Diversification for the sake of diversification

The use of capital markets capacity was originally needed more than 20 years ago to ameliorate a shortage of property catastrophe reinsurance in the aftermath of Hurricane Andrew and the Northridge earthquake. 

Prior to the 2005 Atlantic hurricane season, the ILS sector was viewed by many institutional allocators as a niche investment without the critical market size needed to justify adding ILS to a broader portfolio. Diversification opportunities in the ILS sector were largely limited to natural catastrophe exposures in the US, Europe and Japan, which coincided with the (re)insurance industry’s need for capacity. 

The capacity shortage and hard market conditions that ensued after 2005 helped serve as a catalyst for increased interest in the asset class by investment consultants and early adopters. According to Aon’s April 2016 Reinsurance Market Outlook, alternative capital ($72bn) was equal to 13% of reinsurance capital ($565bn) in 2015 versus 5% in 2007. This rapid growth of alternative capital raises questions: is diversification into ILS sufficient in a broader portfolio context, or is additional diversification needed within the ILS bucket? 

Based on my experience over the past 19 years in the sector, I fundamentally believe that the (re)insurance industry’s need for risk transfer capacity (demand) drives the ILS market, rather than the amount of alternative capital seeking investments (supply). Of course, an excess supply of investor capital can create new demand or shift reinsurance purchases towards the capital markets, but only at a lower price than otherwise. 

The laws of supply and demand have not been repealed for the reinsurance industry. 

Niche 

Alternative capital providers are currently assuming exposure to a number ofnon-peak elemental and niche lines of reinsurance. For example, these can include, but are not limited to, variousnon-US and Japan earthquake risks as well as longevity, mortality, marine, aviation, satellite and terrorism risks. Additionally, there is growing demand for protection against cyber risks and Chinese natural catastrophes. If the reinsurance industry is grappling with how to underwrite these exposures, can alternative capital providers expect to do any better? 

 The investment thesis for expanding beyond traditional peak natural catastrophe areas is generally predicated on the idea of minimising the losses resulting from a single event via broader portfolio diversification and deploying excess investment capital beyond a limited opportunity set within areas of peak risk. 

In theory, diversification may be better than concentration, as the higher probability of a smaller loss outweighs the lower probability of a large loss, though this is dependent upon investor preference. 

Several issues arise in practice. Technical underwriting for some niche risks can be more complex, which may result in greater uncertainty surrounding the probability of loss when compared with peak cat risks. This increases the difficulty of determining whether the risk premium is appropriate. Surplus capacity for niche risks relative to peak risks can lead to lower risk-adjusted pricing, resulting in lower no-loss returns compared to a more concentrated portfolio. 

ILS fund managers may not possess the expertise necessary to source and underwrite niche risks to the same extent as reinsurers, given the limited demand for and technical nature of, some of these exposures. Thus investors could incur adverse selection and moral hazard risks, depending on the type of investment. 

As alternative capital continues to seek new risks for diversification reasons, attritional losses historically covered by reinsurers have potentially negatively impacted some ILS portfolio returns. Notably, the Costa Concordia sinking, Tianjin explosion, Thai floods, Hurricane Patricia, US tornado events and the Christchurch earthquake are all examples of events which potentially have caused losses to creep into more diversified ILS portfolios. 

This raises one final issue for institutional investors – expectations management. Most ILS investors are conditioned for the inevitable “Big One,” such as a devastating Miami hurricane or a Los Angeles earthquake. While a portfolio holding a basket of non-peak and non-elemental risks can help minimize extreme losses, it may do so at the risk of generating frequent, smaller losses from events that have no material impact on overall reinsurance capital levels. 

The laws of supply and demand have not been repealed for the reinsurance industry

Whether investors are prepared to stomach more frequent but smaller losses over the long term remains to be seen, though alternative capital has remained stable and even grown after larger cat events. 

In the meantime, it may well be that ILS investors diversify at their own peril.