ILS to help satisfy investors’ ESG appetite

By A Paris – Large institutional investors are throwing their weight behind insurance-linked securities (ILS) with considerable allocations and mandates being handed down, despite the challenges experienced in the space since 2017. The asset class, particularly catastrophe (cat) bonds, proved resilient through the Covid-19 pandemic, living up to its diversification credentials. Further, with sustainability in investors’ crosshairs, ILS which account for climate change risk are also growing in appeal.

“After big tests during the past three years, the ILS market remains resilient,” details the Global Insurance-Linked Securities Market Survey Report from Willis Towers Watson. “Most end investors are satisfied with their ILS performance; 86 percent of ILS funds expect market growth of 5 percent or more cumulatively during the next five years; more than half of reinsurance and insurance companies surveyed world-wide now use ILS capacity.”

The survey finds market disruptions from catastrophe losses in 2018/2019 and Covid-19 have not significantly dented enthusiasm for ILS investments. Over 80 percent of end investors either expect to increase their ILS allocation in the next 12 months or expect it to be unchanged.

“During Q1 2020, ILS demonstrated its diversifying benefits and low correlation characteristics with other asset classes, as the median fund posted slightly positive returns. It is worth noting that the catastrophe bond market did see some impact when, after positive returns in January and February, sales of cat bonds in March mainly by multi-strategy hedge funds led to a modest decline in the month. Many ILS managers saw this as a buying opportunity. Most ILS funds have significant exposure to private transactions, which did not experience the same mark-to-market losses as cat bonds over the quarter,” Robert Howie, Asset Class Specialist, Diversifying Alternatives Boutique, Mercer, wrote in a recent article.

According to Don Steinbrugge, Founder and CEO of Agecroft Partners, current conditions are seeing a trend in pension funds and other large institutional investors seeking out less correlated alternatives, which is where ILS, cat bonds and other investments directly linked to reinsurance risks sit.

Some of the more notable rises in allocations within the past year came on behalf of the Coca Cola pension fund, the Healthcare of Ontario Pension Plan (HOOPP) and the Swedish national pension buffer fund AP3.

AP3, which has been investing in insurance-related securities since 2008 notes in its most recent annual report: “The strategy looked attractive when first designed 10 years ago. In hindsight, it has more than matched expectations. Returns have been favourable even in peak disaster years like 2011 and 2017.

“Holdings include catastrophe bonds, which are traded outside the traditional financial markets. Returns on these instruments have a low correlation with other investments, which means they help to diversify the portfolio.

Investments in insurance risk are strategic, long-term and help to make insurance markets more efficient. Pandemic insurance helps to channel capital quickly to relief efforts.”

The Canadian HOOPP doubled its investments in the ILS space over the course of 2020, having hired Bernard Van der Stichele early last year as portfolio manager for its new ILS investment program. According to the plan’s 2020 annual report, the total fair value of its ILS investments is USD549 million. This compares to the 2019 valuation of USD260 million.

Climate concerns

Climate change is a critical dimension ILS need to take into account. AP3 outlines: “Analysing and tracking climate trends enables AP3 to make informed investment decisions. Climate change may be a rapid process geologically speaking, but from a financial perspective it is slow. AP3 invests in instruments with a maturity of three years, which means that their pricing adjusts much faster than climate risk.”

“Generally, the asset class is considered to have good responsible investment (RI) credentials. This is because insurance has a positive societal benefit by providing a safety net to individuals, businesses and public entities (assuming premiums are reasonable) and supporting climate resilience,” remarks Howie.

He goes on to outline how ILS can support climate resilience: “ILS contracts usually have a short term (mostly one to three years), whereas the impact of climate is likely to be a multi-decade phenomenon, creating a natural time-horizon disconnect. 

“As the effects of climate change occur and the quality of climate data improves, we expect ILS pricing to adjust. Investors in an efficient market should therefore receive compensation through higher premiums for any increase in expected claims resulting from climate change.”

Mercer believes natural-catastrophe-focused strategies for investing in ILS present a compelling opportunity in the current environment. 

And managers are clearly aware of this. Jamie Rodney, Executive Director of ILS Analytics, Twelve Capital comments: “Climate change and ESG are prevalent topics in our dialogue with investors and discussed in almost every meeting.”

In one example of the efforts to capture this opportunity, earlier in 2021, Nephila Capital launched an ESG impact fund. Greg Hagood, co-founder and co-CEO, Nephila outlines: “The past year has shaken awake many organisations that have neglected these mounting climate risks and has increased the appetite for Nephila’s risk transfer solutions. 

“Just as businesses with remote work strategies were better prepared for the pandemic, organisations with climate risk strategies will be better prepared for climate change. ‘Theoretical’ risks (e.g. a global pandemic or a warming planet) are becoming real, and organisations previously unprepared for global disruption do not want to be caught on the backfoot.”

In the view of Jake Weber, Partner and Head of Analytics for Elementum Advisors: “Climate change is increasing the level of uncertainty in the ILS market, especially for investments covering the perils of hurricane and wildfire. The most commonly used catastrophe models have not yet evolved to the point where they directly contemplate the effects of the global warming trend, leaving each manager to depend on their internal analytics capabilities to quantify the impact.”

According to Richard Lowther, managing partner at Integral ILS, the connection between ILS and sustainability needs to be further quantified. In an interview with The Insurer TV, he spoke of the need for a framework to measure progress against ESG objectives: “An independent framework to score ESG would be extremely helpful, as right now it is largely a self-certification process.” Lowther believes a structure which enables that would “be a win for investors and the ILS asset class as a whole.” 

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