Insurance has long been recognised as a crucial risk management tool. But it can also be a profitable and important diversifier for investors' portfolios, especially in challenging times for traditional investments.
One way for investors to access the insurance market is through insurance-linked securities (ILS). ILS are a way for insurers to manage their risk and potentially generate profits, whereby they transfer a portion of their insurance risk to capital market investors. This means that ILS investors act like a re-insurance company, receiving premiums in exchange for accepting the risk of a loss.
How do ILS work?
ILS take various forms, including public, tradeable instruments (e.g. catastrophe bonds or ‘cat bonds’) and private, non-tradeable instruments (preference shares and notes) issued by special-purpose vehicles.
These securities have a different structure compared to corporate or sovereign bonds. Unlike traditional bonds, cat bonds are not directly exposed to the credit risk of the issuer. This means that the financial health of the issuer does not impact the value of the bond. Instead, the focus to determine the risk of losses for ILS is on the probability of the defined risks happening.
In ILS such as cat bonds, if the triggering events, such as a hurricane, do not happen within the agreed period, the investor will receive regular coupon payments based on premiums. The principal will be repaid at the end of the investment term.
However, if any of the specified events occur, a portion or all the principal will be used to cover insured losses, resulting in a reduction or cessation of the investor's coupon payments. At maturity, the principal repayment amount may be zero or reduced.
Therefore, events in the natural, rather than the corporate world, drive the performance of ILS. This means performance is not correlated with traditional asset classes, whose returns are more closely linked to factors such as economic strength or weakness, a company’s good or bad performance, or geopolitical concerns.
What are the key benefits of investing in ILS?
Investing in insurance-linked bonds offers several advantages compared to corporate bonds, particularly in relation to the risks of the economy.
The key advantages are:
1. Low correlation and diversification: ILS are not directly correlated with traditional asset classes like stocks and bonds, which means that their performance is less influenced by market fluctuations or economic conditions. Recent rate hikes and their impact on the economy or the potential of a soft landing or a recession in 2024 shouldn’t be a concern for investors. ILS like cat bonds have a unique source of returns, their risk premium is derived from the probability of certain natural catastrophes’ occurrence. This means cat bonds are not correlated to the credit cycle or other asset classes and act as a diversifier in a portfolio context.
2. Attractive yields: Due to the nature of the risks involved, these bonds often offer higher coupon rates compared to traditional fixed-income securities. The yields are designed to compensate investors for taking on the insurance risk.
3. Reduced portfolio risk: The non-correlated nature of ILS can help reduce portfolio risk. As ILS are tied to specific insurance risks, they may exhibit more resilience and act as a hedge to mitigate the impact of broader market downturns on the portfolio.
4. Income generation: Many ILS offer attractive yields to compensate investors for taking on insurance risks. These higher coupon rates can provide a potential income stream that is independent of interest rate fluctuations or dividend payments from stocks.
5. Weather-related risks vs. credit risks: Compared to traditional corporate bonds, investors in insurance-linked securities are swapping credit risk for weather-related risks. While corporate bonds are exposed to the creditworthiness of the issuer, insurance-linked investments are tied to the occurrence of specific natural events. That’s why most insurance-linked instruments are not rated by agencies like corporate or government bonds. This shift in risk profile can provide diversification benefits to investors, especially during periods of economic downturns when credit risks tend to increase.
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