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Insurance-linked securities (ILS) has proven complementary to an array of insurance companies’ existing allocation categories.
Many liability-driven investors allocate to ILS as an efficient lever for income generation and diversification within the regulatory constraints they operate. Depending on investor-specific risk and liquidity preferences, various ILS access points and structures are available, including Cat Bonds, sidecars, collateralised reinsurance and ILS funds managed by specialist investment managers.
Inflation uncertainty and the increasing correlation between debt and equity returns have led many investors to seek further diversification through alternative investments, and for some, an allocation to ILS has proven to provide this added diversification while also complementing existing investments
Inflation is a key concern for the property insurance industry due to the direct and adverse impact of rising costs of goods and services on the value of claims, which increases insurers’ need for risk capital (sourced either through raising equity, issuing debt or purchasing reinsurance) to comply with regulatory capital requirements.
This inflation-driven demand growth for reinsurance and other forms of risk capital (such as ILS) leads to reinsurance and ILS price increases that can outpace inflation’s impact on the cost of claims, increasing ILS market spreads for new issuances, and potentially improving ILS modelled returns.
In addition to price increases, many ILS instruments have structural components that mitigate the adverse effects of unanticipated rises in inflation, such as:
• Annual resets: The underlying exposures of multi-year ILS transactions (such as Cat Bonds) can change year over year due to inflation’s impact on insured values, a sponsor’s business growth or other reasons. Annual resets reassess the transaction’s risk and ensure that investors are compensated for material risk-return profile changes
• Growth limitation factors: Between annual resets, a transaction’s underlying exposure growth is limited, usually to 10%, to mitigate the potential impacts of inflation or rapid business growth on a transaction’s risk profile. If the sponsor exceeds this limit, potential losses incurred by the instrument are scaled back
• Floating rate coupon structure: Many ILS transactions are fully collateralised, with the collateral often invested in short term money market funds. As central banks tend to increase interest rates during inflationary periods, ILS investors gain a natural hedge against eroded real returns.
ILS is viewed as a long-term investment for many investors. Although a 10% allocation may make sense from a theoretical (mean-variance) approach, the average allocation is generally smaller, as some investors are cautious of the asset class’s modelled tail risk or are not yet familiar (and therefore uncomfortable) with the asset class’s esoteric nuances.
Depending on investors' objectives and liquidity preferences, many access points are available that can complement existing allocation categories. Specifically, many have chosen to place ILS allocations within their alternative fixed income or hedge fund portfolios, depending on the structure invested within and whether an investor participates directly in ILS transactions or through specialised investment managers.
Regardless of access point or allocation categories, the asset class's diversification benefits, resiliency to macroeconomic contexts and attractive risk-return profile can make ILS an important long-term addition to institutional portfolios.
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