Insurance-linked securities – what investors need to know

In ILS the greatest risk to an investor is that there are more/higher claims than predicted or priced into the securities. This can cause significant drawdowns in the coupons and capital repayment. Full loss on an individual security is possible, and is more common than a traditional corporate bond experiencing full loss with no recovery. 

This is because, in the event of a corporate bond default, investors typically receive a proportion of the bond value in the form of a recovery payment. For ILS, if there is an event (e.g. a hurricane) that causes the insurer losses beyond a specified threshold, the insurer will call on capital held in the ‘Special Purpose Vehicle’ (SPV) (which has been funded by investors – see diagram above), potentially drawing all of the capital from the SPV and leaving none to be returned to investors.

A significant and topical consideration is the impact of climate change. The physical risks that climate change present should not be understated. Past performance of the insurance market (and of ILS) does not reflect the far greater impact that weather-related risks may have in future as the impact of a warmer climate is felt. Predicting this impact is hard (and no model with forecast is perfect) but the Bank of England has estimated annual losses to general insurers under a 'no additional action' scenario (where companies and governments do not change current behaviours and policies around carbon emissions). This is shown below.

^{Source: Bank of England}

Insurers will, of course, reprice premiums to take account of these elevated risks going forwards where possible. However, there is concern that the risks surrounding climate change are much harder to model – and therefore much harder to correctly price – than any other risks that have faced the industry before now. Furthermore, due to regulations in place in some areas of the world, climate risks may not be completely priced in. For example, in the state of California, insurers must use past data to price insurance. This has led to some insurers exiting the general insurance market in California as they consider risks related to Californian wildfires uninsurable. 

The return and risk profile of ILS may, therefore, be more volatile in future.  

The significant impact of any single loss event means that diversification across risks is therefore essential. A fund manager who manages a portfolio of ILS should diversify exposure by geography and across different risk sources (e.g. weather related, mortality, operational and reinsurance), but this may not be possible or achievable, and indeed some managers may prefer concentrated and/or thematic risk.

It is difficult to achieve a 'whole market' approach with one single ILS fund manager, so an investor may need to invest with multiple fund managers (or directly across several securities) in order to achieve sufficient diversification. Even then, your risk profile may still be skewed towards one (or a handful of) risk exposures. 

Investors may decide that concentrated risks are appropriate when considered as part of an investment strategy that is well diversified across many different markets and return sources.

Whether each risk is priced attractively requires specialist expertise. This is the basis of the insurance, and reinsurance, industries. A reinsurer’s business model will involve 'balancing the books' across different sources of risk. A risk that they do not want to keep on their books could be passed on to the ILS market. This makes it far more difficult for an ILS fund manager to achieve sufficient 'balance' across different risks, and to be selective with risks they deem to be attractive. 

As mentioned above, specialist expertise is a necessity when investing in this market. The ILS market has historically shown variable performance across different managers (or manager dispersion). This highlights the need for investors to pick an ILS manager who can select the 'right' risks at the right time, assuming they are available.