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Aon Retirement and Investment Blog

Investigating Insurance Linked Securities

What are Insurance Linked Securities?
Insurance Linked Securities (ILS) form a relatively new and growing asset class, specifically concerned with catastrophe. With ILS, insurers pass on some of the risk they face to investors; investors receive a series of payments from insurance companies but risk losing capital if a specific catastrophic event occurs.
ILS has unique attributes which may serve a portfolio well due to the independence of risk which ILS represent. The risk of a catastrophe occurring, such as a hurricane or earthquake, is very distinct from the financial and macroeconomic risks that cause prices in equities and bonds to fluctuate. Thus ILS may help increase portfolio diversification.
The ILS market makes up part of the Reinsurance market which dates back hundreds of years to the earliest known reinsurance contract written in 1370!  The Reinsurance market has grown to approximately $575* billion (including reinsurer's equity) and now represents a deep, mature, and efficient market with many participants from both the reinsurance and insurance worlds. ILS investors (pension funds for example) are known as 'alternative capital' within the industry and comprise upward of 10% of the reinsurance market. 
How is the ILS market evolving and why should an investor be interested?
Today, the industry increasingly sees alternative capital as an 'investor here to stay.’ Whereas in the past interest from investors had ebbed and flowed, alternative capital is now considered as an important source of capacity, competition, and a mainstay. Since the first issue of a catastrophe bond post Hurricane Andrew in 1992, the ILS market (consisting of cat bonds and other privately negotiated reinsurance contracts) has continued to develop and issuance of cat bonds has been higher in successive years. The total value of ILS outstanding has been brought to new highs (approximately $63.8B as of 12/31/2014*), although over the past year, the pace of this growth has been stabilising.
While ILS instruments have bond-like qualities, we do not see them as fixed income, and they have a very low correlation to all asset classes including fixed income and alternative investments such as equity and credit hedge funds. ILS is an asset class in its own right and, in our view, this distinction is a key attraction. 
In terms of investment return, it varies from year to year in tandem with the reinsurance market, and investors can pitch for various levels of desired risk, bringing with it more or less expected return. A typical and achievable approach today is to seek returns in the region of cash +5% per annum but target returns will vary by strategy. Like bonds, the upside of investing in ILS is limited to the premium earned for collateral (similar to the coupon earned on a bond). Volatility is far lower; however, as investors expect to earn a full premium for as long as no major catastrophe occurs. If a major catastrophe does occur, performance could take a significant hit.
What are the risks?
ILS ensures money is paid to an insurance company on the occurrence of a catastrophe, known as an 'event' being triggered on the portfolio. The loss to the investor will be limited to the investment initially made. A well-constructed portfolio will look to minimise losses by diversifying investments across both region and peril. Whilst individual bond/contract losses could be full losses, each would form a small allocation within the fund. There are other risks, but they are smaller by comparison.
Is now the right time to invest?
As of the date of this post, ILS prices have been rising for two reasons. First, as of September 30, 2015 there has not been a major global natural disaster since the Japanese earthquake in 2011, and, secondly, the market demand from capital markets in ILS issuances has further driven premiums down as the search for yield continues. This market environment as of September 30, 2015 means that the ILS market was considered expensive relative to its historical trading levels. However, we now have reason to believe that a floor could be found and yields may stabilise. The interested investor should become familiar with the asset class before making a small allocation and look to add to allocations as and when the market starts to look more attractive - a toe in the water approach.  
How can the investor best access the asset class?
An experienced fund manager with specialist expertise is required to understand all the risks and to crystalise value within the ILS industry. The number of fund managers in the ILS space has increased since the first fund manager entered the market in 1998, and there is now choice to be had with different investment styles developed. 
*Source: Aon Benfield, Reinsurance Market Outlook, April 2015. 
Mette Charles is a senior member of Aon Hewitt’s global investment management research team, based in London.  

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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