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Insurance is typically viewed as a necessary evil. Whether it’s auto, health or home/renter’s insurance, those are expenses most of us to incur and simply deal with it. Profit potential? Forget about it.
Aside select forms of life insurance or investing in insurance equities, generating upside from insurance can be tricky. However, there other avenues through which advisors can turn clients onto income and capital appreciation. Consider insurance-linked securities (ILS).
“Insurance-linked securities (ILS) are products of the rapid development of financial innovation and the convergence of the insurance industry and the capital markets. The securitization model has been employed by insurers eager to transfer risk and use new sources of capital market funding. ILS, both from the life and property/casualty (P/C) sectors, hold great appeal for investors,” according to the NAIC.
While not on par with corporates, munis and Treasurys, catastrophe bonds (cat bonds) – the most prevalent form of ILS – saw issuance exceed $10 billion in each of the past seven years. There are other ILS segments, including life insurance securitization and sidecars, to consider.
Investigating ILS
It’s likely that many clients haven’t heard of ILS and that’s alright because the asset class is easily explained. In essence, a holder of an ILS is acting as reinsurance company, meaning they collect premiums while taking on some risk, namely the specter of potential loss.
Another point for advisors to articulate to clients is that ILS differ from traditional bonds in that the credit quality of the issuer isn’t all that important. Rather, the probability of a loss-making event is what defines risk in this asset class.
“In ILS such as cat bonds, if the triggering events, such as a hurricane, do not happen within the agreed period, the investor will receive regular coupon payments based on premiums. The principal will be repaid at the end of the investment term,” notes Schroders.
Conversely, if a force mejure event occurs during the life of the ILS, it’s possible that the interest paid to the investor could be reduced and should such an event take place, it’s also possible that when the bond matures, the repayment terms delivered to the ILS holder could be dramatically altered for the worse or outright eliminated.
Translation: ILS have benefits, but they aren’t free lunches when it comes to risk.
Speaking of ILS Benefits…
Simply because there is some risk attached to ILS doesn’t mean the asset class lacks for selling points. In fact, ILS offer perks relative to standard fixed instruments because, as noted above, credit risk is minimal. Likewise, ILS aren’t sensitive to the Federal Reserve raising interest rates.
Additionally, ILS can act as important portfolio diversification tools because this form of debt has low correlations to standard bonds and stocks. Plus, there are robust income streams tied to ILS.
“Many ILS offer attractive yields to compensate investors for taking on insurance risks. These higher coupon rates can provide a potential income stream that is independent of interest rate fluctuations or dividend payments from stocks,” concludes Schroders.
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