The constant search for asset classes with low or no correlation to equities and fixed income is leading a growing number of asset owners to consider insurance-linked securities (ILS) including catastrophe bonds.
The Investment Magazine Fiduciary Investors Symposium in the NSW Blue Mountains heard that the uncorrelated or orthogonal return profile of ILSs delivers both strong absolute returns and clear diversification benefits.
But with multi-asset portfolio allocations typically in the low single-digit range, the question arises as to whether it’s worth the time and effort it often takes to unpick and understand the risk and return drivers of a complex asset class.
A poll of delegates revealed that 45 per cent of asset owners have never invested in ILS, but 44 per cent currently invest, either with a single or external manager or with two. Around 10 per cent have previously invested in the asset class but currently do not.
The symposium heard from an asset owner at the event that its catastrophe bond allocation had returned around 24 per cent a year for the past three years or so, “but the five years before that were disgusting” and investors should only enter the asset class with their eyes wide open.
“It’s a trade-off that everyone will have to make based on their own relative frameworks and considerations,” said Jehan Sukhla, co-head of alternative strategies for MLC Asset Management.
“For us, it has been worth it. There’s not that many genuinely non-correlated return streams that are out there, that aren’t skill-based, that are accessible [and] that are scalable to create a degree of relevance within portfolios. Our experience has been a favourable one. That hasn’t necessarily been the case of other investors in in the asset class.”
Irrespective of the perceived complexity, Sukhla said there are “not that many allocations out there that are truly diversifying to the rest of the portfolio”.
“When we started our journey in alternatives, going back 20-plus years, this was one of two that made it through our screening process. We started with a niche strategy because it was very, very differentiated to the to the rest of the portfolio. It had its own set of unique, idiosyncratic return drivers: that mix of demand and supply of reinsurance capital that sets price; and then it has a tail risk that’s very different to the rest of the portfolio.”
Andrew Whittaker, QIC director of investment strategy and implementation, said that the organisation is attracted to catastrophe bonds as “an uncorrelated, orthogonal return stream in our portfolios”.
“When you do the maths on it, it correlates to equity markets with a 0.2 correlation. It correlates to high-yield credit markets with 0.3 correlation. So it’s a pretty attractive diversifier in a portfolio context,” he said.
“But also when you look at it in the long run, the returns of this asset class, if you take the Swiss Re natural catastrophe bond index, for example, it’s returned 7 per cent since 2006 and it’s done so with a Sharpe Ratio of greater than two. So it’s a pretty attractive risk-adjusted return.”
Whittaker said QIC’s capital market assumptions identified the asset class as offering “the highest nominal return over our seven-year expected time horizon… so, 11.3 per cent nominal return, 8.5 per cent real yield, and it’s also got the second-best Sharpe Ratio, only second to private debt”.
“Now, we know you can’t eat Sharpe Ratios; we know that there’s a myriad of assumptions in capital market assumptions; but nevertheless, we think it’s an attractive asset class to own in a multi-asset portfolio context.”
Robert Graham-Smith, Colonial First State (CFS) head of fixed income and alternatives, said catastrophe bonds’ role in the alternatives allocation of a portfolio is “a bit different from traditional direct lending or other private debt strategies”.
“A lot of [those] are floating rate in nature, so you have an idea of what your spread is likely to be,” Graham said.
“But in the case of this asset class, it’s an annual resetting of risk, so another attractive feature is you can modulate up and down your exposure annually, in general terms; and effectively you’ve got an expected return minus an expected loss – which is a modelled loss – minus your fees, which gives you your net expected return. There’s a lot more science and complexity to it, but simplistically that’s the way it works.”
Graham-Smith said CFS was “not naive enough to expect that we’re not going to get hit at some point in time”.
“But it’s how big that hit is, and how you construct portfolios is really important,” he said.
“Our allocation sits within or alongside our private credit portfolio. The diversification element here is that direct lending is predominantly corporate cash flow-related, asset backed [and] there’s credit in that as well, although performance is driven by underlying pools of assets.
“One common factor there is credit risk, and nothing really is without credit risk. But this is different, it’s primarily linked to natural catastrophe risk and its impact on insured property. That’s pretty different in the context of a private credit portfolio.”
Being linked to extreme weather events like hurricanes or cyclones, climate change is playing an increasing role in how the asset class performs. Investors in catastrophe bonds divide potential events in to “primary perils” and secondary perils”.
“We’re trying to have a focus on primary perils, so that’s primarily wind and earthquake; and have as little exposure to secondary perils, which are floods, hail storms, that type of thing. And the reasons for that are twofold: you can get paid better for taking the primary perils; and the secondary perils, in a lot of cases, are more climate-impacted.”
MLC’s Sukhla said the manager has sought to “stay relatively risk remote – i.e. you need a larger loss event to have a meaningful loss impact on our portfolio, with the simple premise being that if we take a material loss on our portfolio, it’s going to be a material event for everybody exposed in the in the reinsurance sector”.
Should this occur it is “likely to lead to some insurers going out of business,” he said.
“So if you can stay the course post-event, the opportunity set’s going to be very attractive.”
In addition to the diversification benefits to a portfolio, investing in catastrophe bonds also gives investors and portfolio managers something different to think about.
“The good thing about this asset class is it takes you away from other asset classes,” Whittaker said.
“We’re all prone to looking at Bloomberg when we wake up; we go Whisky Tango Foxtrot – what did Trump do overnight? Where’s the US 10 year-yield? Whereas this asset class, you’re glued to the Weather Channel; you’re looking at what’s happening with wildfire risk.
“It’s cathartic in some ways, because it’s totally uncorrelated to everything else that you’re invested in.”
