With the insurance-linked securities (ILS) sector continuing to expand, institutional investor appetite within the space has been resurgent.A new paper from consultancy firm bfinance acknowledges that manager selection within the market involves distinct challenges, with unique investment risks and notable operational complexity to consider.Recent demand for ILS strategies has been particularly strong.While pricing has begun to soften, with rate-on-line levels coming off their historic highs, returns are still elevated when compared towards the pre-2020 period.

“Higher-for-longer interest rates have supported attractive yields, while the sector demonstrated its ability to provide diversification versus traditional asset classes thanks to its dissociation from macroeconomic variables,” bfinance explains in its paper.“Yet asset owners looking to invest in catastrophe (cat) bonds and/or private ILS transactions should be wary to avoid ill-suited strategies.The investment universe is broad and evolving, with new trends including the emergence of the cyber risk segment.

ILS investment strategies vary greatly in terms of their objectives and underlying risks, contributing to significant performance dispersion.” Years of elevated catastrophe activity, underperforming funds, and trapped collateral exposed gaps in risk models, portfolio construction and deal terms.However since 2022, enhanced pricing, higher interest rates and revised structures have contributed to  improved catastrophe bond outcomes and attracted new and returning capital into ILS strategies.bfinance also urges allocators to frame ILS portfolios primarily through a risk lens rather than fixed return hurdles.

The firm points towards expected loss as being the core risk anchor, often supplemented by tail measures such as 99% Value at Risk (VaR), to establish risk appetite and compare strategies.“A typical cat-bond-only strategy might target an expected loss of 2–3%, with a 1-in-100 year modelled loss (99% tail VaR) in the range of 25- 30%.More aggressive strategies that include private reinsurance contracts may tolerate expected losses of 5-6% and tail losses up to 40% or more.

The most aggressive strategies (those aiming for cash plus 10–15%) may accept expected losses approaching 10% and higher modelled tail risks,” bfinance explains.Additionally, liquidity is described as a key design variable for ILS mandates.Portfolios concentrated in listed catastrophe bond funds can often support daily or frequent dealing, whereas strategies with exposure to private collateralized reinsurance may need longer notice periods, lockups, gates and slow-pay mechanisms to reflect underlying settlement timelines.

bfinance goes on to suggest that investors should not expect full redemption in under a year where private ILS forms a significant share of the portfolio.Furthermore, the consultancy’s report also lists out a number of constraints and limits that asset owners can use to shape risk.These include caps on niche instruments such as industry loss warranties, quota shares, or retrocessions, peril-specific limits informed by contribution to expected loss rather than portfolio market value, diversification by cedant and trigger type, as well as controls on specialty lines, aggregate structures and leverage.

Regarding implementation, bfinance’s report weighs the merits of pooled funds, funds-of-one and separately managed accounts (SMAs) noting that SMAs in this specialist segment can involve greater operational and documentation complexity.“Fund managers are typically willing to replicate their standard strategy with a carve-out SMA or fund- of-one for mandates of around US$30 million and above; for US$100 million many will go further and fully customise a portfolio to meet client-specific objectives and constraints.“The choice of whether to do so tends to rely on the investor’s preferences around customisation and transparency, as well as the tolerance of operational complexity.

Funds offer immediate exposure and better liquidity, while funds-of-one and SMAs can provide tailored portfolios and full position-level visibility.” bfinance’s report also highlights how fee structures and ESG integration are further design considerations.The firm outlines how some ILS managers integrate ESG criteria into cedant selection, although data limitations and varying disclosure standards across cedants pose challenges.To conclude, bfinance affirms that manager selection in ILS involves a number of unique challenges, due to the investment risks and high operational complexity associated with the sector.

“Mandates should consider appropriate (risk and return) objectives, investment constraints and limits, choice of vehicle, liquidity parameters, fees and ESG.In many cases, pragmatism is required: a highly prescriptive approach may excessively limit the number of strategies available for consideration.“The stresses experienced by ILS fund managers in 2017-2022, precipitated by a series of catastrophic events that placed risk models under strain, have resulted in strategic improvements in a number of these areas,” bfinance concludes..

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