the new algorithmic modeling and secure marketplace, offer non-correlated, stable, and predictable investment options which long-term portfolios need. The next bear market should be met with robust investments in the insurance space.

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