The steady, positive returns delivered by insurance-linked securities (ILS) during times of broader financial market downturns, shows that the asset class offers reliable and consistent diversification potential for investors, according to PIMCO.
In a recent report, PIMCO (Pacific Investment Management Company LLC), which is owned by insurance giant Allianz, explores the case for a dedicated ILS allocation amid investor concern about the resilience of their portfolios.
PIMCO, which launched its ILS business in January 2019, argues that as investors search for diversification and higher yields, an ILS allocation is a way to increase both portfolio resilience and return potential.
“ILS are getting increasing attention as investors search for ways to improve portfolio efficiency,” says PIMCO. “As a source of diversification and attractive return potential, they may reduce portfolio volatility and bolster performance during bear markets.”
A hallmark of the ILS asset class is its low correlation with wider financial market turmoil, as seen in the 2008 global financial crisis and more recently during the early stages of the COVID-19 pandemic when markets were volatile.
PIMCO notes that during the 2008 crisis, when global equities posted a -54% peak-to-through return, ILS delivered a positive 5.1%. And, during the pandemic outbreak in Q1 2020, as equities fell by more than 21%, ILS again showed its resilience with a return of -0.1%.
“In fact, between 2002 and 2021, in months when equities posted a negative return, or when high yield spreads widened, ILS delivered positive returns 84% of the time and 86% of the time, respectively,” says PIMCO.
The reason for this lack of correlation is, of course, driven by the fact ILS performance is mostly linked to natural catastrophe events, making the asset class independent of the broader financial market cycle.
“Additionally, as floating-rate securities with yields linked to occurrences of catastrophe events, ILS have managed to stay resilient during periods of rising interest rates,” continues PIMCO.
While ILS has produced “steady income” during times of market stress, PIMCO emphasises that the asset class is not negatively correlated to risk assets. This means that unlike government bonds and tail hedges which can generate meaningful positive returns during these times, it’s more of a steady income flow from ILS.
This is, of course, dependent on the volume of insured losses from natural catastrophe events. After all, ILS will experiences losses and drawdowns when a major catastrophe event, or series of large events occurs.
“Importantly though, history shows that global financial markets have been mostly unaffected by natural catastrophes. For example, over the course of the largest peak-to-through ILS drawdowns – triggered by hurricanes Harvey, Irma and Maria in September 2017, the Tohoku earthquake in March 2011, and Hurricane Katrina in August-October 2005 – global equities were mostly unchanged.
“This is not to say a truly systemic event couldn’t change this dynamic: however, that risk would be unprecedented, and likely undiversifiable,” says PIMCO.
Concluding that, “As investors seek ways to increase the resiliency of their portfolios to market downturns, ILS offer an opportunity to add what we believe is consistent and reliable diversification potential with attractive risk-adjusted return potential.
“We believe ILS can play a variety of roles in investor portfolios, including as an addition to diversifying or absolute return-oriented allocations or as a source of uncorrelated yield in fixed income or alternative credit allocations. Additionally, current pricing may present an attractive opportunity to capture an expanding risk premium.”