Insurance-linked securities help investors ride out the storm

Investors will always remem­ber the moment cap­i­tal mar­kets acknowl­edged the impend­ing doom posed by the coro­n­avirus cri­sis, caus­ing unprece­dent­ed tur­moil in their port­fo­lios. It wasn’t long before the age-old lessons on diver­si­fi­ca­tion were being recir­cu­lat­ed in investor forums and pub­li­ca­tions, though when most tra­di­tion­al asset class­es are affect­ed, it’s eas­i­er said than done.

Decor­re­la­tion is one of few ways investors can seek pro­tec­tion in times of tur­bu­lence, but var­i­ous mar­ket events have shown tra­di­tion­al asset class­es are more cor­re­lat­ed than many peo­ple think. The ben­e­fits of diver­si­fi­ca­tion only work prop­er­ly when the port­fo­lio’s assets are tru­ly uncor­re­lat­ed. No amount of diver­si­fi­ca­tion can guar­an­tee immu­ni­ty to loss­es, of course, but achiev­ing real decor­re­la­tion in an invest­ment port­fo­lio will reduce risk and volatil­i­ty.

Among the rare, gen­uine­ly diver­si­fy­ing asset class­es is insur­ance-linked secu­ri­ties (ILS). Though not main­stream, the size of the investable ILS mar­ket is approx­i­mate­ly $100 bil­lion. Com­pris­ing a suite of instru­ments, of which the cat­a­stro­phe bond is the best known, ILS enables insur­ance and rein­sur­ance com­pa­nies to trans­fer insur­ance event risk from their bal­ance sheet to cap­i­tal mar­ket investors.

ILS reduces volatil­i­ty for insur­ance and rein­sur­ance com­pa­nies by shar­ing the bur­den of insur­ance claims after a nat­ur­al cat­a­stro­phe while offer­ing investors the abil­i­ty to access long-term, attrac­tive, risk-adjust­ed returns, which are uncor­re­lat­ed to most tra­di­tion­al asset class­es; a stock mar­ket crash does not make a hur­ri­cane or earth­quake any more or less like­ly to hap­pen. By iso­lat­ing the insur­ance claim com­po­nent, investors are immune to the impact broad­er finan­cial mar­ket tur­moil may have on the asset bases of those insur­ance and rein­sur­ance com­pa­nies.

“ILS has been the most suc­cess­ful attempt in con­verg­ing the insur­ance indus­try with the cap­i­tal mar­kets,” says Veg­ard Nilsen, chief exec­u­tive of Securis Invest­ment Part­ners LLP, an asset man­age­ment com­pa­ny spe­cial­is­ing in ILS. “With inter­est rates at record low lev­els, invest­ment returns across tra­di­tion­al asset class­es are not only expect­ed to be low­er, but also more cor­re­lat­ed and volatile.

“In a wound­ed econ­o­my, which has seen a spec­tac­u­lar lev­el of mon­e­tary inter­ven­tion, the fis­cal tool­box is emp­ty and this should be a con­cern. Uncor­re­lat­ed invest­ment strate­gies and fixed-income alter­na­tives are more rel­e­vant than ever. Our val­ue propo­si­tion is to pro­vide investors with the abil­i­ty to access investable insur­ance risk in its purest form,and to elim­i­nate expo­sure to the issuer in a struc­ture where the col­lat­er­al – the invest­ments made – is entire­ly ring-fenced and pro­tect­ed.”

Born in the mid-1990s, when the first cat­a­stro­phe bond was issued amid a short­age of insur­ance cov­er fol­low­ing Hur­ri­cane Andrew, the ILS mar­ket has evolved sig­nif­i­cant­ly since, dri­ven by the fun­da­men­tal goal of secu­ri­tis­ing insur­ance event risk. Today there are sev­er­al mech­a­nisms avail­able to trans­fer insur­ance risk to investors.

The insur­ance and rein­sur­ance events investors are exposed to relate most­ly to nat­ur­al cat­a­stro­phes, but also include life and health-relat­ed risks. Securis invests exclu­sive­ly in ILS, via a range of dif­fer­ent funds, for an investor base pre­dom­i­nant­ly made up of large pen­sion funds and insti­tu­tion­al investors. Securis man­age approx­i­mate­ly $4.5bn of assets on behalf of its investors.

ILS has been the most suc­cess­ful attempt in con­verg­ing the insur­ance indus­try with the cap­i­tal mar­kets

A cat­a­stro­phe bond is sim­i­lar to a fixed-inter­est bond, but rather than being exposed to the default or bank­rupt­cy of a cor­po­ra­tion, it may be exposed to con­tin­gent event risk aris­ing from low-fre­quen­cy, high-sever­i­ty insur­ance events, such as the occur­rence of a large hur­ri­cane or earth­quake. When cer­tain con­di­tions are met, the bond defaults. The investor col­lects a reg­u­lar coupon for the dura­tion of the bond and, in the absence of that event, the cap­i­tal invest­ed is returned upon its matu­ri­ty.

The glob­al finan­cial cri­sis in 2008 was the first real test and proof of con­cept for ILS and it lived up to expec­ta­tions. Securis post­ed per­for­mance that year in line with what it had mod­elled and expect­ed, uncor­re­lat­ed to the cap­i­tal mar­kets and more tra­di­tion­al and well-known assets. ILS had its own chal­lenges dur­ing 2017 and 2018 when there were an unusu­al­ly high num­ber of nat­ur­al cat­a­stro­phes around the world. This demon­strat­ed how both the ILS and cap­i­tal mar­kets are cycli­cal in nature, only ampli­fy­ing the val­ue of a diver­si­fied invest­ment port­fo­lio with prop­er decor­re­la­tion.

“ILS can be very help­ful for investors who have the gov­er­nance capa­bil­i­ty to prop­er­ly imple­ment and man­age an ILS allo­ca­tion with­in a diver­si­fied invest­ment pro­gramme,” says West­on Tomp­kins, head of investor rela­tions for Securis in North Amer­i­ca.

Investors should treat it like any oth­er strate­gic asset class: do your due dili­gence, edu­cate your­self and get to know the invest­ment man­ag­er. ILS does act unlike any­thing else in their port­fo­lio and for all the right rea­sons.

“The inci­dence of hur­ri­canes or earth­quakes isn’t relat­ed to glob­al GDP or any of the cap­i­tal mar­kets, so ILS is an unques­tion­ably diver­si­fy­ing asset class. It’s real­ly easy to under­stand: if the wind doesn’t blow and the ground doesn’t shake, you should typ­i­cal­ly make mon­ey. There should be a pos­i­tive return pre­mi­um for under­writ­ing poten­tial­ly large glob­al prop­er­ty cat­a­stro­phe loss­es and his­tor­i­cal­ly that has been the case. Imple­men­ta­tion can be incred­i­bly com­plex, but that is why Securis exists.”

For pro­fes­sion­al investors look­ing to embrace the diver­si­fi­ca­tion oppor­tu­ni­ty that ILS presents, Espen Nord­hus, Founder and Exec­u­tive Chair­man, rec­om­mends a strate­gic long-term allo­ca­tion, with at least a five-year per­spec­tive.

“Take a long-term view and be pre­pared to adjust your com­mit­ted cap­i­tal over time,” Nord­hus adds. “If ILS out­per­forms the rest of your port­fo­lio, reduce your posi­tion. If it under­per­forms or there is a mean­ing­ful mar­ket dis­lo­ca­tion, add to ILS despite the pre­ced­ing returns. This is the most crit­i­cal point for a long-term suc­cess­ful ILS expe­ri­ence, as it means you’re reduc­ing your allo­ca­tion when expect­ed returns are declin­ing and increas­ing allo­ca­tion when return expec­ta­tions are increas­ing.”

Q&A: Leading the evolution of ILS

Veg­ard Nilsen, chief exec­u­tive of Securis Invest­ment Part­ners, reveals how the com­pa­ny has helped shape the evo­lu­tion of insur­ance-linked secu­ri­ties over the last 15 years and con­tin­ues to lead the charge

What role has Securis played in the devel­op­ment of this bur­geon­ing asset class?

When Securis was estab­lished in 2005, very few invest­ment man­agers were deploy­ing investors’ cap­i­tal to pro­vide pro­tec­tion to insur­ance and rein­sur­ance com­pa­nies via a fund prod­uct. There was a sig­nif­i­cant amount of inno­va­tion and inven­tion preva­lent in those ear­ly days. Asset man­agers were in many ways spurred on by the large rein­sur­ance com­pa­nies seek­ing avenues to pass on risk.

Fif­teen years on, it’s clear we were a dis­rup­tive force and now actu­al­ly com­pete with the rein­sur­ance com­pa­nies. The uni­verse of insur­ance risks is very broad and Securis has always been at the fore­front of extend­ing the part of it that is acces­si­ble to ILS invest­ments. This has not meant to branch out into areas where insur­ance risk is com­bined with mar­ket risk or cred­it risk, but rather to find new mar­kets for insur­ance risk par­tic­i­pa­tion and gen­uine­ly diver­si­fy­ing risks for our investors, increas­ing risk-adjust­ed returns.

What approach do you take to ensure you can con­tin­ue to inno­vate in this space?

As an exam­ple, we cre­at­ed an Insur­ance Solu­tions Group last year to focus entire­ly on pur­su­ing new strate­gic ideas. We see a num­ber of oppor­tu­ni­ties to deploy life financ­ing tech­nolo­gies to the non-life space, where the com­bi­na­tion of tak­ing on insur­ance risk togeth­er with financ­ing can be a pow­er­ful com­bi­na­tion to enhance returns, par­tic­u­lar­ly in the areas of insur­ance pre­mi­um financ­ing, com­mis­sion financ­ing and spe­cial­i­ty risk financ­ing.

Securis also has one of the longest track records in the Life ILS space, a high­ly spe­cialised propo­si­tion which involves risks includ­ing mor­tal­i­ty, life expectan­cy, lapse (when a pol­i­cy is can­celled or mod­i­fied) and mor­bid­i­ty. The suc­cess of a Life ILS trans­ac­tion should be down to high­ly pre­dictable actu­ar­i­al risks that can be analysed, not the risk of a coun­ter­par­ty fail­ing to pay us or any gen­er­al mar­ket risks like equi­ty shocks or inter­est rate ris­es.

“This is why par­tic­u­lar focus is paid to putting in place appro­pri­ate col­lat­er­al ring-fenc­ing struc­tures for most of our life trans­ac­tions. This, in turn, allows us to pro­duce a high­ly diver­si­fied, return max­imis­ing port­fo­lio for our investors, with min­imised expo­sure to tra­di­tion­al mar­ket risks” Andrea Cav­al­leri, CIO (Life) adds.

How will the con­tin­ued effects of cli­mate change impact the ILS mar­ket and asset class?

Cli­mate change has the poten­tial to impact all asset class­es. The cli­mate is chang­ing, for exam­ple aver­age sea sur­face tem­per­a­tures have risen approx­i­mate­ly 1.1 degrees Cel­sius since the late 19th cen­tu­ry and sea lev­els have risen 20cm in the same peri­od. And although it has a neg­a­tive impact on our plan­et, that doesn’t auto­mat­i­cal­ly make it neg­a­tive for ILS as an investable asset class.

If the assump­tion is that cli­mate change cre­ates a more volatile cli­mate, you should also assume the need for insur­ance will increase, the mar­ket will grow and the addi­tion­al risk will dri­ve insur­ance pre­mi­ums up, which will ulti­mate­ly ben­e­fit our investors. It’s also impor­tant to note that nat­ur­al cat­a­stro­phe risk is not just a func­tion of the haz­ard or cli­mate, but rather the expo­sure to the haz­ard.

Hur­ri­cane Kat­ri­na cost the insur­ance indus­try $39 bil­lion when it flood­ed New Orleans in 2005. That’s $63 bil­lion in present-day val­ues, how­ev­er con­tem­po­rary analy­sis sug­gests the dam­age would have been 60 per cent less had the lev­ee sys­tems been at cur­rent stan­dards, fol­low­ing recon­struc­tion and improve­ments which have reduced the city’s vul­ner­a­bil­i­ty to storm surge. Our mod­el­ling esti­mates that a repeat of Kat­ri­na, with present day expo­sures and pro­tec­tions in place, could in fact cost the insur­ance indus­try less than $25 bil­lion.

How do you eval­u­ate risk in a com­pli­cat­ed cli­mate envi­ron­ment?

Securis employs around 70 peo­ple with a unique mix of cap­i­tal mar­kets and insur­ance expe­ri­ence in addi­tion to a num­ber of tech­ni­cal experts, actu­ar­ies and math­e­mati­cians. We apply a robust and sophis­ti­cat­ed approach to the risk mod­els and tools we use to eval­u­ate cat­a­stro­phe risks. How­ev­er, the con­cept of eval­u­at­ing cat­a­stro­phe risk using mod­els adjust­ed to rep­re­sent the cur­rent cli­mate, rather than just the full avail­able his­tor­i­cal record, has been around in the cat­a­stro­phe mod­el­ling com­mu­ni­ty for a long time. 

Cli­mate change is one of sev­er­al risk fac­tors that must be con­sid­ered, quan­ti­fied and priced accord­ing­ly. We are very famil­iar with the tools and approach­es, have adapt­ed them based on our own analy­sis and con­tin­ue to use the phi­los­o­phy of non-sta­tion­ary dis­tri­b­u­tion of risk when pric­ing risk. Many aspects of cli­mate change are grad­ual, it may take decades, even cen­turies, for trends of changes to be observed – while ILS can adapt quick­ly.

Her­bie Lloyd, CIO (Non-Life) adds, “We are very well posi­tioned to mod­el, analyse and price risk to reflect changes in expo­sure, con­struc­tion vul­ner­a­bil­i­ty and the insur­ance-relat­ed impacts of the chang­ing cli­mate. The short-term nature of insur­ance poli­cies allows for annu­al repric­ing when poli­cies are renewed and rene­go­ti­at­ed, so new sci­ence, bet­ter data and updat­ed views of nat­ur­al cat­a­stro­phe risk are read­i­ly adopt­ed into our invest­ment deci­sion mak­ing frame­work.”

What is your own com­pa­ny stance on the envi­ron­ment as well as oth­er ESG com­po­nents?

We believe ILS has inher­ent ESG-friend­ly char­ac­ter­is­tics as through insur­ance, investors in ILS sup­port rebuild­ing fol­low­ing nat­ur­al cat­a­stro­phe events for non-life, and after ill­ness or death on the life side, i.e. with­in, an ele­ment of social return for investors. Longer-term, insur­ance pro­motes resilience and incen­tivis­es good risk man­age­ment.

As a sig­na­to­ry of the Unit­ed Nations Prin­ci­ples for Respon­si­ble Invest­ment, we are firm­ly com­mit­ted to the envi­ron­men­tal, social and gov­er­nance (ESG) agen­da. At a cor­po­rate lev­el, we are devel­op­ing a more sus­tain­able work­ing approach, which will result in both envi­ron­men­tal and social ben­e­fits with reduced reliance on phys­i­cal infra­struc­ture, min­imis­ing waste and extract­ing effi­cien­cies through util­is­ing cloud tech­nolo­gies.

Our most valu­able resource is our team. Our cul­ture is built around an inclu­sive, ambi­tious and dynam­ic envi­ron­ment that encour­ages trans­paren­cy, integri­ty, col­lab­o­ra­tion and cre­ative think­ing. We encour­age staff to embrace the con­cept of cor­po­rate cit­i­zen­ship, and we’re ded­i­cat­ed to mak­ing a pos­i­tive impact in our local com­mu­ni­ties and glob­al­ly, through the Securis Foun­da­tion, our Char­i­ty.

We also recog­nise cor­po­rate gov­er­nance and eth­i­cal con­duct as essen­tial dri­vers of long-term suc­cess. Embed­ding prop­er, trans­par­ent prac­tices in our organ­i­sa­tion is core to Securis’s risk man­age­ment frame­work and oper­a­tions in a glob­al­ly reg­u­lat­ed envi­ron­ment.

For more infor­ma­tion please vis­it securisinvestments.com

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