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Insurance Linked Securities Strategies Set For Strong 2021 – And Beyond

Insurance Linked Securities strategies – in particular, catastrophe bond portfolios - are set to prosper in 2021. That’s according to Franklin Templeton’s alternative investment division K2 Advisors, whose K2 Advisors First Quarter Hedge Fund Strategy Outlook points to ILS as a strategy to watch.

One driver of K2’s bullishness stems from their belief that investors that are yield- and income-centric will need to consider alternative yield products - such as ILS – to provide them with what they desire given that the zero lower bound interest rate environment is delivering a zero (often negative) real yield.

The bond replacement theme is a zeitgeist one in investing and portfolio construction currently, but Jonathan Malawer, Head of ILS, Commodities and Environmental Strategies at K2 Advisors, says that investors may approach their ILS allocation with a different perspective on where it may reside in their portfolio.

“We see investors typically allocate to cat bonds from either their alternatives or fixed income buckets,” he said. “ILS generates income with a low correlation to markets because the primary risk factor - natural catastrophe activity - is unique. Investors are attracted to the diversification benefits ILS can offer, including equity downside protection. But there are different instruments within ILS that offer varying liquidity. Cat bonds do offer investors liquidity, but the market size and depth differ from government bond and corporate credit markets. Investors should be aware of these liquidity differences when allocating capital into ILS.”

Liquidity differences between ILS strategies and bonds aren’t the only consideration for investors looking more closely at ILS products. Manager selection is often touted as the most critical part of an allocation to alternative investment strategies due to the wide dispersion in performance between various managers; the past three or so years have seen an increasing focus in this area by investors in ILS strategies as well.

“If you look at relative performance you wouldn’t see much dispersion of returns prior to 2017 but the stress events that year - the wildfires in California and the Atlantic hurricane season [the costliest on record] - provided an opportunity for investors to examine how different ILS funds responded to a very challenging period,” he said. “In addition to performance analysis, this includes portfolio construction, risk management, investor transparency, valuation, liquidity and use of leverage.”

The effects of climate change have come increasingly into focus in the investment management arena in recent years, and even more so in the past year, after Blackrock CEO Larry Fink published his annual letter to clients and CEOs in January 2020 explaining that the asset management giant saw climate change as the most significant sustainability-related factor affecting economic growth, asset values and financial markets generally. The impact of climate change is something that the ILS industry has been analysing and managing for a while, however.

“Early investors in the ILS industry had exposure to the higher frequency of events during the 2004, 2005 hurricane period when 7 hurricanes made landfall in Florida and Hurricane Katrina hit New Orleans,” said Malawer. “Since then, the gap between insured and economic losses from natural catastrophes has widened, which is likely attributable to the effects of climate change.”

K2 Advisors specifically points to the growing differential between the US high-yield BB corporate bond spread and the catastrophe bond market spread in its first quarter outlook piece; yields are running at approximately 3% for the former, which is on a downwards trend, and 7% for the latter, which is on an upwards trend. K2 Advisors uses the US high-yield BB corporate bond spread as a comparator due to some catastrophe bonds being rated BB by some of the ratings agencies. Malawer says that whilst the increasing differential provides the short-term case for ILS opportunities, the long-term opportunity should not be overlooked.

“The Cat bond spread is being supported by a more favourable reinsurance pricing environment following a period of above average insured losses, so we expect the differential to be sustainable over the near term,” he said. “But the bigger picture is that ILS has an opportunity to close the uninsured gap with new solutions that can drive growth in the market. We anticipate the increasing frequency of flood events will accelerate the development of the private flood market and more efficient risk pooling and risk sharing mechanisms will help to alleviate financial flood risk exposure. The effects of climate change also present ESG-conscious investors a potential investable opportunity through an ILS allocation as the industry is helping homeowners, families and communities to rebuild. The structural developments in the ILS market support opportunities in the long term.”

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