Insurance Linked Securities Face Morality Premium

“Perceptions of immorality” tied to catastrophe bonds and other insurance linked securities (ILS) may be forcing issuers to pay investors a higher return, according to research from Germany’s WHL Graduate School of Business and Economics.

“Interestingly, to date issuers of ILS have had to guarantee disproportionally high returns in order to be able to place the bonds on the market,” the paper co-authored by professors Jörg Lindenmeier and Tristan Nguyen says. “It is hypothesized that these disproportionally high returns are at least partially explained by the resistance to innovation of private investors.”

According to the research, catastrophe bonds have offered comparable returns to high-yield since 2002 (Swiss Re Global Cat Bond Index was has returned – 3.56% compared to Barclays BB High Yield Index was – 13.71%) while also giving investors high-grade volatility (cat bonds’ 2.75% volatility compares to high grade bonds’ 6.33%) over the same period.

Despite those attributes, catastrophe bonds have paid a much high spread after being priced over Libor when compared to high and low grade bonds. “From the theoretical view, the expected return on cat bonds should be lower than that of corporate bonds with the same risk rating, since investors should be prepared to pay a premium for the benefit of diversification supplied by cat bonds,” the paper says “However, the ILS market has often showed the opposite result.”

Traditionally, ILS market makers have argued that catastrophe bonds demand a high premium because of illiquidity, a “novelty” premium for their unusual trigger and the “cliff risk” — or immediate payout — of the structures.

“But these explanations seem to be unsatisfactory,” the researcher argues.

Instead, investors are demanding to be paid for ILS “morality risk” in the securities. “The abnormally high returns from insurance, which may be regarded as a symptom of consumer resistance, may be due to the fact that the private investors hold the opinion that the financial risk of insurance-linked securities is systematically higher than the financial risk of comparable financial products,” the paper says “[Insurance-linked] securities may not be perceived as compatible with social norms (“I am not allowed to earn money by investing in catastrophes or disasters!”).”

The solution to getting past investor morality worries and cutting the premium, the research argues, is communication and peer pressure.

“Consumers with a high openness for experience should have a higher inclination towards insurance-linked securities. Within the scope of non-marketer controlled communication processes, these persons can be regarded as innovators, which can push non-innovators to invest in insurance-linked securities by means of social pressure.”

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