The case for ILS as a responsible investment

Responsible investment strategies have experienced rapid growth in recent years. One report estimates that $6.6 trillion (18%) of US domiciled assets are engaged in responsible investment practices. Robert Howie and Alex Bernhardt from Mercer believe that investors with a mandate for responsible investment should be looking closely at insurance linked securities.

Screen Shot 2016-01-27 at 2.38.41 PMAlthough many of us think of insurance as a necessary evil, it nonetheless serves a clear and important social purpose: It supports sustainable economic growth and helps prevent hardship. In the absence of insurance, certain risky activities could not reliably be undertaken by individuals (for example, buying a home) or businesses (for example, many forms of capital investment). And where uninsured losses do occur, public entities (and therefore citizens/ taxpayers) are often left to foot the bill. By virtue of this dynamic, a lack of insurance penetration is a problem for society, which is why the widening gap between economic and insured catastrophe losses worldwide is of concern. Long-term trends such as climate change and rapid coastal urbanization only stand to exacerbate the issue.

This article revisits the case for investment in insurance-linked securities (ILS) and explores whether ILS can be part of a responsible investment (RI) strategy.

Screen Shot 2016-01-27 at 2.38.50 PMTHE CASE FOR INVESTMENT IN ILS

ILS can be any type of financial instrument through which the return of principal and the payment of interest are linked to a pre-defined “trigger” insurance event, such as a hurricane or an earthquake of a specific magnitude. These instruments allow capital market investors to participate in a market that was traditionally reserved for insurance and reinsurance companies. An investor in ILS effectively becomes the insurance provider and is paid an insurance premium as compensation. There are many types of instruments — perhaps the most well-known of which are catastrophe bonds.

The interest in ILS comes as global investors seek alternative alpha and beta exposures to enhance portfolio return and diversification. ILS are particularly interesting, as natural catastrophe risk has shown very low correlation with traditional financial risk. This can be seen statistically via a correlation analysis of catastrophe bond indices versus typical fixed income and equity indices and anecdotally — after major US natural catastrophes, there have been no significant impacts to equity market returns, volatility, or interest rates.

Although some regional equity markets have declined following significant events (the most recent example being the Tohoku earthquake in Japan in 2011), the impact of such events on traditional financial markets has been brief.

Overall, we believe that sophisticated investors should investigate the use of ILS to gain exposure to an alternative source of risk premia. However, due to their unique nature, investors with ILS exposure need to be able to withstand rare but possibly extreme drawdowns. They also need to be able to ride out the insurance pricing cycle and even be prepared potentially to increase exposure after experiencing significant losses, as pricing can be very attractive following major events. Moreover, the current market cycle has resulted in a decline in reinsurance rates over the past few years, but despite the reduction in returns, we believe that the diversification benefits presented by the asset class still remain attractive.

ILS AS A RESPONSIBLE INVESTMENT?

Although an argument could be made for the social benefit of a catastrophe bond protecting a typical for-profit Floridian insurer, greater RI opportunities are likely to come from innovations in ILS that are being used to increase insurance penetration. Some examples of these with a clear social benefit are:

  • African Risk Capacity Ltd’s Aggregate Excess of Loss reinsurance program supporting the provision of parametric (a.k.a. index-based) drought insurance for African sovereign countries to bolster their disaster relief budgets.
  • The reinsurance for acronym-heavy programs, such as CCRIF and PCRAFI, providing parametric hurricane, earthquake, and extreme rainfall protection to small island nations in the Caribbean and Pacific, respectively.
  • The Mexican MultiCat Cat Bond transactions providing parametric hurricane and earthquake protection to FONDEN (the Mexican disaster agency) to support its disaster relief activities.
  • The reinsurance of large, often government-sponsored micro-insurance programs, which provide low-income communities around the world with innovative parametric protections against specific risks for pennies of premium.

Such innovations can also be used to transfer risks that historically have proved difficult to insure in the standard market because of their size or complexity, such as flood and drought risk. Finding ways to transfer such risks is important to the fiscal sustainability of public entities, citizens, and businesses. It also represents an attractive business opportunity for the burgeoning ILS asset class. Thus, investors looking for thematic RI opportunities should be looking closely at ILS for their ability to bolster the resilience of society to catastrophic loss, de- risk public budgets, and support efforts to combat and adapt to climate change — not to mention offering potentially attractive uncorrelated risk/return.

ILS investors — particularly those who have a parallel focus on RI — have a choice. They could sit on the sidelines and wait for the market to develop organically, or they could instead take a more activist position and engage more with stakeholders on catastrophe/weather risk management issues. As highlighted in Mercer’s Investing in a Time of Climate Change report, the risks posed to their portfolios by the physical impacts of climate change are real and warrant increasing attention, particularly with respect to real-asset portfolios.

In summary, ILS offer attractive diversification benefits to sophisticated investors. In addition, for those investors committed to RI, frontier of the ILS market could potentially be widened as a means of strengthening individual entities — and society at large — against shifting catastrophe and weather risks.

ABOUT THE AUTHORS

Alex is the head of RI for Mercer in the US. Prior to joining Mercer, Alex worked at Marsh & McLennan sister company Guy Carpenter, where he founded the GC Micro Risk Solutions group focused on micro(re)insurance business development and thought leadership worldwide.
He may be reached at alex.bernhardt@mercer.com.

Robert is a principal in the Hedge Fund Boutique of Mercer’s Investments business. He leads manager research and the generation of intellectual capital for alternative assets in Europe, focusing on hedge funds, ILS, multi-asset, and other liquid alternative strategies. Additionally, he advises institutional investors on the use of alternative assets, including manager selections and portfolio construction. He may be reached at robert.howie@mercer.com.

This article originally appeared in the December 2015 issue of  Research Perspectives produced by Mercer’s investment research boutique.

 

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Posted: Monday, February 15th, 2016