Alternative credit comes in many different shapes and sizes, with fund managers of all sorts of strategies competing for a slice of an institutional investor’s illiquid credit allocation. The risk exposures and sources of return in these products vary significantly, and each has a solid claim for a place in a diversified portfolio for different reasons.
One of the few things that most of these products have in common is that a rising interest rate regime, in theory, makes them less attractive to investors; traditional, liquid fixed income investments have always offered lower risk and better liquidity terms, but now, these benefits are being supplemented with a higher yield.
One sector of the alternative credit world that might not be as affected as others if interest rates revert back to something resembling a long-term norm, however, is life ILS. Whilst the initial transactions involve life insurance companies and other related entities, according to Adam Robinson, Head of Life at ILS investment manager Securis in London, says that the nuance of the strategy means that it behaves differently to other sectors of the alternative credit market such as private debt, for example.
“In a rising interest rate environment, the opportunity and projected return profile of life ILS strategies stays pretty much the same. Interest rates aren’t the main driver of performance,” he said. “It’s an opportunistic and solutions-driven product; we enter into transactions that life insurance companies can’t do ordinarily, and that opportunity should persist regardless of the prevailing interest rate environment. Indeed, I’d argue that life ILS should exhibit fairly defensive characteristics when compared to other alternative credit products.”
The risk profile and the lack of correlation of the return stream to capital markets are two other features of life ILS strategies that are touted by those in the sector as a reason to allocate to their products. Mortality and longevity risk are generally uncorrelated to capital markets whereas lapse risk – the risk that policyholders either stop paying their premiums or pay less into a policy – tends to be more correlated, meaning that managers in the space need to construct their portfolios to compensate.
“Mortality and longevity are generally almost entirely uncorrelated but lapse risk can be more correlated depending on who the product is sold to and what the purpose of it is. It’s a much more subtle risk and depends on counterparty but these risks can be mitigated out with structural features such as lower loan to value deals, and exposure to different populations and products that don’t move in tandem. When you blend it all, it’s typically pretty immunised to financial market risk,” said Robinson.
Two of the reasons holding the life ILS sector back in terms of more investors entering the space is its smaller size when compared to other alternative credit options and the longer timescales that are part and parcel of investing in this space. For those not in the asset class but who are curious about it, Robinson urges patience.
“Life ILS strategies take time to deploy capital. Our trades are largely privately sourced and privately originated. There’s a long lead time from an initial meeting with a counterparty to originating a trade, which can be as much as six to twelve months. The ideal investor for this asset class is one that is willing to take a long-term view on the opportunity because you’re buying into the manager’s ability to source and execute transactions.”
Investors that are taking a closer look at the life ILS space for the above reasons are also looking at the ESG credentials of these products. Life ILS managers suggest that their products can be a natural fit for an ESG mandate due to the social benefit derived from supporting individuals’ insurance needs, and investors aren’t looking at this as purely a box ticking exercise.
“A lot of investors are asking us to confirm that we can satisfy their ESG policies,” said Robinson. “This has only really begun to pick up steam in the past few years, but investors are pushing through our layer to one layer beyond which involves the counterparties that we work with, where we invest and in what we invest. It’s getting more rigorous, but I welcome it, because the more investors that see that life ILS strategies can satisfy their ESG requirements, I think the better it will be for the industry at large”.
The U.S. Federal Reserve says that it expects interest rates to rise to around 4.5% in 2023, before cooling off again in subsequent years, assuming inflation is brought under control. Whether the life ILS market can seize this opportunity to pitch what it says are the benefits of the strategy remains to be seen, but for Robinson, the capacity challenges could well go away.
“The market is fairly untapped. I don’t brush shoulders with my peers,” he said. “Most conversations I have with counterparties are educating them for the first time about why life ILS is a good idea. A tell-tale sign of a mature market is when you meet a counterparty, and they say that one of your competitors already met with them. I’m not sure where the ceiling is, but I don’t think that we’re close to it.”
