How Insurance Linked Securities can potentially improve the diversification in an institutional portfolio.

Traditionally, natural catastrophe risk from events such as hurricanes and earthquakes has been underwritten and largely retained by insurance and reinsurance companies. The traditional approach has been a transfer of the risk from the generally smaller balance sheets of primary insurance companies, to the larger, more global balance sheets of reinsurers. Over recent decades, this has been changing. In pursuit of capital efficiency and better solvency, the insurance industry has been offloading these risks and the associated premiums to increasingly receptive capital markets, via various types of Insurance-Linked Securities (ILS).

In this paper, we describe the characteristics of ILS and their usefulness to institutional investors. We show that adding a particular type of ILS, Industry Loss Warranties (ILWs), to typical endowment, pension and insurance portfolios would have led to an improvement in risk-adjusted returns and resilience to tail market scenarios, while conforming to the usual constraints and regulatory requirements faced by these investors. We also explain why ILWs may present some unique advantages among all ILS types.

Executive Summary

  • Today’s institutional investors face some common challenges: the current credit cycle has experienced a very long extension; sovereign spreads are generally tight but have become volatile in some countries; balance sheet tail risks are increasing; and the search for yield has driven investors into more illiquid alternative asset classes.
  • Traditionally, natural catastrophe risk has been the domain of the insurance and reinsurance industries. In recent decades, however, the capital markets have begun taking on a greater role in natural catastrophe risk, in the form of ILS.
  • We believe Insurance-Linked Securities (ILS) provide genuine diversification from traditional asset classes and offer attractive risk-adjusted returns.
  • In our view, the rapid growth of the ILS market reflects the potential benefits they bring to both sides of the equation: freeing up solvency capital for insurers while providing a diversified source of return for investors.
  • We focus on one particular type of ILS, so-called Industry Loss Warranties (ILWs), which are short-duration, small ticket-size, privately negotiated contracts that are based on standardized indices rather than specific indemnities. They offer portfolio construction agility and ease of deployment for institutional investors.
  • We show that adding ILWs to models of typical endowment and pension portfolios would have improved their balance sheet efficiency and reduced their exposure to credit cycles and sovereign spreads, while conforming to their objectives and constraints.
  • We also explain why we think ILWs may be a viable choice for insurance investors: their transparency and easy-to-understand nature make it easy to incorporate them into an insurance capital model and have their use approved by the regulator. In particular, they provide a strong source of long-term solvency stability improvement.

Diversification: ILWs Hit Their Allocation Cap in a Volatility-Optimized Portfolio at All Levels of Target Return

Source: Bloomberg, Neuberger Berman analysis. The charts show results for a portfolio optimized for target return versus volatility, with allocation caps of 30% for each sub-portfolio, except for listed equities (capped at 80%), total illiquid assets (50%), cash (3%) and ILWs (capped at 15% of the overall portfolio). For illustrative purposes only. Based on a hypothetical backtested model between October 2002 and October 2018. Please see important disclosures at the end of this paper.