When reviewing hedge fund portfolios, those investing in insurance-linked securities (ILS) are finding that this oft-overlooked strategy is buoying performance for the whole year. Callan published an extensive primer on the strategy in 2021.

Since then—and really since 2017 when the trifecta of Hurricanes Irma ($61 billion), Maria ($109 billion), and Harvey ($151 billion) led to record losses in the U.S.—insurance premiums have been steadily increasing as insurance carriers charge homeowners more in higher-risk locations, and reinsurance investors have not stepped in to fill the demand for capital, further fueling the dislocation in the reinsurance market.

ILS Returns 2023: Background

Reinsurance premiums have increased as measured by the Guy Carpenter Rate-on-Line Index from 2017, when the current increasing trend started, to 2021, when Callan published its ILS primer, by 17%. In the past two years, pricing has increased 42% and is expected to further increase in 2024 (index values of 170.8 in 2017, 199.19 in 2021 and 285.4 in 2023).

While the accelerating rate of pricing on reinsurance contracts is impressive, this only represents how much insurers are paying cedants to offload reinsurance risk for the year. Said another way, it’s the maximum return ILS investors can expect to receive, assuming no losses. Reinsurance investors are also being paid about 60% more for taking the same risk today versus in 2017.

How much institutional investors are taking home in this banner year is dependent on a product’s differing levels of risk. Retrocessional and collateralized reinsurance contracts that will share starting at a lower level of insured losses will naturally have a higher return than much more liquid catastrophe bonds and other collateralized reinsurance contracts that will start sharing at a higher level of insured losses.

As we noted in the primer, the two primary indicators of reinsurance performance are the SwissRe Cat Bond Index and the Eurekahedge ILS Advisers Index. Year-to-date through October, the indices have returned 17.7% and 12.9%, respectively. And as the hurricane season comes to a close around this time, conventional reinsurance accounting allows investment managers to realize the lion’s share of this year’s gains during the hurricane season, which starts in June.

This year’s banner year is due to a perfect storm (pun intended) of economic and market-based factors. First and arguably most important, there is a supply/demand imbalance in the market for reinsurance capital that is pushing up reinsurance premiums. Second, the recent increase in inflation is built-in to the level of insurance capital required as repairing or rebuilding damaged properties is more costly than in prior years. Third, the higher interest rates are a tailwind to the strategy. Collateralized contracts require funds to be placed in a trust account for the duration of the contract, and the assets are typically invested in T-bills. Compare the interest rate now—rates are around 5%—to 2021 when rates were just above zero, and investors are essentially given a 5% head start. Fourth, insurance companies have been smarter limiting risk in their insured portfolios by either deeming some properties uninsurable or charging exorbitantly high premiums for high-risk property. Lastly, so far, 2023 has seen relatively low (although still devastating) hurricane and firestorm activity in the U.S. Thankfully, nature has given human-kind a bit of a break so we can focus on geopolitical and economic issues, in many cases disasters of our own making.

In summary, astute investors that were fortunate enough to identify the opportunity and invest are reaping the rewards in this strategy. While current levels of natural disaster activity should not be the expectation going forward, the other factors contributing to outperformance are expected to persist or not change for 2024.