Insurance-linked securities as a diversifying asset in a portfolio: A mean-variance analysis

Abstract

This study explores the possibilities insurance-linked securities offer from the viewpoint of the investor. Insurance-linked securities are a growing market of assets that, at least on the surface, display characteristics of largely uncorrelated returns with the general market, which could make them an extremely valuable asset in terms of diversification and risk management for an investor. Previous literature has explored especially the risk and return characteristics of the asset, as well as possible hedging, diversification, and even safe haven capabilities of it. However, no studies were found regarding the optimal weighting of the asset in a portfolio.

Thus, in this study, diversification, risk-return profiles and the overall performance of a portfolio including insurance-linked securities are studied. This is done in hopes of either confirming or disproving earlier findings of diversification and even hedge benefits regarding the asset. This is done through a mean-variance analysis, comparing a portfolio optimization including and excluding insurance-linked securities. Another key detail to consider is the trade-off between risk and return. For an asset that seemingly offers great diversification benefits, is the investor giving up too much in return for the safety, especially during times when inflation is high and investors are chasing returns?

As the area surrounding the study is an unknown one for many students and even professionals in the field, the research also takes an exploratory stance regarding insurance-linked securities as an asset. The study focused on introducing the asset class and its specific characteristics extensively, although further research by the reader is also recommended, as the asset class itself is very complex. This was done in an attempt to familiarize the subject, but also as a note on why investing in the asset requires more consideration than just measures of risk and return.

The key findings of this research are that insurance-linked securities do seemingly offer great diversification benefits, they are largely uncorrelated with other assets in the market, and that the mean-variance portfolio does include insurance-linked securities especially in lower return portfolios that minimize volatility. In addition, the highest Sharpe ratio portfolio included insurance-linked securities, suggesting that the usage of insurance-linked securities in an investment strategy may lead to excess returns per level of risk. However, questions are left to be asked, as the returns of insurance-linked securities are extremely non-normally distributed. The methodology used in the study largely assumes normality of returns, which reduces the validity of the results.

Concluding the research, insurance-linked securities could be a consideration for many investors, especially those that value low volatility and mostly positive returns. However, careful weighting of the asset is crucial, as the asset has exhibited catastrophic tail events in the past 10 years. Future research is advised, especially regarding areas like the possible increase of natural catastrophes, insurance-linked securities and ESG (environmental, social, and governance), and more sophisticated models that take non-normality into account.