Diversifying into Insurance Risk Premia

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.


The hypothetical performance results included in this material are for backtested model portfolios and are shown for illustrative purposes only. Neuberger Berman calculated the hypothetical results by running a model portfolio on a backtested basis using the methodology described herein. The results do not represent the performance of any Neuberger Berman managed account or product and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expense were reflected, returns referenced would be lower. The model portfolio may not be appropriate for any investor. The model may change in the future due to market events and risks in the insurance industry.

There may be material differences between the hypothetical backtested performance results and actual results achieved by actual accounts. Backtested model performance is hypothetical and does not represent the performance of actual accounts. Hypothetical performance has certain inherent limitations. Unlike actual investment performance, hypothetical results do not represent actual trading and accordingly the performance results may have under- or over-compensated for the impact, if any, that certain economic or other market factors, such as lack of liquidity or price fluctuations, might have had on the investment decision-making process or results if assets were actually being managed. Hypothetical performance may also not accurately reflect the impact, if any, of other material economic and market factors, or the impact of financial risk and the ability to withstand losses. Hypothetical performance results are also subject to the fact that they are generally designed with the benefit of hindsight. As a result, the backtested models theoretically may be changed from time to time to obtain more favorable performance results. In addition, the results are based, in part, on hypothetical assumptions. Certain of the assumptions have been made for modeling purposes and may not have been realized in the actual management of accounts. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the hypothetical results have been stated or fully considered. Changes in the model assumptions may have a material impact on the hypothetical returns presented. There are frequently material differences between hypothetical performance results and actual results achieved by any investment strategy. Neuberger Berman did not manage any accounts in this manner reflected in the models during the backtested time periods shown.


Industry Loss Warranties (“ILWs”) are private investment contracts enabling the transfer of catastrophe risk from the protection buyer to the protection seller. The term “industry loss” refers to the fact that the triggers for the contracts are typically based not on the losses of a specific insurance company but rather on insured losses across the insurance industry as reported by a third-party, independent reporting agent. ILWs are typically fully cash-collateralized by both parties, reducing credit risk. ILWs are short-term instruments, typically 180 days to 365 days in duration, and are self-liquidating. In addition, as they are privately negotiated instruments, ILWs allow for greater customization of risk and return profiles.

Catastrophe bonds are typically 144A securities structured as floating-rate principal-at-risk notes of 3- to 5-year maturity, and designed to transfer reinsurance risk to the capital markets. A central feature of a catastrophe bond is its trigger mechanism, which defines the type of event that would cause a principal reduction to the notes. The trigger mechanism could be based on actual insured losses of the issuer (known as indemnity cover), industry-index losses (aggregating all insured losses in the covered area) or even parametric data (e.g. wind speed measurements). Today, most catastrophe bonds are indemnity-based, approximately a quarter index-based and the rest in parametric form.

Reinsurance Quota Shares are financial arrangements (typically called “sidecars” when utilizing special purpose vehicles) established to allow third-party investors to take on a pro-rata exposure to the risk and returns of a reinsurer’s portfolio or a specialized portfolio with risks selected by the reinsurer. Unlike traditional reinsurance, reinsurance quota shares are usually fully collateralized and of limited duration, typically from one to three years. The terms and risk-return profiles of sidecars vary widely.

Sharpe Ratio is the ratio of excess return (over the risk free rate of rate, i.e., cash or Treasury bills) to risk (measured by volatility). A higher Sharpe ratio means a better risk/return trade-off.


The Swiss Re Cat Bond Total Return Index tracks the total return of a representative basket of the global catastrophe bond market, excluding life and health catastrophe bonds.

The Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD measures the total return of a more liquid component of the USD-denominated high-yield fixed-rate bond market.

The Guy Carpenter Global Property Rate on Line Index is an index of global property catastrophe reinsurance Rate-on-Line movements, on brokered excess of loss placements, covering all major global catastrophe reinsurance markets. It has been maintained by Guy Carpenter since 1990 and is updated following renewals on January 1 each year by calculating the year-on-year change in rate-on-line across the same renewal base.

The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies, including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset-weighted based on the distribution of assets in the hedge fund industry.

The Markit iBoxx USD Liquid Leveraged Loans Total Return Index measures the total return of the approximately 100 of the most liquid, tradable USD-denominated leveraged loans.

The Bloomberg Barclays U.S. Treasury Total Return Unhedged USD measures the total return of USD-denominated, fixed-rate U.S. Treasury bonds with a maturity longer than one year.

Correlation with Other Asset Classes. Catastrophic events are unpredictable and it is entirely possible that major losses will occur at or about the same time as other components of an investor’s portfolio are also declining in value. In addition, the amount of global capital investing in insurance-related risks may be impacted to some extent by interest rates and other events affected traditional asset classes within the broader capital markets.

Reliability of Valuations. Investments that are illiquid (including ILWs), not traded or for which no value can be readily determined, generally will be assigned value based on pricing models, dealer quotes or independent appraisals, or such other factors, as applicable. Such valuations may not be indicative of what actual fair market value would be in an active, liquid or established market.


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