Debunking the Myth: Chasing Heat in Natural Catastrophe Insurance-Linked Securities?
Natural Catastrophe (‘Nat Cat’) Insurance-Linked Securities (‘ILS’) are financial instruments that allow insurance and reinsurance companies to transfer risk from natural disasters (such as hurricanes, earthquakes and floods) to investors. Nat Cat ILS provides insurers a mechanism to manage their risk exposure while offering investors a chance to earn returns that are generally not correlated with traditional financial markets.
Investors enjoyed record high spreads in the cat bond market in 2023, and the excess spread above expected loss for 2024 appears healthy relative to historical expected returns. Accordingly, Nat Cat ILS strategies have continued to draw increasing attention from investors globally.
After a period of historically high returns for any asset class, the phenomenon known as "hot money" is an oft-quoted fear amongst seasoned investors. The concept is simple. The influx of “hot money” can lead to speculative bubbles, where the price of assets increases beyond their intrinsic value. When the bubble bursts, investors may face significant losses as prices correct themselves. Classic examples have included the Dot-com bubble of the late 1990s or cryptocurrency speculation in 2020-21.
However, a closer examination of the Nat Cat ILS market reveals a starkly different narrative. Contrary to popular belief, Nat Cat ILS has not been a magnet for hot money. This article delves into the reasons behind this phenomenon.
Misconceptions Around Nat Cat ILS
The misconception that Nat Cat ILS attracts hot money primarily stems from the misunderstanding of the nature of these instruments. ILS, including catastrophe bonds, sidecars, and collateralized reinsurance, are designed to transfer risks from insurance and reinsurance companies to capital market investors. They are more akin to fixed income as opposed to speculative investments, such as equities, commodities or cryptocurrencies.
According to Aon Securities, the reinsurance industry’s alternative capital grew from $93 Billion in 2022 to $108 Billion. The share of alternative capital as a percentage of global reinsurer capital was 16.1% - slightly ahead of the 10-year average of 14.5%. Such a measured yet healthy increase underscores the evolving investor confidence in the ILS sector, indicating a shift towards long-term, strategic investments rather than the transient, speculative capital flows typically associated with “hot money”.
This also points to the growing demand for insurers and reinsurers to expand their use of alternative capital. According to John DeCaro, Founding Partner and Co-CIO of Elementum Advisors LLC: “One of the sea changes is the fact that there is a very broad level of interest in issuing product across the universe of potential issuers, and that’s very beneficial.” Further, “The question is going to be will there be sufficient capital coming into the market to absorb all the supply that sponsors will want to bring to the market.”
Investors in ILS funds are often institutional investors, such as super funds, pensions and insurance companies, seeking diversification and long-term uncorrelated returns (as opposed to quick profits). These investors require a long-term investment horizon. This, added to the fact it takes a long time for them to complete due diligence and educate an investment committee before allocating capital, is why institutional investors are generally less prone to chasing heat.
Regulatory and Entry Barriers
The insurance and reinsurance market is also characterized by regulatory and entry barriers that discourage the influx of hot money. The regulatory framework for the insurance and reinsurance market includes rigorous approval processes, licensing requirements, and solvency and capital adequacy regulations. These ensure transparency, risk disclosure and investor protection.
Investing in Nat Cat ILS often requires specialized knowledge and the ability to navigate operational complexities, which acts as a deterrent to the speculative, short-term investors typically associated with hot money. Furthermore, the due diligence process for these investments is rigorous and time-consuming, favouring investors committed to understanding the underlying risks fully.
Performance Stability
Despite the inherent risks associated with natural disasters, the Nat Cat ILS market has shown resilience and stability over time. Since 2005, the Eurekahedge ILS Advisors Index (a benchmark which tracks the performance of participating ILS funds) has exhibited an annualized standard deviation of only 3.5%. For reference, the annualized standard deviation of 10-year treasury bonds has been roughly 3.8% over that same period.
This stability is one of the key reasons investors favour Nat Cat ILS. However, this same stability and uncorrelated nature make them less attractive to hot money, which often chases volatility and high returns in more traditional asset classes.
Conclusion
The narrative that hot money has been flowing into Nat Cat ILS is a misconception borne out of a fundamental misunderstanding of the nature and requirements of these investment instruments. The long-term investment horizon, sophisticated risk assessment, regulatory barriers, and the need for specialized knowledge have collectively acted as a bulwark against the influx of hot money. As the Nat Cat ILS market continues to evolve, it remains an essential tool for risk transfer and diversification, grounded in the commitments of long-term, strategic investors rather than the fleeting interests of speculative capital.
