“Essentially, investors are rewarded for a willingness to take on event-based risks that may, in some instances, require payouts to the insurance companies to cover losses,” says Natalie Burke, senior research analyst at U.S. Bank Wealth Management. “The key is that premiums are priced with the goal of providing investors with a competitive return, even in the event the reinsurer needs to pay claims to cover insured losses.”
Income paid to investors is generated by the reinsurance premiums plus interest income generated by those premiums when invested in high-quality instruments like U.S. Treasury securities.
If, over the term of the security, no trigger event occurs (such as a major hurricane that creates significant insured losses), all principal is returned to investors. However, if a trigger event results in insurable losses, the investor’s principal return will be reduced or even eliminated. It does not affect income payments, since they are primarily generated from premiums charged.
Overall, positive returns are expected when premiums received are in excess of total claims paid out.
Insurance-linked securities and reinsurance
Reinsurance is often funded by investors who purchase insurance-linked securities (ILS). ILS is an umbrella term for financial instruments designed to transfer insurance risks to the financial market, including reinsurance. Unlike traditional investments, ILS essentially put investors in the insurance business. “Your total returns are based on premiums you receive that are intended to cover insured losses while still generating a competitive income stream,” says Merz.
There are various types of insurance-linked securities. Among the most prominent are catastrophe bonds (also known as cat bonds), designed to cover losses from specific, low-frequency, high-severity events such as hurricanes and other natural disasters. Some ILS are considered private, non-tradeable instruments such as quota shares, in which investors purchase a share of an insurance company’s book of business. Different forms of ILS offer different risk exposures and degrees of liquidity.
Burke notes that reinsurance has been a profitable sector over time despite years when significant insurable losses occurred. “Premium pricing adjusts to compensate for new risks or changes in market dynamics,” says Burke. “Experienced catastrophe modeling firms have built models based on hundreds of years of data analytics, and those models are used by reinsurers and funds to determine premium pricing. This enables more effective underwriting of current and evolving risks.”
Although some investors may be concerned that natural disasters such as hurricanes and wildfires are more commonplace, such trends are factored into reinsurance premiums. “Premiums in the catastrophe bond market (as of late summer 2023) pay investors income in the range of 15%,” says Merz. “While reinsurers have more commonly been required to cover losses in recent years, the income stream remains compelling even if we assume average or above-average insurable losses.” This reflects the ability of reinsurers to adjust premiums in response to changing conditions. “Insurable losses are unpredictable from year-to-year, but we know the economics of reinsurance premiums are compelling,” says Merz.
Notably, given that natural disasters seem to be increasing, Merz says it actually creates more attractive opportunities. “Some investors feel the urge to shy away from this segment of the market after large catastrophic events, but insurance premiums (which translate to higher income received by investors) often rise soon after those large events to help insurers recoup losses, which can make the asset class even more compelling.”
Burke adds, “From a social perspective, investors in reinsurance help communities rebuild, typically with more resilient structures after a natural disaster, which has a positive impact.”
Insurance-linked securities diversification benefits
For investors with a long time horizon, a key attraction of ILS is that their performance is not highly correlated with that of other investable assets. Stocks and bonds often respond to economic developments and corporate earnings growth, along with investor sentiment. ILS performance depends on insurance premiums (driven by quantitative and statistical models deployed by insurance companies) minus insured losses (typically driven by the occurrence and severity of natural disasters). Significant differences in return drivers compared to stocks and bonds creates return streams that move differently over time, thus presenting the opportunity for more consistent portfolio performance on a year-to-year basis.
Correlation measures the extent to which asset prices move in the same direction. For example, two “perfectly” correlated asset classes, which experience the same performance, would have a correlation of 100%. Asset classes that perform in perfect contrast to each other would theoretically have a correlation of -100%, and investments with no consistent relationship have a correlation of 0%.
Investors seeking to benefit from diversification search for asset classes with low correlations with one another (along with strong return potential). Lower correlation indicates greater diversification value. As the table below demonstrates, the historical monthly correlation between catastrophe bonds and other major asset classes is low.