Noncorrelated
Yet perhaps what makes ILS most attractive for investors is that these securities are not correlated with equity or bond markets. Catastrophes, after all, can happen regardless of what the S&P 500 or interest rates are doing.
“Yields will of course vary by year,” says Aaron Koch, a consulting actuary at Milliman, a Seattle-based consulting and actuarial firm, “but the underlying motivation for investing in the space is that the occurrence of natural catastrophes is generally uncorrelated with the performance of the financial markets, making insurance-linked securities an excellent portfolio diversifier.”
A Brief History Lesson
To understand ILS, it helps to understand a little about the insurance business. The insurance industry was ostensibly designed to help reduce clients’ liabilities in case of an unforeseen expense they can’t afford. But insurance is not charity; in addition to compiling actuarial risk data, companies have to sell policies to make a profit. “No one likes buying insurance,” observes Larry Swedroe, director of research at St. Louis-based Buckingham Strategic Wealth. “You pay a premium to protect against losses you can’t handle on your own, but you know the insurance company is covering its costs and making a profit.”
How can investors participate in that profit? One way would be to buy shares of leading insurers and reinsurers. “But the problem with that is, insurance companies have lots of other assets on their books—real estate investments, stocks, bonds and so forth,” says Swedroe. “You don’t want a piece of that. You just want to isolate the reinsurance risk.”
That’s where cat bonds come in. Each cat bond typically covers a specific set of risks, such as Florida wind damage. “That’s a problem for me,” says Swedroe. “Cat bonds are not very diversified. They mostly cover U.S. hurricane risk. You don’t see insurance companies that only cover hurricane risk, right? That’s not a good strategy.”
Another drawback of cat bonds, he cautions, is that they have become highly liquid and tradable. “That means you’re losing the illiquidity premium,” says Swedroe.
Consequently, he prefers a reinsurance “sidecar” commonly known as a “quota share.” This is a kind of risk-sharing arrangement that allows the investor to own a piece of a broader array of risks that the reinsurer covers. So quota shares tend to provide greater diversification than cat bonds while allowing investors to capture the illiquidity premium.
“Quota shares are privately negotiated pro rata slices of the book of business of a reinsurer,” explains Thomas Connelly, president and chief investment officer of Versant Capital Management in Phoenix.