Insurance-Linked Securities: Growing Opportunities and Risk Management
Insurance-linked securities (ILS) have captured renewed interest from institutional investors, with catastrophe bond issuances reaching new heights. A report from consultancy firm bfinance highlights robust returns compared to the pre-2020 era. However, effective mandate design and astute manager selection are essential to avert past performance challenges encountered between 2017 and 2022.
Market Expansion and Risk Management Strategies
This resurgence of interest aligns with market data indicating significant expansion in ILS capacity by 2025. By the end of Q3, issuance surpassed $18 billion, while the outstanding market value is about $56 billion, as reported by Artex Risk. The previous years of high catastrophe losses revealed deficiencies in risk models and portfolio approaches. However, since 2022, improved pricing, advantageous interest rates, and revamped structures have bolstered catastrophe bonds' performance, drawing both new and returning investments in ILS.
Risk Evaluation and Portfolio Design
bfinance's insights underscore the importance of evaluating ILS portfolios with a risk-based approach instead of focusing solely on fixed return benchmarks. The expected loss is the primary risk measure, supplemented by tail risk indicators like 99% Value at Risk to gauge risk tolerance and compare strategies. Catastrophe bond strategies commonly target an expected loss range of 2% to 3%. In contrast, portfolios with significant private ILS allocations may entertain expected losses from 5% to 6% or higher, necessitating an understanding of larger modelled tail losses.
Liquidity and Compliance Considerations
Liquidity significantly influences ILS mandate structuring. Portfolios heavily invested in listed catastrophe bonds offer frequent liquidity. Those exposed to private collateralized reinsurance may necessitate longer notice periods, lockup terms, and other mechanisms for settlement processes. bfinance advises against planning for full redemption in less than a year for portfolios dominated by private ILS, emphasizing the alignment of liquidity terms with risk. This prevents forced sales or unexpected restrictions, which are crucial regulatory compliance requirements.
Constraints and Implementation Options
The report outlines various constraints asset owners can apply to manage risk effectively. These include caps on niche instruments, peril-specific limits based on expected loss contributions, and diversification controls by ceding company and trigger type specialization. Also discussed are the benefits and pitfalls of pooled funds, funds-of-one, and separately managed accounts (SMAs), noting that SMAs may introduce operational and documentation complexities within the sector.
Finally, considerations around fee structures and ESG (Environmental, Social, and Governance) integration are particularly crucial for significant insurance and pension investors. Success in the ILS domain is tied to pragmatic mandates aligned with investor goals, while balancing risk management, liquidity, and manager diversity, as institutions navigate an asset class reshaped by the 2017-2022 market experiences.