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

In a market rocked by a considerable increase in cross-asset volatility, the need to search for alternative means of diversification that embrace different sources of risk and return is crucial. One solution for pension plan sponsors to consider is investing in insurance-linked securities.

Often a misunderstood and underutilized asset class, insurance-linked securities are investments whose performance depends upon the occurrence of pre-specified catastrophic events. The events, though statistically unlikely, have historically been expensive to re/insurance companies when they do occur. ILS provide a way for re/insurance companies to transfer a portion of their risk and premiums to the capital markets, which allows investors to participate in the re/insurance market. The concept of re/insurers transferring risks to the capital markets gained traction following Hurricane Andrew in 1992, which cost the industry USD$15.5 billion.

ILS investors take on the role of a re/insurance company, receiving premiums in exchange for accepting the risk of a loss. If one of the specified events occurs, all or part of the principal is used to pay insured losses and the investors’ coupon payments cease or are reduced. At maturity there is either zero or a reduced amount of principal repaid. If the triggering events do not occur during the tenor of the agreement, the investor enjoys a periodic coupon payment related to insurance premiums and principal repayment at the end of the investment term.

The ILS market has seen significant growth, particularly in recent years. As of Sept. 30, 2020, the overall outstanding ILS market was over USD$90 billion, nearly 40 per cent larger than at the same point during 2014. Significant events over the past fifteen years, including U.S. hurricanes, Japanese typhoons, wildfires and the financial crisis of 2008 have also “tested” the asset class, increasing investors’ comfort level.

There are four common types of ILS formats: Catastrophe bonds, industry loss warranties, collateralized reinsurance and quota shares.

Catastrophe bonds are the most well-known ILS format. CAT Bonds are issued as tradable securities, which allow them to have a limited secondary market. They provide a precise level of protection above a certain threshold. They also contain triggers with defined conditions, which must be reached before losses accumulate.

Industry-loss warranties are private, customizable reinsurance contracts through which a re/insurance company can reduce or hedge risk exposure. The payout is based on industry wide losses rather than company specific experience. A benefit to investors is they are not reliant on the quality of the underwriting and claims management process of the individual insurer.

Collateralized reinsurance are private, customizable reinsurance contracts that insurance companies use to reinsure losses related to company specific claims (indemnity triggers). Collateralized reinsurance allows investors to take on the role of a reinsurance company. This product is increasingly popular as it allows the reinsurance protection buyer to use capital markets as an additional source of reinsurance protection. Collateralized reinsurance provides investors broad diversification across geographical region and peril.

Quota shares, also known as reinsurance sidecars, are different in structure from the ILS described above in a few important ways. Quota shares allow investors to participate side-by-side with the reinsurer and share in the profit or losses of its book of business. Investors may need to be careful with the pieces of business being shared in order to avoid adverse selection, or the possibility of participating in unfavourable “cherry picked” risks. If structured correctly, quota shares may better align investor and the reinsurance protection buyers’ interests than other forms of ILS. They are highly diversified across region and peril with losses gradually paid out of the structure as they occur.

Each format has its distinguishing features. However, it is important to realize there are also overlapping characteristics across the formats. Key distinguishing features include binary versus gradual loss payouts, indemnity versus non-indemnity payout triggers and secondary markets. Structures with more gradual curves provide greater diversification. Binary structures can be wiped out quickly if the pre-specified event occurs. These structures allow for more targeted risk exposures.

The mechanism that quantifies the loss magnitude following events can be based on re/insurance company specific experience (indemnity) or more general non-indemnity-based triggers. ILS are offered in tradable or private structures. As such, the level of secondary market transferability varies. Private structures typically offer potentially higher premiums compared to tradable instruments with similar risk to compensate for the lack of liquidity.

Including ILS within a broader asset allocation may have powerful diversification benefits and total return potential. ILS portfolio returns are not determined by economic factors such as gross domestic product growth, interest rates or corporate profitability. Rather, performance is driven by the occurrence of low-frequency, high-severity natural disasters such as earthquakes and hurricanes. This is a key distinguishing feature, which has resulted in a very low correlation to other asset classes. The return profile and liquidity of the asset class does require a long-term investment horizon, and all investments are subject to risk and possible loss of principal. Given these characteristics, ILS may fit well within the alternative asset class portion of an investor’s portfolio.

The re/insurance industry has endured for countless decades and has multiple tools that allow it to be able to adapt to any potential changes. These include adjusting rates, regions covered, perils covered, or requiring modifications to obtain coverage, which I can discuss more in future columns.

Joseph Morgart is vice-president and a client portfolio manager at Amundi Pioneer. These views are those of the author and not necessarily those of the Canadian Investment Review.