Is it time to revisit insurance-linked securities?
BY Stephan Ruoff, deputy head, Schroder Secquaero | June 2, 2020
The outbreak of the novel coronavirus has triggered major corrections in the equity, commodity and debt markets as participants try to gauge the full extent of its impact.
It is times like these when the advantages of insurance-linked securities become apparent again. Insurance-linked securities are financial instruments whose performance is driven by the occurrence of insurance events, such as natural catastrophes like hurricanes, earthquakes or winter storms.
The risks embedded within these assets are largely uncorrelated to the economic cycle, political backdrops and traditional financial markets.
The current environment is a stark reminder that market shocks can have devastating impacts at the portfolio level. Naturally, investors will once again think about best ways to seek portfolio protection. As we have seen through various market corrections, decorrelation benefits between assets classes often break down when most needed as correlations tend to converge to one during times of crisis. However, because natural catastrophe insurance-linked securities are driven by the occurrence of these disasters, the decorrelation benefits are very robust; there is no direct link to the credit or economic cycle.
As a reminder, insurance-linked securities are investable through their tradable securities called catastrophe bonds, known as cat bonds, or via private contracts. These are principal-at-risk assets. This means that investors can lose all or parts of their investments, subject to the occurrence of predefined insurance events.
As market-traded instruments, cat bonds are not immune to financial market vagaries. Asset flows and mark-to-market considerations may be observed, but they are more muted compared to other asset classes.
For example, the correction in March, which saw the steepest decline in equities on record, the Swiss Re Cat Bond Index was negative 1.8 per cent for the month. This is a far cry from the negative 12.5 per cent and negative 13.5 per cent on the S&P 500 and MSCI world indexes, respectively. Even during the global financial crisis, insurance-linked securities proved their case. In September and October 2008, the Swiss Re Global Cat Bond Total Return Index lost only negative 1.3 per cent and negative 1.8 per cent respectively and ended the year at positive 2.4 per cent.
The insurance-linked securities world is much more than tradeable cat bonds, with 60 per cent of the market being funded through private contracts, also referred to as collateralized re-insurance. These contracts are buy-and-hold and generally have a one-year duration. Compared to cat bonds, private transactions cover a broader risk spectrum, covering more regions and including other perils. Their valuation changes may be reflected throughout the year based on events, but will not have the mark-to-market movements, which may affect cat bonds.
Other means of portfolio protection such as long volatility or put strategies may generate strong returns in declining markets, but these can be very costly in performance during good times. Meanwhile, insurance-linked securities provide decorrelation benefits while generating strong absolute performance. Current yields are at their highest levels in at least six years.
Yield levels are always function of embedded risk making broad brushed statements difficult, but currently it appears that balanced insurance-linked securities portfolios can reach yields of high-single, low-double digits. Furthermore, cat bonds are short duration assets. There is almost no interest rate duration as cat bonds price over money market and re-set every three months. Spread duration is also low given most cat bonds have three- to five-year maturity.
It is fair to say, insurance-linked securities as an asset class has probably not lived up to some investor expectations. While 2017 and 2018 were years with high insured losses, which is when insurance-linked securities investors are expected to lose money, it is probably more how these losses developed over time which has frustrated some participants.
Various factors explain why many investors faced adverse loss development, i.e. a continued deterioration of performance months after the events hit, but mostly it boils down to the quality of the underwriting and modelling capabilities of the underlying insurance-linked securities manager. A good manager with true in-house insurance expertise can, for example, better assess the losses of an event and its impact on the value of an insurance-linked securities portfolio than a manager that lacks these skills.
Another point to highlight is that capital inflows to insurance-linked securities stagnated for the first time in 2019. Yet, despite this, I believe the underpinnings of insurance-linked securities remain strong and should continue the path to growth for several reasons.
Various factors will drive the increasing demand for risk transfer through insurance or re-insurance protection, including overall population growth and further value concentration in urban areas. Additionally, significant growth of the middle class globally will increase insurance penetration as protection becomes affordable. Ongoing industrialization and interdependencies of economic value chains will further grow loss potentials.
There’s also an increasing trend to reduce the protection gap, i.e., the difference between economic and insured losses, in emerging and frontier markets. Initiatives have led to the formation of public-private partnerships, which aim to install protection mechanism that grant access to liquidity post-event to reconstruct infrastructure such as hospitals or freshwater access, increasing the resilience of less developed countries.
Further, the catastrophe events of the last few years have triggered a welcomed re-pricing of various perils across the globe. Just as it always has, capital is expected to take advantage of these moves. Whereas in the past often new insurance/re-insurance companies were formed after market dislocating events, (e.g., 1992 after Hurricane Andrew and the U.S. casualty crisis, 2001 following 9/11 and 2004 to 2005 following Katrina, Rita and Wilma) nowadays needed risk capital is brought into the market by insurance-linked investors and this trend is expected to continue, even as the coronavirus fallout changes many aspects of the market.
Insurance-linked securities have, with some exceptions, proven largely immune to the pandemic as the majority of the risks transferred via these vehicles cover natural perils. While there is a section of the insurance-linked securities market focusing on life-related risks, it constitutes a relatively small fraction, so the impact of the virus is expected to be limited and these vehicles are proving to be an attractive investment for investors to reconsider.
Stephan Ruoff is deputy head of Schroder Secquaero. These views are those of the author and not necessarily those of the Canadian Investment Review.