Diversification for ESG portfolios: the case for Insurance-linked securities
2024 was a year of positive surprises for financial markets, with the S&P500 surging over 27% defying earlier forecasts. Much of this growth was driven by tech stocks, with market polarization being a defining theme of the past year. This market concentration has hurt active managers and thematic investments such as sustainable and impact investing, with the latter underperforming unconstrained mandates.
When looking forward to 2025 we are mindful of the risk of higher rates on the economy. Inflation is on a downward trajectory, but bond markets might have overestimated the speed at which central banks can bring inflation back to their 2% target. The Bank of England has slowed down the pace of cuts, deciding not to lower the base rate in December and the Federal Reserve has signaled that their priority is once again taming inflation.
With this scenario in mind, we have focused on alternative investments that are not exposed to the risk of higher rates for longer, such as insurance linked securities which we have added to ESG portfolio in Q4 last year.
ILS or insurance-linked securities are financial instruments that transfer insurance risk from insurers and re-insurers to capital market investors. They allow the former to offload risk and access additional capacity, and since returns are determined by weather events- which are naturally uncorrelated to bond and stock markets – they can provide diversification to a balanced portfolio.
By their nature, ILS align well with our commitment to environmental, social, and governance principles as they play a crucial role in addressing climate change-related events.
In particular Cat bonds, a specific segment of ILS, mostly transfer reinsurance risk associated with natural peril events that are remotely occurring but highly costly for the insurance markets. These may include hurricanes, earthquakes and other weather-related events.
ILS help insurers and reinsurers manage these growing risks. By investing in these products, we can then support the insurance industry’s ability to provide coverage for climate-related events, enhancing social resilience and providing financial support for rebuilding efforts after natural disasters.
For instance, when a catastrophic event occurs, ILS can quickly release funds to affected areas, supporting rapid recovery and reconstruction of housing and public infrastructure.
While traditional investments, such as the aforementioned infrastructure and real estate, are vulnerable to the long-term impacts of climate change, ILS have a low duration of typically up to a year, mirroring the annual renewal of the underlying insurance policies they back-stop. This implies that ILS can re-price their returns to climate change risk in the near term, offering up-to-date compensation to investors.
As the asset class develops, insurance-linked securities are also gaining recognition for their ESG credentials. A significant portion of ILS assets are now classified as Article 8 under the European Union Sustainable Finance Disclosure Regulation (SFDR), highlighting their sustainability focus. Moreover, ILS are increasingly being used with a development angle, such as bonds issued to protect against earthquake risk in developing countries. This approach allows investors to support disaster risk financing in developing nations, aligning with sustainable development goals.
The financial benefits of these products also offer a compelling narrative. They often offer favorable terms compared to corporate bonds of similar credit quality. ILS are trading on an average spread of 8.8% over the risk free and they display a current average expected credit loss of just over 2% which compares favorably to the 3.2% credit loss for global high yield bonds as reported by the credit rating agency Moody’s.
Figure 2: Insurance-linked securities average expected loss and spread by year
Source: www.Artemis.bm
In conclusion, by incorporating ILS into our investment strategy, we are not only potentially enhancing returns and diversification but also contributing to a more resilient and sustainable global economy. This addition reaffirms our commitment to responsible investing and our dedication to generating positive impact alongside financial performance.
Tiziana Maida
Head of Research