We are living in a low interest environment for almost 5 years. Reviewing various factors it looks that short term rates most likely will remain below long-term average for some time and rates at the long end of the yield curve may have seen most of the uptick for some time. Of course the current situation is a drag on performance of fixed income portfolios and as a result it has become more difficult to achieve targeted absolute returns. Consequently, asset allocators are desperately searching for yield in more risky traditional asset classes such as fixed income emerging markets and credit products in general. Alternative asset classes such as Insurance-Linked Securities (“ILS”) are popping up on the radar screen of institutional investors these days. Comparable to all other asset classes ILS do not have only benefits but have inherent risks that are mostly not known and managed by investors. In a two-part series, we will address both sides of the equation.
In a nutshell, ILS are reflecting instruments of securitized potential liabilities! This may sound awkward and certainly reflects an unusual way of presenting the asset class. The reality is that insurance companies seek to transfer some insurance risks to the financial market (primarily potential damage due to storms and earthquakes in rich countries) through the securitization process. The investors receive a high floating-rate coupon but may lose part or the entire investment if a costly natural disaster strikes (event risk). Generally, „out-of-the-money“ events that happen once in every 100 to 200 years are considered for the securitization. Instruments involved in these transactions include fixed income, futures, options and equities. After nearly 20 years of existence, the ILS market is still a niche market, but is continuously growing on the supply side. On the demand side growing interests from family offices and asset allocators is notable for the last 2-3 years.
There are good reasons to consider ILS in a portfolio:
Historically, the ILS market has had low correlation with traditional and other alternative asset classes and has delivered downside protection in phases of financial market dislocations. Returns have been relatively stable. Due to the floating rate structure of ILS instruments, they offer good protection against interest rate and inflation risks.
At the first glance, the asset class looks flawless. But potential investors need a clear understanding of the embedded risks before making the final call of an investment. Thus, in the second part of our series, we will have a look at the flip side of the coin and see that hiring an expert makes sense for a successful implementation.
Should you like to continue the discussion or have interest to learn more about our expertise of insurance-linked securities, please don’t hesitate to contact us via email or telephone.