Mariagiovanna Guatteri interview: ILS in an institutional portfolio

What has attracted institutional investors to ILS allocations in the past few years? 

Mariagiovanna Guatteri: Interest in insurance-linked securities (ILS) had been growing steadily since the market was created in the 1990s. 

That growth was supported by the rise in interest rates in 2022, which prompted something unexpected in financial markets: debt and equity markets struggled simultaneously. Historically, a portfolio with a mix of debt and equity instruments was the default option for many investors, because the two asset classes were understood to be negatively correlated. But as central bankers hiked rates, debt and equity valuations fell at the same time. 

That led portfolio allocators to ask themselves difficult questions about correlation within their portfolios and take a critical look at how their portfolios would fare in new kinds of market conditions. 

One asset class which appeared to tick a lot of boxes was catastrophe bonds, or cat bonds – a form of ILS. 

As a way to add diversification to a portfolio? 

MG: Exactly. Cat bonds pay a relatively high return to investors in normal years. When a specified event occurs – an earthquake or hurricane, for example – the bond's coupon payments and possibly even principal are reduced. But crucially, there's nothing about a stock market crash which causes a hurricane, or another event which could trigger a cat bond. So we see that these instruments have very low correlation to financial markets, and are therefore an excellent source of diversification. 

Can you put some numbers to that? 

MG: For more than two decades, we've been tracking the cat bond market via the Swiss Re Cat Bond Index. The index has produced positive monthly returns 89.5% of the time since its inception in 2002. And the chart below plots that performance against other asset classes through periods of high financial market volatility: 

And what about inflation? 

MG: Inflation is a key concern for the property insurance industry: higher insured values at risk mean higher potential losses. But inflation can actually be a tailwind for the cat bond industry, since those expected higher losses are modelled and they increase insurers' need for risk capital. That increase in demand can increase ILS market spreads for new issuances, and therefore increase returns.  Furthermore, inflationary periods will normally lead to higher interest rates but, as most cat bonds have a floating rate coupon structure typically linked to treasury money market funds, this will also increase the return on cat bonds. 

Where do ILS investments tend to sit in institutions’ allocation categories? 

MG: There's no one answer – it's actually a conversation that we have often with investors. It tends to depend on how the investor views and uses their allocation. 

Many investors place ILS allocations within their alternative fixed income portfolios due to the structural similarities between many ILS instruments and fixed income products. In particular, cat bonds are structured in a way which makes them a good fit for this category. Notably, cat bonds are traded in a secondary market, providing liquidity to investors. 

On the other hand, we also see investors placing ILS investments alongside hedge fund allocations, partly because of the high-yield, floating rate structures. Because these instruments are often high-yielding and short in duration, they can be viewed in this sense as a diversifying total return lever, rather than an asset liability matching tool. This category of investor primarily accesses these returns through funds offered by specialist investment managers, due to the skillset required to understand and price the underlying risks. 

Lastly, some investors consider ILS as a standalone asset class. This approach enables the development of a diversified ILS portfolio that aligns well with an investor's objectives, while also promoting deep internal knowledge of the asset class, better positioning the institution to take advantage of opportunities and dislocations that arise in the market. 

And how much do institutions tend to allocate to ILS? 

MG: Our analysis indicates that an allocation to ILS has the potential to enhance various modelled metrics in an institutional portfolio. 

We have conducted modelling with allocations of up to 10%, which are effective on a theoretical basis, but the average institutional allocation is generally smaller, as some investors are cautious of the modelled tail risk or are still understanding the asset class. In practice, we see most institutional investors who allocate to ILS doing so at a level of around 1-3% of total portfolio assets, which provides incremental portfolio diversification and income while remaining within their natural catastrophe-related tail risk comfort levels. 

Regardless of access point or allocation categories, the asset class's diversification benefits, resiliency to macroeconomic contexts and potential for a favourable balance of risk and return can make ILS an important long-term addition to institutional portfolios.