Damage Control

The reinsurance market delivers steady income in tough times.

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vince-fleming-487800-unsplashWhile insurance-linked securities (ILS) might seem like a new or niche asset class, property reinsurance has actually been around for more than 150 years, says Jonathan Malawer, managing director at K2 Advisors.

A catalyst for the industry occurred in 1861 when a large fire devastated a small town in Switzerland. The insurance industry didn’t have enough capital to cover the damage.

As a result, a new kind of insurance product (reinsurance) emerged to protect insurance company balance sheets from a large-scale catastrophic event.

An offshoot of the reinsurance market, ILS are aimed directly at investors seeking income in exchange for taking on insurance risk, says Malawer. And while most investors tend to think of insurance exposure in terms of life and health, the ILS market is dominated by property catastrophe reinsurance, which dominates the roughly US$100-billion market.

“Growth has been driven by institutional investors looking to diversify,” Malawer says. “ILS is uncorrelated to other assets in a portfolio because of the risk characteristics and income stream in return for taking on that risk.” This is played out clearly in the numbers — since 2008, the average return in the ILS space has been 5.3% since 2008, with 3% volatility.

And this during a particularly rocky time in the insurance market. “That includes two major stress periods in 2011 — the Japan earthquake and, more recently, 2017,” Malawer explains, adding that last year was hit hard with three major hurricanes in the U.S. and the Caribbean, an earthquake in Mexico, and wildfires in California. Together, these disasters delivered greater than $100 billion in losses for the insurance industry in 2017 alone.

WHICH RAISES THE QUESTION OF RISK

“There’s no free lunch in ILS — but you generate income in return for taking that risk,” Malawer explains. The returns themselves come from two components — put simply, you get a coupon for taking on the insurance risk. But investors can also gain a return from their collateral, which is typically held in Treasuries — another return
stream that is improving as interest rates rise.

In exchange for solid returns, investors do bear event risk, one of the biggest risks in the ILS space. At the same time, there’s model risk: since insurance models are used to price these securities, investors should understand that such models aren’t a perfect science and they can get it wrong.

Malawer concludes that the outlook is positive for ILS, especially as interest rates rise, but value may be offered currently in certain areas of the ILS market and not others. The key for investors is to diversify based on risk and return objectives.

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