A strong insurance-linked securities (ILS) manager is distinguished over a full market cycle by their ability to maintain discipline, limit drawdowns during severe events and ability to avoid reaching for yield late in the cycle, according to Francois Divet, Head of ILS Team at BNP Paribas Asset Management.
“A strong manager maintains discipline, limits drawdowns during severe events and avoids reaching for yield late in the cycle. Diversification may reduce returns slightly in quiet years, but it protects capital when large events occur. That consistency is critical,” Divet explains.
Throughout recent years, the ILS market has gained rapid momentum with more insurers and reinsurers entering the market whether its through the use of catastrophe bonds, reinsurance sidecars, industry loss warranties (ILWs), or life insurance-linked products.
The most well-known form of ILS is catastrophe bonds. In the article, Divet explains why insurers choose to issue cat bonds rather than solely relying on traditional reinsurance.
“Insurers use both traditional reinsurance and capital markets solutions. ILS is both a complement and, in some ways, a competitor to the traditional reinsurance market. One key advantage of cat bonds is that there is no counterparty credit risk. The collateral is fully funded and segregated in an SPV. In contrast, with traditional reinsurance you are exposed to the creditworthiness of the reinsurer,” the executive noted.
However, Divet outlines that another key difference is maturity, which can ultimately play a factor towards strengthening an insurer’s negotiating position with reinsurers.
“Cat bonds typically provide three years of protection, whereas traditional contracts are often renewed annually. That allows insurers to lock in pricing for longer. In some cases, using capital markets can also strengthen an insurer’s negotiating position with traditional reinsurers,” he added.
Whilst the ILS asset class can afford meaningful diversification, Divet cautions that it cannot truly eliminate tail risk.
“If you invest in a single cat bond, you can lose 100% of your investment. So diversification is absolutely essential. We diversify across perils and regions — for example US hurricane, US earthquake, European windstorm or Japanese earthquake. We diversify geographically at a lower regional level. For example, within the US hurricanes, exposure to Texas is not the same as exposure to Florida. We also diversify structurally, across senior and junior layers and different trigger types,” the executive noted.
Adding: “That said, we cannot eliminate tail risk entirely. Many bonds are exposed to peak perils such as US hurricane and US earthquake. If a truly extreme event occurs in those regions, multiple bonds in a portfolio may be affected simultaneously. Diversification reduces drawdowns, but it does not remove systemic catastrophe risk.”
In regard to what perils and regions BNP Paribas Asset Management chooses to emphasise across the ILS market, Divet affirms that the company operates within clear portfolio guidelines, and targets a specific expected loss at fund level, which he says is typically around 2–2.5%, and applies hard limits by peril and geography.
“US hurricane remains the largest risk in the market, followed by US earthquake. But we manage exposure carefully to control downside risk. We are not trying to trade the market actively; once we are comfortable with a bond, we typically hold it to maturity unless conditions change materially or when the bond is no longer at risk due to the seasonality of the underlying perils covered,” he added.
