ILS


The benefits of ILS for diversification

ILS has proved to be a strong diversifier for investors, especially as lower interest rates have dampened the ability of bonds to act as a hedge for equity portfolios, says a report from Schroders.

“The credit cycle is being closely monitored, given its impacts on interest rates, company earnings and default rates.”
Zeba Ahmad, Schroders Capital

A new report from UK-based investment manager Schroders has highlighted the benefits of insurance-linked securities (ILS) as a tool for investor diversification.

Bermuda houses the overwhelming majority of ILS assets currently in the market, and as the current economic cycle has weakened the link between earnings and valuations while interest rates remain at historic lows, the asset class has attracted the attention of more investors.

Given that ILS is largely uncorrelated with moves in other segments of the financial markets, it provides investors with an alternative “compelling income stream” that also offers genuine diversification, says Zeba Ahmad, alternatives director at Schroders Capital.

With diversification top of investors’ minds as the bond market and equities continue their long upward trend on the back of a historic expansion of the economy over the past decade, there is a growing demand for alternative assets.

“Returns that are less dependent on the economic cycle are now increasingly sought-after. This is because the current economic cycle is increasingly long in the tooth and many investors are eyeing it with some caution.

“In particular, the credit cycle is being closely monitored, given its impacts on interest rates, company earnings and default rates,” Ahmad says.

“Investors in search of income in traditional asset classes have been forced to reach further up on the risk spectrum. Similarly, stock markets are ever more expensive, with the link between headline valuations and earnings weakening.”

“ILS introduces genuine diversification by isolating risks that are not related to the economic cycle.”

While catastrophe bonds are the most well known part of the ILS market among investors, given they make up some 40 percent of the overall total and provide a secondary market to facilitate higher liquidity and trading activity, private ILS assets could play a more important role in investors’ portfolios, Ahmad said.

With a similar structure but lower liquidity, adding an extra premium to the returns on offer, private ILS helps provide the opportunity for greater returns while still providing genuine diversification.

“Investors are typically most familiar with cat bonds as the most liquid portion of ILS markets. However, private ILS, the largest portion of the ILS market, can also be an important tool for sophisticated investors seeking diversification,” she says.

“Their structure is similar to cat bonds, but private ILS—such as collateralised reinsurance—can provide access to a broader range of covered events and the ability to harvest ‘illiquidity premia’.

“Cat bonds typically attach at the most remote level of risk. This means that investors experience losses only once a company’s own loss-retention and other layers of reinsurance have been exhausted. They are compensated with lower yields as a result. Private ILS, such as collateralised reinsurance, provide investors with the opportunity to earn higher returns by attaching at other points,” she explains.

Ultimately, given current dynamics in the markets and the erosion of the ability of fixed income and other traditional hedging avenues to provide investors with the ability to diversify their portfolios, ILS offers a complete uncorrelated way to achieve a more rounded risk profile.

“The traditional approach of diversifying within the boundaries of bonds, equities, and possibly real estate does not adequately address the issue of diversification. In times of elevated market stress, correlations for these assets can draw towards one,” Ahmad says.

“ILS introduces genuine diversification by isolating risks that are not related to the economic cycle.”


Image Credit for ILS cover: Shutterstock.com / sarayut_sy. Image Credit for current page: Boule

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NOVEMBER 2021


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