Stormy with a chance of alpha: the rising tide of insurance-linked securities

The potential for insurance-linked securities (ILS) is on the rise, which may not come as a surprise as the Atlantic hurricane season was historic in the number of named storms as well for the damage they’ve caused. Jonathan Malawer, the head of insurance-linked securities, commodities, and environmental strategies for K2 Advisors, the fund of hedge fund unit within Franklin Templeton, discussed the present state of the ILS strategy. The ILS market comes about because insurers want to spread their risks, especially the risks that involve low-probability but high impact events. One part of the market consists of catastrophe bonds, groups by their level of risk and sold in portfolios. One question for Malawer concerned how much institutional investors need middlemen for decisions in this space. Can they make picks for themselves? Can a pension fund, for example, decide what positions they take in-house and cut out the intermediaries? Or is it wiser to invest in a specialized fund already in the space? He said that most pension plans use an ILS manager to access the market as the allocation size is relatively small and an ILS multi-strategy approach has barriers to access directly. Malawer also acknowledged that there are exceptions and that they include sovereign wealth funds who may “use a hybrid approach, developing their own expertise in specific sub-strategies while also investing through managers.” But when it comes to the attraction to ILS, much of it is due to the yields captured, which are very competitive in the current low interest rate environment. In the firm’s fourth quarter investment outlook, K2’s investment research team said that while hedged strategies looking for long/short trades in equity and fixed-income markets should capture relative value trades, other areas less impacted by the pandemic such as ILS may also perform well going forward. ILS essentially provides capital to back the global re-insurance market. This underwrites exposure to the risks associated with storms or other natural disasters, in return for annual premium income. The instruments are highly uncorrelated from traditional investments and other alternative investments generally, according to proponents of the strategy. Some background on hurricane seasons Every month literally for years now there has been a brief item in the monthly Eurekahedge Report, a much-followed data provider for the alternative investment industry, about the returns of insurance-linked securities advisors. Every month for a long time now too and through October 2020 that item has included some version of the following statement, “ILS hedge fund managers suffered considerable losses from the recent Atlantic hurricane seasons in 2018 and 2017, during which the index lost 3.92% and 5.60% respectively.” In 2017, Harvey, Irma, and Maria came through in quick succession, causing devastating damage in Texas, the southeastern US, and Puerto Rico respectively. The season as a whole caused close to $300 million in damage and more than 3,300 deaths. In 2018, the featured players were Florence, Michael, and Lesli. Hurricane Michael was the first Hurricane to hit the US coast as a Category 5 since Andrew in 1992. Those two hurricane seasons were traumatic for the ILS industry and its investors. The strategy returned just 0.92% in 2019. Eurekahedge attributed that to “loss creep from past events,” apparently those two hurricane seasons still. This year may go down in the history of ILS as the year that trauma was finally transcended. The Eurekahedge ILS Advisers Index, after all, was up 1.33% in September, bringing its year-to-date return to 3.61%. Does that mean ILS positions can be used as a form of very short-term speculation? By way of example, when the next North Atlantic hurricane season nears fund managers might be inspired to bet one another on how much insurable damage will occur in North America over the coming months. “You don’t trade the market with insurance-linked securities,” said Malawer. “It’s a longer-term buy-and-hold investment. While the market offers some liquidity through cat [catastrophe] bonds, we do not see an advantage of trading these bonds during live natural catastrophe events.” Transparency and modelling .According to Malawer, “ILS managers have increased their level of transparency over the past decade, but since different managers do their own modeling and calibration, investors may find it difficult to make a direct comparison.” The issue of models, and the challenge they may pose for institutional due diligence, raises a final issue: global climate change. Is it true that due to long-term changes hurricanes are getting worse, and the atmosphere in general is getting more volatile, over time? Does that affect the bottom line of investors, especially if the insurance companies and intermediaries might be using outdated models? "Industry risk modeling has incorporated the more recent period of higher frequency of hurricanes by utilizing the ‘near term’ view of risk,” Malawer said. And, yes, this near-term view “generally shows higher risk levels than the ‘longer term’ historical perspective.”

Stormy with a chance of alpha: the rising tide of insurance-linked securities

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Christopher Faille

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