The product warning that ‘past performance does not necessarily predict future results’ may be truer for insurance-linked funds than for any other asset class. The heavily skewed distributions of possible fund returns mean that, in any year, returns are unlikely to be close to the average. It would take decades – if not centuries – of performance data to differentiate between lucky portfolio managers and skilful ones.
But there are real differences between managers and funds. When insurance losses happen (and when they don’t), funds perform very differently. On at least nine dimensions, insurance-linked funds pursue divergent strategies. There are good arguments for each strategy and, to an extent, different business models will suit different investors. Knowing which choices each manager has made and understanding the implications are key to making wise investment choices.
Users who have registered (for free) can read part two of the article here.
1. Remoteness of risk. The underlying assets in insurance-linked funds can sit at very different points on the risk-reward spectrum. Is it better to invest in highly rated, risk-remote tranches or more ‘in the money’ layers?
Expected returns can be greater for high-yielding transactions but the ratio of coupon (or rate-on-line) to expected loss is often higher for deals at the lower end of the risk-reward spectrum.
2. Diversification. Funds have different philosophies regarding the importance of reducing the correlation of assets within their portfolios. Is it better to select the most profitable business or to diversify by geography and peril?
Insurance-linked funds are inherently diversifying, and investors typically allocate less than 5% to the strategy. This makes many investors very tolerant of focused portfolios. Other investors would rather trade part of their returns for exposure to a well-diversified portfolio.
3. Reinsurance value chain. Insurance-linked funds participate in all stages of the insurance-reinsurance-retrocession value chain. Is it better to protect the original insurance buyer or portfolios of portfolios of policies?
Funds that move close to the customer can access better data and improved transparency, while reinsurance and retrocession contracts offer the fund more flexibility and the ability to structure deals that are a better fit for collateralised reinsurance structures.
4. Scale. The largest managers are over 50 times bigger than the smallest ones. Is bigger better?
Large managers argue that their scale gives them negotiating power, while smaller ones contend that they have more opportunities because they can make material investments in more transactions.
Users who have registered (for free) can read part II on the other five questions here.
Posted: Monday, November 28th, 2016