Diversification, not yield, is becoming ILS’s stronger calling card

Higher interest rates have changed the proposition that insurance-linked securities must make to institutional investors, with diversification and portfolio function becoming more important than simply offering an attractive yield, according to Bob Smith, president of Sage Advisory.

With conventional fixed income and other alternatives now providing more compelling returns, Smith said investors no longer need to look to alternative strategies purely to generate yield.

“Higher rates have raised the hurdle for every alternative strategy. Investors no longer need alternatives simply to manufacture yield, so the discussion has shifted toward portfolio function,” Smith told Bermuda:Re+ILS ahead of ILS Bermuda Convergence, held October 12-14.

For Smith, that puts greater emphasis on ILS’s diversification characteristics. Traditional institutional portfolios remain heavily exposed to equity, credit and interest-rate risks, which can become increasingly correlated during periods of market stress.

ILS, by contrast, provides exposure to a return stream primarily driven by insured events rather than economic growth, central bank policy or corporate earnings.

“In an environment where true diversification is increasingly scarce, insurance risk premiums can provide a genuinely differentiated source of return,” Smith said.

The comparison with private credit is particularly relevant as institutional investors weigh competing alternative allocations. While private credit can offer comparable headline yields, Smith noted that its performance remains linked to economic activity, borrower fundamentals, defaults and refinancing conditions.

“The competitive advantage of ILS is not yield alone, but the potential to improve total-portfolio efficiency by adding a return source that is structurally distinct from conventional credit risk,” he said.

At the same time, attractive market conditions have not reduced the emphasis on selection. In fact, investors are becoming increasingly selective between managers, instruments and individual exposures.

Due diligence is extending beyond headline returns to underwriting capabilities, portfolio construction, peril and regional concentrations, trigger types, collateral arrangements, liquidity and reporting.

That scrutiny also applies to catastrophe and climate risk. Smith said investors recognise the uncertainties involved and are asking whether spreads, structures and terms adequately compensate them for both modelled and unmodelled risks.

While the repricing that began in 2022 has left the opportunity set attractive, investors are placing greater emphasis on current catastrophe models, exposure data, attachment points and managers’ willingness to avoid inadequately priced risks.

For ILS to attract materially larger institutional allocations, however, Smith believes the next stage is as much about infrastructure as investment performance.

The cat bond market provides something of a roadmap, with observable pricing, contractual triggers, third-party catastrophe modelling, secondary trading and increasingly established independent frameworks for assessing risk.

Private ILS remains more challenging, particularly where valuations depend on manager-specific models, reserve judgements and loss-development assumptions. “The investment case is already credible; the next stage of growth will depend on institutional infrastructure,” Smith said.

Greater position-level disclosure, consistent valuation practices, stronger performance attribution and clearer reporting could therefore become increasingly important to the market’s growth.

If private ILS can develop stronger standards in these areas, Smith believes institutions will find it easier to “evaluate, monitor, and defend from a fiduciary perspective” – potentially creating the foundations for larger strategic allocations.

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