Watson Wyatt is advising some of its clients to consider incorporating a portfolio of insurance-linked instruments in their return-seeking portfolios.
According to the firm, most investors lack genuine diversity – being mainly reliant on equity exposure – which can be remedied through greater allocations to other forms of rewarded risk, such as credit or insurance.
Robert Brown (pictured), chairman of Watson Wyatt’s global investment committee, says: ‘We recommend that institutional funds with sufficient governance seriously consider the merits of certain insurance-linked instruments as they offer attractive risk-adjusted returns, while at the same time genuinely diversifying the portfolio.’
According to the firm, insurance-based strategies break down into three main categories:
• Price assurance strategies, which provide an extra return to the investor in exchange for price certainty i.e. the investor takes on the price risk (e.g. commodity futures)
• Price insurance strategies, which compensate investors for providing protection against extreme price movements, but provide a highly asymmetric payoff profile (e.g. selling puts on equities or bonds)
• Event insurance strategies, which compensate investors for providing protection against extreme events (e.g. catastrophe reinsurance)
Brown says: ‘For example, a well-structured portfolio of insurance instruments provides an effective diversification opportunity for investors. They also appear attractive now, based on elevated premium levels due in part to a reduction of available capital in the market. This approach is more a direct play than investing in insurance company shares, which also have undesirable general equity exposure.’
According to the firm, an appropriately diversified portfolio of insurance instruments can return around four to six per cent above Libor. In addition to the insurance risk premium, the firm advocates diversity across strategies that exploit other risk premia such as equity, credit, time/ illiquidity and skill.
Brown adds: ‘Given the complexity, this is for investors with high governance. With a typical allocation of two to five per cent of their return-seeking allocation, investors need to acknowledge that this will involve specialist management, a diversity of non-traditional instruments and deployment that matches liquidity conditions. All of these require the application of significant resources.’
