We believe natural-catastrophe-focused strategies for investing in insurance-linked securities (ILS) present a compelling opportunity in the current environment. This article examines the features of the asset class, the case for investment, and implementation. We also comment on environmental, social and governance (ESG) factors and the potential impact on the asset class from climate change and COVID-19.
In essence, ILS provides insurance protection in return for a premium, much as an insurance company does. The investor provides capital that is held as collateral to support insurance against defined insured events (such as a hurricane in Florida). The arrangement is for a fixed term, usually one to three years, and the return achieved by the investor comprises the premiums received plus the return on collateral less any claims paid out. ILS therefore provides a very different set of risk and return drivers from traditional asset classes.
ILS portfolios tend to focus on what are termed “peak perils,” where property insurance volumes are deep, such as US hurricane and earthquake, Japanese earthquake and European windstorms.
The reason the insurance industry has existed for centuries is that insurance premiums, on average, overcompensate for the risk they insure. Risk aversion means people are prepared to pay more for insurance than the modeled expected loss. ILS is highly diversifying, with no significant direct link to other traditional or alternative asset classes. Historical correlations to other assets (including equities) have been close to zero. Generally, the asset class is considered to have good responsible investment (RI) credentials. This is because insurance has a positive societal benefit by providing a safety net to individuals, businesses and public entities (assuming premiums are reasonable) and supporting climate resilience. Importantly, we see scope for value-add through active management, where good active ILS managers can source the best possible deals and prudently manage and diversify risk.
Over the 10 years ending June 30, 2020, publicly traded catastrophe bonds have returned 5.8% p.a., with a volatility of 3.3%, resulting in a Sharpe ratio of 1.8. It is important to note that the realized volatility of the index underrepresents the left-tail risk associated with investing in ILS. A longer-term history is shown in Figure 1.
Figure 1 – Long term performance of ILS compared to selected asset classes
Source: MercerInsight™. The chart above shows the growth of $1,000, before fees, for an investment in various index strategies for the period January 31, 2002 to June 30, 2020. Catastrophe bonds are represented using the Swiss Re Global Cat Bond Index, equities using the MSCI All Countries World Index, US high yield debt using a Bloomberg Barclays US High Yield Composite Index and cash, the
3-month T-Bill rate.
As of June 30, 2020, the average yield on catastrophe bonds (or “cat bonds”) was around 7.6%. By contrast, the yield on US high-yield debt was 6.9%. With an average expected loss of close to 2.7%, the expected return (the difference between the yield and the expected loss) on cat bonds is approximately 5%, before deducting any investment management fees. The forward-looking estimates of returns from selected ILS managers show a range of 5%–9% (net of investment management fees and expected losses), with the higher-returning strategies typically having a higher allocation to private transactions.
During Q1 2020, ILS demonstrated its diversifying benefits and low correlation characteristics with other asset classes, as the median fund posted slightly positive returns. It is worth noting that the catastrophe bond market did see some impact when, after positive returns in January and February, sales of cat bonds in March mainly by multi-strategy hedge funds led to a modest decline in the month. Many ILS managers saw this as a buying opportunity. Most ILS funds have significant exposure to private transactions, which did not experience the same mark-to-market losses as cat bonds over the quarter.
There is potential for some ILS portfolios to have exposure to business interruption (BI) claims because of COVID-19, but forecasters expect it to be limited. Some insurance contracts explicitly exclude or include claims related to pandemics, and the liability will therefore be clear. But some are silent, and there is some concern that liabilities might arise from these or from retrospective political interventions to pay claims. Most ILS managers believe this type of contract will not need to pay claims (although insurers may still incur legal costs) and that retrospective political intervention is likely untenable.
That said, some ILS managers issued side pockets due to uncertainty around BI claims. Investment managers use side pockets to differentiate illiquid or hard-to-value assets from more liquid ones, separating them from the other investments by creating a “side pocket” for the holding. Their purpose is to protect existing and new investors from uncertainty surrounding the ultimate cost of settling claims after an event, such as after the US hurricanes in 2017 and 2018.
Investors are paying more attention to the impact of climate change, what this will mean for ILS performance and how ILS can support climate resilience. ILS contracts usually have a short term (mostly one to three years), whereas the impact of climate is likely to be a multi-decade phenomenon, creating a natural time-horizon disconnect. As the effects of climate change occur and the quality of climate data improves, we expect ILS pricing to adjust. Investors in an efficient market should therefore receive compensation through higher premiums for any increase in expected claims resulting from climate change. However, it is also possible that uncertainties around the short-term impact of climate on regional-weather-driven perils and other market factors will mean that premiums are slow to adjust, resulting in climate-driven losses in the asset class. If it becomes apparent that investors are not receiving adequate compensation, the relatively liquid nature of many of these strategies makes divestment at that point feasible.
Increasingly, ILS fund managers should be able to demonstrate their views on the impact of climate change on their portfolios. Despite good responsible investment (RI) credentials for the asset class, ILS managers have found it challenging to incorporate ESG considerations in their investment processes to date. We are, however, seeing rapid progress in ILS manager engagement on RI, and many are developing frameworks and signing up to the Principles for Responsible Investment and other initiatives, such as those at the Standards Board for Alternative Investments, focusing specifically on ILS. Despite the ESG credentials of specific ILS funds and portfolios, in the context of a changing climate, the generally positive social merits of catastrophe risk pooling and transfer support allocation to ILS as a responsible yet diversifying addition.
No asset class is without its challenges, and as a niche asset class with limited capacity, ILS has its share. Insurance is a simple concept, but deals are complex to implement. ILS has less liquidity than traditional assets, and there is the potential for significant losses if insured events occur. Investors therefore need sufficient understanding of the complexity and left-tail risks involved. Investors should also be aware of the widespread use of side pockets, which can delay disbursements and adds complexity, particularly in terms of interpreting returns.
Manager selection is crucial. A wide range of ILS strategies are available, ranging from the more complex and actively managed (with both long and short positions) to those with more of a buy-and-hold approach. Typical management fees range from 0.75% to 1.5% p.a., and more sophisticated funds often have a performance fee. Liquidity ranges from monthly to annual, usually linked to the proportion of more-liquid cat bonds in the strategy. There is a small universe of managers, but the quality is mixed. We like managers with access to high-quality deal flow and a strong network, as the industry is heavily relationship- and intermediary-based. We also expect to see the right level of skills, experience and tools.
In recent years, the declining trend in reinsurance premiums has reversed following losses from hurricanes and other events in 2017 through 2019. Premiums have also increased, helped by rising demand for reinsurance and reduced capital in the reinsurance sector. Indeed, after a few years of challenged performance, ILS managers tell us they have seen significant premium increases at the June 1, 2020, renewals. Some are calling this a return to a “hard market,” typified by stricter terms and conditions that benefit investors. As a result, most ILS managers see the outlook for the asset class as better now than it has been in many years.
 MercerInsight™. Catastrophe bonds are represented here using the Swiss Re Global Cat Bond Index, which tracks the broad market of publicly traded securities. Mercer calculated performance characteristics using monthly performance data in US dollars for the period July 1, 2010, to June 30, 2020.
 Source: Elementum Advisers, LLC. Quoted yield includes the return on collateral held and is as at June 30, 2020
 Thomson Reuters Datastream, based on the Bloomberg Barclays US High Yield Corporate USD Index as at June 30, 2020.
 Source: Elementum Advisers, LLC.
 The estimated range is based on data, as provided by managers. A total of six managers were surveyed by Mercer, managing a combined total of 14 strategies.
 Source: MercerInsight™
 Source: Guy Carpenter