As a growing segment of the alternative investing landscape, insurance-linked securities (ILS) may provide a diversifying source of returns that help embed resiliency in portfolios during periods of financial market stress. PIMCO has built an ILS investing platform to tap into this growing opportunity. In this Q&A, Portfolio Manager Rick Pagnani, Head of Corporate Development Colin Riendeau, and Strategist Chris Santore discuss the role ILS can play in portfolios and PIMCO’s approach to the asset class.
Q: What are insurance-linked securities, and why do they exist?
Pagnani: Growth in the global demand for insurance has outstripped growth in traditional reinsurance capacity – which is how property insurers manage their risk and continue to grow. So the capital markets have developed a solution: Insurers can transfer a portion of their insurance risks to investors through insurance-linked securities, or ILS.
Increasingly, many insurers and reinsurers are tapping into the ILS market. Reinsurance can be particularly valuable for insurers in managing exposure to natural catastrophes, which is costly to maintain on the balance sheet in part due to high regulatory capital requirements. Many reinsurers are also facing capital constraints, much like insurers, and are looking to cede some risks by issuing ILS.
The result has been a substantial increase in overall market capacity, with investors meeting almost $100 billion in demand for global reinsurance last year (see Figure 1).
Catastrophe bonds (cat bonds) are probably the most well-known securitization of insurance risk. The typical cat bond works as follows: Issuers pay coupons to investors in exchange for protection against losses from specific catastrophe events over a certain time period. More recently, other forms of insurance securitization – industry loss warranties (ILWs), sidecars, and collateralized reinsurance – have become large components of the market, creating a broader and deeper ecosystem for active ILS managers (see Figure 2).
Q: Why are investors embracing ILS?
Santore: ILS are appealing, in part, because they may provide portfolios with a diversifying source of returns. Because ILS performance is driven by the occurrence of natural events – such as hurricanes, earthquakes, and floods – and not by the financial markets, ILS may provide a source of returns that is unrelated to the performance of financial markets.
Importantly, the diversification properties of ILS have been demonstrated across severe financial market events. For example, during the global financial crisis in 2008−2009 – when global equities were down 54% – ILS returned 5.1%, based on the Swiss Re Cat Bond Index (see Figure 3).
ILS have also generated attractive returns on a standalone basis, delivering positive annualized returns of nearly 8% between 2002 and 2018, with volatility of less than 4% (for the Swiss Re Cat Bond Index).1
Taken together, diversification and attractive absolute and risk-adjusted returns can have a powerful impact on portfolios, potentially increasing returns, decreasing volatility, and improving the overall downside risk profile. For these reasons, ILS allocations are on the rise globally. ILS may be of particular appeal in the context of late-cycle challenges of lower expected returns and higher potential volatility across financial asset classes.2
While we think all ILS instruments can serve as portfolio diversifiers, we believe that customized, direct origination in collateralized reinsurance contracts (collateralized re), which are bespoke, privately negotiated investments, have particular alpha generation potential.
Q: What should investors consider when determining whether to invest in ILS or equity in a reinsurance company?
Pagnani: The simple answer is that reinsurance equity invites market-beta risk. Looking across the universe of reinsurers, most carry an equity beta of 0.4 to 0.6. And that makes sense: Reinsurance company stock is subject to the same myriad underlying risk factors that would move any publicly traded equity (macroeconomics, geopolitics, interest rate risk, and others).
Exposure to reinsurance company equity also brings with it the idiosyncratic risk associated with the operations of the company and the multiple lines of insurance written. There is not a single reinsurance company that only reinsures property catastrophe risk; most write many lines, including workers’ compensation, directors and officers liability, professional liability, etc., that have potential correlations to financial market performance.
By contrast, ILS are intended to provide pure exposure to catastrophe risk, which is uncorrelated to financial market performance.
Q: How did PIMCO build an ILS platform?
Riendeau: At PIMCO, we want to help clients meet the challenge of generating returns across varying market environments, and we seek opportunities to develop investment strategies that are designed to deliver returns that are unrelated to financial markets, but the inherent complexity of ILS presented notable barriers to entry. We assessed the expertise and infrastructure required to build a high-quality ILS platform and determined that we believe we have what it takes to build a differentiated platform.
We determined that the right investment team at PIMCO, one of the largest global asset managers, and a strategic relationship with Allianz, one of the largest global insurers and PIMCO’s parent company, could make ILS a compelling investment solution, and we committed significant resources to building this business. By working together with Allianz, PIMCO now has an ILS platform with a distinctive value proposition that is built on:
- Access. A defining component of alpha in ILS is the ability to have direct and consistent access to risk, which can be difficult to achieve for start-up managers and difficult to scale for even established participants. To that end, we have developed a new strategic relationship in ILS with Allianz that provides numerous potential advantages, including access to risk, operational efficiencies, and knowledge-sharing.
- Independence. While our relationship with Allianz is a key differentiator, we were careful to structure it to align the interests across both firms with the interests of PIMCO’s clients. The PIMCO team is fully independent and under no obligation to take any risk from Allianz; we have full flexibility to source risk from both Allianz and third-party insurers and reinsurers.
- Underwriting. We have carefully selected a team of dedicated insurance specialists with an average of over 20 years of multidisciplinary insurance experience, supported by proprietary analytics and technology.
Q: How is PIMCO’s ILS business different from others’?
Pagnani: PIMCO has the prerequisites for a successful platform: an experienced team, multidisciplinary experience, infrastructure, and analytics. But our relationship with Allianz is a key component of what sets us apart.
Allianz is the largest property and casualty insurer in the world, with the commensurate resources, relationships, and infrastructure. Their experience and size are valuable enough in themselves, but they have also built their reinsurance business in a distinctive way. They have only 2% exposure to U.S. risk, with the rest of their portfolio diversified elsewhere. The typical ILS market portfolio is exactly the opposite: U.S. peak peril risks (such as Florida hurricane exposure) dominate, and sourcing quality risks in the rest of the world is a tough challenge. We believe that Allianz’s global risk footprint significantly enhances our ability to build robust, diversified ILS portfolios.
Achieving diversification in ILS is not easy. Our strategic relationship with Allianz enables us to manage downside risk through extensive diversification across global exposures, with the ultimate goal of seeking to deliver more consistent returns to clients.3
Q: How do you go about analyzing ILS investments?
Pagnani: PIMCO’s ILS platform focuses first and foremost on fundamental underwriting. Our team, which has broad technical experience in traditional insurance and reinsurance, conducts fundamental analysis and underwriting of risk, and we believe that is ultimately how we can deliver alpha for our clients.
To support our underwriting effort, we use multiple catastrophe-risk models enhanced by proprietary analytics that help us understand, quantify, and manage risks based on meteorological science (earthquake, hurricane, flood, etc.), property engineering, and claims information.
All models have their limitations, however, and we find considerable uncertainties in vendor-model outputs even for well-understood regions and perils – and non-modelled perils present even more uncertainty. Understanding those limitations and adjusting risk exposure accordingly are crucial to our process. This is another area where our relationship with Allianz adds value, affording us access to the resources and experience of one of the largest and longest-tenured insurers, including the latest meteorological insights, analytical tools, and technical experience.
Q: Where does PIMCO fit in the ILS landscape?
Riendeau: Historically, captives and independents have dominated the ILS market. Captives are funds set up by reinsurance companies with direct access to their book of business, but no flexibility to source risk elsewhere. Independents have the flexibility to source risk wherever they want in the market, but no dedicated access or alignment of interests with insurance companies.
At PIMCO, we have built a hybrid model that combines direct access to a reinsurance company with the flexibility to source risk wherever we see value. We have direct access to Allianz’s global book of risk but no obligation to take it. That’s an important point: We have full flexibility to source risk from both Allianz and the open market, which expands our opportunity set.
Our business model results in the ability to build a flexible portfolio diversified across the spectrum of ILS, by instrument, geography, peril, and issuer.
Q: How do you see the opportunity in ILS evolving?
Riendeau: First of all, insurance markets are growing. There is more and more need for primary coverage and thus reinsurance capacity, which opens up more opportunities for an ILS platform like ours.
We also see a clear opportunity to bring investor capital closer to the source of risk, and we intend to continue searching for ways to trim costs associated with transacting reinsurance.
Ultimately, we think PIMCO is well positioned to capitalize on continued growth and evolution in the ILS market. We have access to ILS risk from a variety of sources; we have dedicated resources to deploy capital, with runway to expand and grow; and we have a long-term, strategic partner that wants to grow with us and our clients.
1 Past performance may not be indicative of future results.
2 There can be no guarantee that the trends above will continue. Statements concerning financial market trends are based on current market conditions, which will fluctuate.
3 Any investment entails the risk of loss, including loss of the entire investment.