As institutional investors seek portfolio diversification and the insurance industry seeks additional capacity amid global growth, investment strategies incorporating insurance-linked securities are providing a solution for both parties.

Insurance-linked securities allow insurers to transfer some of their risk to investors. For example, in the case of catastrophe bonds, the issuer pays a coupon to an investor in exchange for protection from a specified type of event — such as a hurricane or earthquake — for a particular duration of time. Other forms include industry-loss warranties, which pay out industry-specific losses that exceed a particular threshold, and collateralized reinsurance, in which investors put up collateral to cover potential claims in a contract.

Read: What role can insurance-linked securities play in pension portfolios?

While the strategy started to catch on with pension funds in the early 2000s, it grew steadily following Hurricane Katrina in 2005, as insurers sought additional capacity to cover claims, says Rick Pagnani, executive vice-president and head of insurance-linked securities at PIMCO.

“The perfect analogy is an auto or home [insurance] policy. You pay a premium to the insurance company so those dollars go to finance a variety of things. With catastrophe bonds, a sponsor is buying reinsurance protection for themselves. They may issue $200,000 in catastrophe bonds and we’ll pay a coupon, which is highly analogous to what would be paid for a reinsurance or an insurance premium.”

For institutional investors, insurance-linked securities offer diversification and real returns independent of the capital market, while insurers and reinsurers benefit from access to increased capacity and decreased risk.

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By the numbers

The percentage of global ILS funds that expect market growth of five per cent or more over the next five years

The percentage of institutional investors that expect to either increase their ILS allocation in 2021 or expect it to be unchanged

The percentage that identified natural catastrophe insurance as suitable for ILS mandates, compared to non-catastrophe weather insurance (64%) and life, accident and health risks (46%)

Source: Willis Towers Watson, 2020 survey

Capacity is a particular issue on the reinsurance side, says Pagnani, referring to the U.S. southeast wind market. “They’ve had a rough couple of years — 30 main storms in that market in 2020. It took some money out of the reinsurance marketplace and there’s continuing demand for reinsurance that’s got to be replaced.”

The Healthcare of Ontario Pension Plan began investing in insurance-linked securities in January 2020, says Bernard Van Der Stichele, the pension fund’s insurance-linked securities portfolio manager, noting the strategy has provided positive returns for the plan so far.

“The performance and risk profile of insurance and reinsurance investment vehicles have little to no correlation to those of financial asset classes. As a result, they generate returns which are independent of capital market volatility. We’re focused on insurance risks which are well defined, can be quantified and for which we receive an adequate return.”

Read: Is it time to revisit insurance-linked securities?

Before entering the insurance-linked securities market, the pension plan carefully mapped out its strategy, says Van Der Stichele. While the HOOPP has in-house expertise, he says some of the challenges institutional investors can face when first approaching these investments include the learning curve in understanding reinsurance market products, dynamics and underwriting practices, as well as the development of capabilities to understand and quantify reinsurance risks and learning how to deploy capital efficiently.

“As an investor, you need to ensure your capital is filling a demand that’s not being filled by traditional reinsurers and is therefore complementary to traditional reinsurance markets.”

Looking ahead, Van Der Stichele says insurance-linked securities will remain part of the pension plan’s long-term strategy. “HOOPP’s participation in the ILS market may scale up or down over time, in response to market conditions, but its value to the fund will be expressed over the long term.”

Blake Wolfe is an associate editor at Benefits Canada.