How insurance-linked securities provide diversification for investors

Providing exposure to natural catastrophe risk such as earthquakes and hurricanes, the performance of insurance-linked securities (ILS) is effectively uncorrelated to that of broader capital markets – and is therefore unaffected by market, economic, or geopolitical volatility.  A financial market crisis cannot cause an earthquake or a hurricane.  As a result, the asset class is seeing increased interest from investors seeking diversification and an alternative source of income and returns.

Furthermore, since September 2022, when Hurricane Ian hit Florida in the USA, the ILS market recovered very quickly from the impact of that storm and saw record returns in 2023 and 2024, driven by high spread multiples and a lack of major catastrophe events. 

The decorrelated nature of ILS has insulated it from volatility related to major market crises

Today's insurance-linked securities market stands at around $115 billion – $55 billion in catastrophe bonds (the “public”, traded segment of the ILS market), and $60 billion in private transactions.  While this may seem small compared to other fixed-income markets, the growth is substantial as the asset class becomes increasingly institutionalised.

A key attraction is its decorrelation to current and past market volatility. From the Financial Crisis in 2008 or COVID volatility in 2020, to the current trade war and geopolitical tensions, natural catastrophes don't care about interest rates going up or down or stock market peaks and falls.

Forecasts for hurricane season activity do not necessarily correlate to impacts on portfolios

Portfolio construction and positioning, based on the ability to assess risk as accurately as possible, are key.  We employ a combination of third-party and in-house models to help us understand the risk that is presented to us and to determine the appropriate level of risk premium.  Among other key drivers, our modelling capability allows us to factor in the effects of climate change.

A US hurricane is a major peril within the ILS market.  Indeed, the ILS market emerged in the years immediately following Hurricane Andrew in 1992, during which time it became increasingly apparent that risk-bearing capital, in addition to what was available in the reinsurance industry, was necessary to cater to the size of potential future catastrophes.  Note that the growth in size of losses is driven not only by the impact of climate change for certain perils and territories but also by the increasing concentration of high-value residential and commercial properties in those regions.

Sea surface temperatures in the Atlantic and Gulf of Mexico are one important factor, out of many, when considering potential hurricane activity from year to year.  The 2024 hurricane season was forecast to be materially above average and led to dramatic headlines in the press in the Spring of 2024.  However, for the ILS market to be impacted severely, it is not enough to have an above-average active season from the point of increased frequency and severity of storms.  There also needs to be a landfall of a major storm in a region of high insurance values.  Predicting an above-average season is not the same as predicting where major storms will make landfall.  In the event, 2024 was an active season, but it passed without any major losses impacting the ILS market.

Outlook for ILS

While it’s unlikely to be as active as the 2024 season, the 2025 US hurricane season is touted to be another active hurricane season with warm sea temperatures and the Atlantic Ocean Energy (ACE) measure still high. But, while we expect portfolios to be tested, ILS portfolios allow astute managers to ensure that the focus is not solely on hurricanes but on earthquakes, European storms, and other perils.  Portfolios can therefore be constructed in such a way that they're resilient and diversified within the natural catastrophe space.

That said, we do not over-diversify our ILS portfolios given that the asset class already provides diversification in itself.  As a result, we tend to focus on certain peak risks that we think we can model well.

Structuring and modelling underpin success in this area

Being able to assess the natural catastrophe risk in ILS is critically important, as discussed above.  Our risk analysts include people with relevant scientific qualifications to help us evaluate third-party models and to build our own view of risk where necessary.

A deep knowledge of the insurance and reinsurance industry and its risk transfer mechanisms is also important for building a successful ILS portfolio.  Understanding the underlying business of the protection buyers and the mechanics of ILS transactions, including their trigger mechanisms, is very important.

* Gibson is the senior investment director at Schroders Capital,

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