When conducting investment due diligence on a strategy for inclusion in their portfolios, one of the first things that investors look at is the volatility profile of the return stream. It’s understandable, because timing an investment is one of the hardest endeavours in finance – just ask people who bought Bitcoin in 2017 and 2021 – and if attractive medium-long term returns seem to be influenced heavily by timing, that’s a tough sell to an investment committee.
It’s also understandable because most investors have public equity and/or public/liquid credit experience. So, it makes sense to apply this logic to alternative credit strategies too, right?
In some parts of the industry, like private debt, perhaps. But not so much in the insurance-linked securities space. That’s according to Rainer Gruenig, Managing Partner, Senior Portfolio Manager and CEO at Zurich, Switzerland-based Plenum Investments, who says that ILS products need to be viewed through a slightly different lens.
“When you talk about insurance-based risks, we are actually talking about tail risks. Analysing insurance-based strategies needs approaching from a completely different angle as opposed to equity and bond portfolios where you are dealing with modern portfolio theory. Drawdown risk is the predominant risk here. Many investors struggle to understand that volatility is not one of the main measures for risk in the insurance linked securities space.”
Digging into the nature of expected drawdowns, necessitates an understanding of expected losses, another critical aspect in the investment due diligence process on an ILS strategy. Gruenig highlights drawdown risk because tail-risk events affecting insurance companies can take longer to unwind, and consequently, investment returns from insurance-based exposures can take longer to recover but normally go in line with higher risk compensation (premiums) that again shorten the recovery time. It’s another area of IDD that Gruenig says requires a different view.
“Investors looking at any product with non-normally distributed loss events should be looking at the maximum drawdowns usually modelled on the basis of historic events and the resulting average expected yearly loss. The portfolio manager’s task is to minimize drawdown risk at a given premium income level,” he said.
Other risks in the investment due diligence process includes counterparty risk: in private equity, that’s the portfolio companies; in equity hedge funds, it’s the public companies they have a stake in; and so, in insurance linked securities, it must be…the insurance companies?
Yes, in life settlements and life ILS strategies generally. In the former, one of the two main counterparties, alongside insurance companies, is the individual insured person – if they live longer than expected, that will impact returns. In the latter, most of the transactions carry mortality risk – the risk that the individuals who are the underlying policyholders that the life ILS funds have exposure to live a shorter life than expected.
But in the catastrophe bond market, insurance companies aren’t the risk counterparty: the U.S. Government or the World Bank is. That’s because the special purpose vehicle that holds the catastrophe bonds invests in U.S. Treasury Money Market Funds or IBRD notes, and if there are no disasters, the principal is returned to the investor at maturity. It’s another common misconception in the space, say Dirk Schmelzer, Managing Partner, and Senior Portfolio Manager at Plenum.
“For every cat bond you create, it’s an SPV, and its fully collateralised. The risk is transferred from the insurance company completely to the SPV. Insurance companies are not a counterparty risk in catastrophe bond investing – the risk for a cat bond strategy is the insured natural disasters.”
Understanding the nuances of these risks also helps to understand the opportunity. From a counterparty perspective, life insurance companies offer a significant benefit.
“Life insurance companies are controlled by a regulatory regime that helps protect against insolvency, like Solvency II in the E.U. And in the U.S., even though many insurance companies are regulated at the state level, similar measures apply and in the worst-case scenario, the ultimate measure is to hand over a non-solvent carrier to one that is solvent or distribute the book to several solvent carriers. That’s never happened, which shows that the measures work. The counterparty risk for the book of the life insurance company is very, very small which makes a strong case for life insurance linked securities,” said Gruenig.
In the catastrophe bond market, the risk counterparty is a natural disaster. They are incredibly difficult to predict, and devastating natural disasters like Hurricane Ian carry headline risk for the catastrophe bond market, but Schmelzer says that investors should take comfort in the availability of incredibly complicated but reasonably accurate models, and the infrequency of large-scale events like Ian, as well as the independent and uncorrelated nature of these events, that enable the creation of well diversified portfolios.
“There are decades of data and there have been millions of dollars invested by the insurance industry in developing models that can quantify the financial risk of a natural disaster. What investors would struggle with is if Ian cost more than what was modelled, but it didn’t – the losses are in line with expectations. That’s a testament to the accuracy of the models we have available,” he said. “Investors are willing to accept that and they’re not moving out of the segment because of that terrible event. The drawdown is in the range of what is to be expected. Investors look to strategies like cat bonds for the long term and it’s our job to set their expectations accurately.”
The current macroeconomic environment presents investors with a short-term conundrum – do they pause their alternative credit allocations to take advantage of the current higher yields from government debt before resuming again in the future when rates come down, or do they persevere with their original plan? For Schmelzer, those that are keen to learn more about insurance-based strategies could benefit whether these be life- or non-life based.
“Cat bonds are floating rate instruments – if the fed changes rates, that trickles into the coupon payments. There is no price reaction in ILS generally, they’re not exposed to credit risk or interest rate risk, and the drivers of return are different. Life settlement prices are not directly driven by interest rates, either. The influence comes indirectly via the level of demand. Therefore, adjustments to higher interest rates may be delayed or don’t happen at all, provided the existing demand faces scarce supply that drives IRRs (the discount rate) down while interest rates are flat of rising,” he said. “The diversification aspect is one of the main reasons for including either life ILS strategies or non-life ILS strategies – or both, because they have different risk exposures and drivers of returns – in a diversified portfolio.”