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If you are concerned about the stock market that is reaching all time highs and bond yields, that although higher versus a year ago, are still very low where do you go to invest? This is the same question we have been asking for all our clients. To be sure, virtually every client will retain significant exposure to select stocks and bonds depending on their risk tolerance and goals but recent valuations and yields have pushed us to look into alternative investments.
This area of ‘alternatives’ is broadly defined and mysterious to a lot of investors and even a large amount of advisors. Most of the alternatives we have researched had no or poor true diversification benefits versus some combination of traditional asset classes and the majority had a lackluster return profile. In addition almost all of these had very high fees.
One asset class that did impress is little known, but we feel holds significant return and diversification potential. This asset class was unaffected during the 2008 crash and has no correlation to Fed policy, the economy, or interest rates. In addition it has historical (and expected) long term average annual returns of between 5%-10%. This is a combination that is incredibly hard to find, but ‘insurance linked securities’ appear to fit the bill.
Insurance linked securities come in two flavors, ‘catastrophe bonds’ and ‘quota share’.
Catastrophe bonds are very short term floating rate (1-2 years) bond securities issued by governments or insurance companies that are seeking to remove natural disaster risk ‘off their books’. In exchange for accepting this risk they offer competitive yields (5% – 7%/yr. average) which are immune from interest rate and credit risk. The only trigger that will cause a loss of principal is a natural disaster that causes a certain level of insurable losses. This of course has no correlation with anything but the weather.
Quota Share is an actual slice of an insurance company’s business (incoming premiums minus outgoing losses). This type of security has a higher expected return than catastrophe bonds (7% – 10%/yr. average returns) but with a higher level of risk individually. However if you compile a largely diversified basket of these shares you can reduce risk substantially. This is exactly what we are doing (investing in 10-15 unique quota shares) that span risks from Super bowl cancellation, satellites, natural disasters, pandemics, agriculture, marine, and air travel risk.
While a typical investor has significant exposure to ‘stock market/economic’ risk and some have large exposure to ‘interest rate’ risk, very few have any exposure to ‘insurance risk’. Introducing this other type of risk that is not correlated at to either economic or interest rate risk has a tremendous advantage to an overall portfolio’s risk and return.
No asset class is perfect however, so all investors should be aware of a couple important concerns unique to these investments.
- All-Or-Nothing Payoff: In the case of catastrophe bonds, the vast majority will be an all or nothing proposition in terms of payoff. If the bond triggers are not met the investor (in the vast majority of cases) will get 100% of their principal returned with interest, but if a triggering event does occur the investor will most likely lose 100% of their principal. This makes holding any 1 bond extremely risky and unadvisable. Therefore we are holding a fund that holds many diversified bonds so if any 1 security does trigger it will have a small impact over all.
- Modeling Risks: With both quota share and catastrophe bonds the climate/weather modeling that ‘creates’ the agreed upon underlying investment return/risk metrics are not perfect and are very long term orientated. What this combination creates in the short term are results that will deviate largely from long term modeled outcomes. Modeling is getting better and better however, and again if you hold enough diversified investments the risk of any one event being modeled incorrectly is greatly mitigated.
- Limited Liquidity: Liquidity is more of an issue with quota share than catastrophe bonds, as we hold catastrophe bonds through a normal open end mutual fund we can sell at any time. Even though our quota share will be held through an open end fund as well, it will only have quarterly liquidity, as quota share itself does have little interim liquidity. If purchasing the timeline for the funds invested should be for no less than 3-5 years anyway as it is important to hold through a full insurance premium cycle.
We will be moving approximately 10% of most of our client’s portfolio into the asset class with the allocation coming out of both stocks and fixed income within the next month.