Large and complex as the market may be, it’s far from a Wild West frontier. Transactions occur in regulated marketplaces.
“There are independent modeling firms that compile pricing estimates,” says Connelly. “They exercise rigorous price discovery and transparency, a process of valuing the underlying risk of whatever is insured that, to me, seems a lot more rigorous than most credit modeling.”
In fact, as an asset class, they are “highly regulated,” Evans says.
Moreover, the infrastructure behind ILS is well established. “Whenever we look at any kind of alternative investment, we need to ask, is there a real reason this exists, or is it just some kind of temporary or popular phenomenon?” says Hill. “Well, with insurance-linked securities, there is a real reason why they exist. … This is a market that has a real need and should, over time, return a reasonable profit for the risk-takers.”
Steady, Slow Growth
The ongoing growth of this market seems a natural consequence of several factors. “[The] growth comes down to the efficiency of ILS capital,” says Evans, “making it a very attractive source of reinsurance protection [that is] increasingly sought out by insurers and reinsurers,” and it’s also something in demand from investors who want a relatively uncorrelated asset class.
But has it grown too fast? “We’ve been tracking the growth of ILS since 1999, and the market’s size has increased steadily over time,” Evans says. “There have been bursts of activity in certain years due to market forces in reinsurance, but I would not say growth is too rapid at all. In fact, it could have been more rapid were it not for external factors such as the global financial crisis.”
He warns, however, that investors shouldn’t get carried away. “Allocations should be a small percentage of an overall investment portfolio,” he says. “Investors should … remember that one year of losses can easily be recouped by maintaining a place in the market.”
Clearly, an ILS investment can be volatile in the short run. “But over the longer term,” says Evans, “it tends to exhibit much more stable returns than many equivalent asset classes and with much less correlation to financial markets. Hence, it’s an attractive alternative asset class for investors with large portfolios of traditional assets.”