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The ‘big misconception’ about insurance-linked securities

It’s possible to get equity-like returns from insurance-linked securities with much lower volatility. But a supposed asymmetry of information in the market keeps investors from allocating.

2023 was the best year ever for insurance-linked securities, according to John Wells, co-founder of Leadenhall Capital Partners, with the Swiss Re Catastrophe Bond Total Return Index returning nearly 20 per cent. 2024 is shaping up to give exactly the same opportunities as 2023 – but one big misconception about the asset class remains.

Insurance-linked securities are financial instruments linked to insurance risks – including catastrophe bonds and insurance-linked notes – that provide a way for insurers and reinsurers to transfer some of their risks to the capital markets. Their investors typically assume the risk of specific insurance events like natural disasters and get a return based on the performance of those risks.

But therein lies the rub for many prospective investors.

  • The big misconception, Wells told The Inside Network’s Alternatives Symposium, is that there’s an asymmetry of information in the market and that investors are buying something insurers don’t want.

    “But what we’re not doing is buying risk that insurers and reinsurers want to get rid of because it’s bad; we’re buying risk because they’ve got an exposure to peak perils,” Wells said. “What that means is that from a regulatory and rating agency point of view, they’ve got too much of that risk – and in order to be able to manage that risk from a regulatory and credit point of view, they want to find some to take it on.”

    The instruments Leadenhall buys are floating rate, meaning investors aren’t exposed to long-term duration; the underlying contracts are usually three years or less, depending on the instrument; and over the last 20 years they’ve shown a very low correlation to equity and fixed income.

    “You can get exposure to insurance risk through buying equities or bonds, but what you’re getting is a lot of correlation to market beta,” Wells said. “And most insurance companies have about 40 per cent of their worth in market assets. So what we have here is exposure to pure insurance risk.”

    “The total return on an annual average basis from the Swiss Re index has been about 6.9 per cent – which isn’t far short of the MSCI and is an improvement on both the corporate bond and the aggregate corporate index… Assuming that we have a relatively quiet year, you’re going to get even better returns than last year.”

    Of course, not every year is like 2023. And climate change – which will increase the number of catastrophic events – is still going on in the background.

    “The average event for reinsurance is about $100 billion a year,” Wells said. “Last year, that still happened. But because of the way we structure contracts, because if the way the bonds are structured, none of those bonds paid out because of those events.”

    “Climate change is happening, but this is one of the sectors where you can measure what’s going on with climate change. Every time there’s a new event and capital gets taken out of the reinsurance sector, prices go up… It provides a quick way of pricing climate change, and is also a very quick recovery tool for those areas that have suffered from climate change.”

    Staff Writer

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