Insurance-linked investments are opening up new opportunities for diversification

The current volatile economic environment, with the war in Ukraine, interest rate uncertainty, and the lingering effects of COVID, has enforced the need for investors to diversify their portfolios with uncorrelated assets. Insurance-linked investments, once dominated by catastrophe coverage, actually have a variety of options that, while lesser-known, meet this need and deserve more attention from investors.

Since the early days of insurance-linked assets, they have been somewhat of an outlier of alternative investments. The insurance industry is highly regulated, complex, and much of its terminology varies greatly from traditional finance. As a result, investors often require assistance to overcome these obstacles and benefit from the uncorrelated, consistent, and attractive returns insurance-linked assets can generate.

Most investors will first encounter insurance-linked assets in the form of catastrophe bonds or collateralized reinsurance. Their underlying function could be simplified in one sentence: you can make money if there isn’t a natural disaster, but have a chance to lose your investment if there is one. With global insured catastrophe losses amounting to almost $500 billion over the last five years, the unpredictable and high severity nature of these losses has prompted investors to evaluate emerging options within ILS that may offer improved risk adjusted returns. For some context, over this same time frame, the average combined ratio for the US P&C industry, excluding catastrophe losses, has been quite profitable at approximately 90%. This could be a good proxy for investor returns in some of the emerging, non-catastrophe ILS lines.

The other perils for ILS expansion are quite broad, but some examples include: motor, homeowners’, general liabilities, etc. They offer the unique benefit of having large amounts of data associated with them. With AI specifically, actuarial processes and modeling can be broadened to incorporate a greater number of factors and then tested to see what combination of models most accurately projects a loss distribution. This also provides greater investors transparency when considering these assets.

These types of assets are also largely uncorrelated to the capital markets. A market crash for example is unlikely to cause an increase in cars or house fires. It’s an important characteristic, especially when investors are looking for defensive moves to employ against market volatility.

Another important aspect of this asset class is its potential for yield enhancement. Investors may pledge a high-quality collateral, which is these typically low-yielding, against insurance-linked assets in some cases.

While these types of insurance-linked investments have been around for a while, access has been limited. This is something that Vesttoo and other InsurTech companies are looking to change. With these companies securitizing and packaging risks into more traditional financial structures, pension funds and other long-term institutional investors will soon have a variety of non-catastrophe insurance-linked investments for their consideration.

The reinsurance industry is experiencing hardening market conditions, which in layman’s terms means reinsurers are being more selective of risks they take while charging a higher price for capacity. In their report “Economic Insights” published in June 2021, Swiss Re forecasted that these conditions will persist throughout 2022, if not longer.

From the insurers’ perspective, the capital markets can provide an additional stream of capital, but it’s not a free lunch. Investors with a variety of risk appetites have the option to evaluate a unique market providing a variety of returns. This remains a cyclical market so the supply/demand balance will shift over time, making a diversified portfolio between peril and deal structure imperative in managing cash flows and volatility.

In summary, non-catastrophe insurance-linked investments fill several needs at once. They can offer stability and diversification to investors while supplying insurers with increased capacity to grow the industry. It should prove quite exciting to see this asset class expand and become a staple of global portfolios.

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