In the first part of our series on insurance-linked securities (ILS), we have shed some light on the beneficial effects of adding ILS to a portfolio. Now, we take a look at the flip side of the coin. The purpose is not to deter potential investors but to make them aware of the particular risks of this asset class and of the necessity to hire an expert to ensure a successful allocation of ILS in a portfolio.
Risk AND reward
As mentioned in part one, ILS transactions are related to very costly natural disasters that happen once every 100 or 200 years. To assess the risk of default of an ILS transaction and to manage the overall portfolio risk, ILS investment managers rely heavily on complex risk-modeling tools. These tools not only require particular expertise and long-standing experience, they are also not able to forecast the events triggering default with accuracy. As John Kenneth Galbraith put it: “All models are wrong but some are useful“. Even if ILS investment managers try to create a different impression, it is the nature of these events that nobody knows when they will happen. This is why investors need to be rewarded for taking the risk associated with ILS with a high coupon that more than covers the potential loss over a long-term investment horizon.
UCITS compliant ILS funds? Not recommendable!
There are ILS investment funds available that are compliant with the UCITS (Undertakings for Collective Investment in Transferable Securities) directive. UCITS were developed originally as highly standardized mutual fund vehicles for retail investors, high net worth individuals and smaller institutional investors and therefore have to meet strict requirements in terms of liquidity, leverage limits, and transparent pricing. The Luxemburg regulator considers that catastrophe bonds are eligible assets under the UCITS directive and the first UCITS compliant ILS Fund was launched in 2011. However, we believe that investing in such funds can potentially be harmful to investors in different respects. First, there may be a mismatch between the liquidity of a fund vehicle from the investors’ perspective and the actual liquidity of the underlying assets, particularly in times of market stress. Second, there may be a mismatch between actual buy/sell prices and prices used to calculate the fund price. Investors need to accept the fact that the ILS market is a niche market and therefore not as liquid as traditional fixed-income instruments or UCITS-compliant fund vehicles are supposed to be.
Keep an eye on the cost!
ILS portfolios can be considered as a hedge fund strategy or an enhanced fixed-income strategy. This classification is reflected by the fees associated with ILS strategies. Typical management fees of ILS portfolios are in the range of 1.0% and 2.0% p.a. for low to middle-tier investors. On top of that, a performance fee linked to a low hurdle rate (i.e. risk-free rate) is usually levied. While a performance fee should be a reward to the investment manager for his alpha-generating skills, Lars Jäger found out analyzing the return drivers of ILS portfolios that the alternative beta is the main driver of returns. Actually, the alpha component is often overstated by ILS investment manager, in order to legitimize performance fees. Considering that the gross return of ILS is limited to money market rates plus 6 to 10% p.a., the management and performance fees may absorb a large portion of the performance and thus investors may end up with only 50% of the gross return. This appears rather expensive for an enhanced fixed-income strategy.
All in all, insurance-linked securities are an exciting asset class and deserve a place in a well-diversified fixed-income portfolio. But there is no one-fits-all strategy in this market segment and a lot of consideration is required prior to an investment. Having an expert by your side can speed up this process and help avoid many pitfalls.
Should you like to continue the discussion or have interest to learn more about our expertise of insurance-linked securities, please do not hesitate to contact us via email or telephone.