Diversification, (un)correlation and long-term returns: The case for insurance-linked securities

Insurance-linked securities has been the second-best performing asset class since 2002, but its real appeal lies in being the only truly uncorrelated asset class in a market that has become much more volatile

Mark Gibson

We are living in volatile times. That is particularly true for global markets, with stock market volatility, as measured by the VIX index for the S&P 500, having recently reached the highest level since the COVID-19 pandemic five years ago. Meanwhile, global government bond yields are rising sharply as markets digest rapidly increasing sovereign debt ratios.

Schroders has warned before of the unintentional risks for investors who do not make deliberate, active choices in a world that has become geopolitically and economically much more uncertain.

We have also championed the benefits of portfolio diversification, to enhance downside protection, bring potential return opportunities, and, importantly in the current climate, gain exposure to alternative sources of income.

In this context, it is worth considering the potential benefits of insurance-linked securities as a valuable (and perhaps the only truly) uncorrelated source of income within a diversified portfolio – and one that has generated exceptional performance over both recent years, and the longer term.

What are insurance-linked securities?
For the uninitiated, insurance-linked securities are a form of protection bought primarily by reinsurers, but also some corporations and public entities, against the risks associated with specific, catastrophic natural events, for example hurricanes.

The best-known part of the market is catastrophe bonds, or “cat” bonds, which are conventionally tradeable securities that have a three to five-year lifespan. There are also a wide range of privately agreed, non-tradeable securities contracts that have shorter lifespans and provide exposure to a wider range of insurance risks.

In all cases, the securities are issued by special purpose vehicles, into which capital provided by the end investors in the securities is paid. Those vehicles are backed by a collateral account funded by the proceeds from the issuance – and which in turn invest in low-risk instruments such as money-market funds that supplement the income yield paid to investors from the underlying insurance premium.

The structure means that reinsurers are covered in the event that the insured event occurs – and investors are not exposed to credit risk of either the reinsurer or the issuer, as the capital that would be used to meet payouts is held separately in a trust account.

How insurance-linked securities are structured

Source: Schroders Capital, March 2025. Proceeds include from share or bond issuance. Return and payouts include return on collateral, collateral return to investors at maturity, and/or collateral to cover loss payments. Coupon is made up of risk premium + return on collateral.

Attractive yields
Taking a look at the recent numbers, the Swiss Re Global Cat Bond index, which is the key reference point for the publicly listed bonds that are the most well known part of the asset class, was up 17.3% in 2024 and 19.7% in 2023. Both of these were record years, so it is fair to characterise them as outliers.

However, since the index was launched in 2002, cat bonds have generated overall performance that has beaten every asset class with the exception of global equities in terms of annualised returns.

Fundamentally, therefore, the asset class has generated returns equivalent to investments that entail much higher levels of volatility (see chart). This reflects the nature of the risks involved; the higher coupon rates typically available are designed to compensate investors for taking on insurance risk related to low probability, but high severity, events.

Click here to read more...