Edward Torres, president Baldwin & Lyons Capital Markets, argues that the last 12 months have showcased the diversification benefits of insurance-linked securities

Given the challenges facing investment managers today, it is not surprising that many are casting a wider net in search of attractive yields and less volatility. One option, which has received a lot of attention recently, is insurance-linked securities (ILS).

While much has been written about the diversification benefits of this emerging asset class, the last 12 months seem to have finally validated this hypothesis; during the recent market turmoil, ILS consistently delivered attractive/positive returns. Although structural defects in a few bonds exposed these securities to the financial meltdown, the asset class as a whole performed well and remained un-correlated to the wider market.

Background
For those unfamiliar with ILS, they are structured investment products that allow insurers to transfer the risks associated with catastrophes, such as hurricanes and earthquakes to investors; essentially operating as a substitute for reinsurance. The return earned by the investor is a function of the consideration, or premium, the insurer is willing to pay for this 'risk capital'. They come in a variety of forms, most notably catastrophe bonds, catastrophe swaps, industry loss warranties (ILWs) and sidecars.

While intrigued by both the theory and recent performance, many investors continue to associate ILS with 'betting on the weather'. The most common retort to the benefits outlined above has been: "Sure, these have performed well. There hasn't been a large hurricane recently; once that happens you get wiped out, right?"

The reality is that there are a variety of strategies available to ILS portfolio managers, some of which are riskier than others. A common theme across these strategies is that performance is based on the occurrence of fortuitous events.

While this is difficult for many non-insurance professionals to quantify, the insurance industry has a variety of tools available for this purpose. Equipped with these tools, a portfolio manager can select and modify the level of risk they are willing to assume.

High risk/high reward
The most aggressive strategies capitalise on the rapid change in value that can occur while a catastrophe is taking place; this is known as 'live cat' trading. Although trading on US hurricane exposed catastrophe bonds typically slows down during the hurricane season (1 June through to 31 October), there are investors willing to buy these bonds at steep discounts, even as a hurricane is approaching land. These investors may also sell ILWs - derivatives that pay a stated amount if the industry loss produced by the event exceeds a certain threshold.

There is a lot of uncertainty associated with the ultimate magnitude of loss, even within a few hours of landfall. Given this uncertainty, live cat traders must employ sophisticated forecasting models and get paid substantial premiums for assuming the risk.

Low risk/low reward
As with any asset class, the availability of an index provides investors with a benchmark for the market. Swiss Re has produced an index of catastrophe bonds since 2001 - the Swiss Re Cat Bond Total Return Index (Bloomberg Ticker: SRCATTRR:IND). The index tracks the total rate of return for all outstanding US dollar-denominated cat bonds.

Some ILS portfolio managers attempt to mimic the performance of this index and participate across the full range of catastrophe bonds available. With an average rating of double-B and average annual yield since 2001 of 7.5%, the Swiss Re index has outperformed most other high yield strategies since 2001 (see chart below). Portfolio managers attempting to match the index generally limit their participation to catastrophe bonds that have been rated by a rating agency, avoiding ILWs and sidecars.

Managed risk/return
Finally, some portfolio managers employ proprietary models in an effort to optimise the risk-adjusted return across multiple zones and perils. This strategy is premised on an assumption that there are discernable differences between highly similar securities and that the optimal portfolio does not necessarily match the index.

These funds resemble professional reinsurers in their techniques and in their perception of risk. They employ modellers and actuaries, as well as capital market professionals. Recent advances in catastrophe modelling technology, increased availability of data and a consistent sponsor base has established a firm foundation for the asset class.

Measuring the risk
There are a variety of tools available to measure the efficacy of a particular ILS strategy. Most investors utilise ILS to shift the efficient frontier of risk/return in their investment portfolio.

One should be able to measure the 'risk' associated with a portfolio inclusive and exclusive of a potential investment in ILS. Risk is typically defined as the volatility of an investment.

Measurements can include beta, value-at-risk, the Sharpe Ratio or the Omega Function. While each of these measurements has its merits, the ones most applicable to ILS deal with extreme 'tail' events, such as the Sharpe Ratio and the Omega Function.

The exhibit below compares the standard deviation of ILS to equities and high yield bonds.

Conclusion
It is important to recognise that each of the different strategies listed above populates a distinct point on a risk spectrum. In all cases, they allow investors to access an alternative universe of securities with unique characteristics to add to their portfolios.

The correlation between equities and corporate bonds and ILS is demonstrably low. This is particularly relevant to investors interested in attaining the benefits of diversification without giving up yield.

ILS investment strategies lend themselves to a high degree of transparency. An ILS portfolio manager should therefore be able to articulate the strategy employed and place it on the above continuum.