Insurance-Linked Securities

Insurance-linked securities (ILS) are financial instruments whose value is driven by insurance loss events and not by the credit or equity markets. They allow insurers and reinsurers, and sometimes governments and corporations, to transfer risks such as hurricanes, earthquakes or extreme mortality to investors in the capital markets. Investors receive a return for bearing the risk and lose some or all of their capital if a defined event occurs.

The market emerged in the mid-1990s, after Hurricane Andrew in 1992 and the Northridge earthquake in 1994 depleted reinsurance capital and showed that the largest catastrophes could exceed the industry's capacity. ILS supplement traditional reinsurance; the capital they provide is often called alternative capital. The best-known instrument is the catastrophe bond.

• Catastrophe bonds. These are tradable notes, usually with terms of about three years, that pay a floating coupon and return principal unless a specified catastrophe occurs.
• Collateralised reinsurance. A reinsurance contract is written by a special purpose vehicle and backed in full by collateral provided by investors. It is privately negotiated and not tradable, and makes up a large share of the market.
• Sidecars. These vehicles let investors take a share of a reinsurer's book of business for a limited period, sharing its premiums and losses.
• Industry loss warranties. These contracts pay when total insured losses to the industry from an event exceed a stated amount.
• Life and longevity transactions. Securities linked to extreme mortality, to the pace at which pensioners live longer than expected, or to the future profits of a block of life policies.

The party seeking protection, called the sponsor or cedent, enters into a reinsurance or derivative contract with a special purpose vehicle. The vehicle issues securities to investors and places the proceeds in a collateral account invested in very safe assets, typically government money market funds. The sponsor pays premiums to the vehicle. Investors receive the return on the collateral plus the premium as their coupon.

If no qualifying event occurs during the term, the collateral is released and investors are repaid. If one does, collateral is paid to the sponsor to cover its losses and investors' principal is reduced accordingly. Because the cover is fully funded in advance, the sponsor does not depend on a reinsurer's ability to pay, as it does under a conventional reinsurance cession. The structure borrows from securitisation, and deals may be divided into layers with different risk levels.

The event that causes a payout is defined in one of several ways.

• Indemnity. Payment follows the sponsor's own actual losses. This gives the sponsor the best match but requires investors to understand its book, and settlement can take time.
• Industry loss. Payment depends on an independent estimate of total industry losses from the event.
• Parametric. Payment depends on physical measurements, such as wind speed or earthquake magnitude at specified locations. It is fast and transparent.
• Modelled loss. Event parameters are run through an agreed catastrophe model to calculate a notional loss.

Triggers other than indemnity leave the sponsor with basis risk: the payout may differ from its real loss.

For investors such as pension funds, endowments and specialist fund managers, the appeal is diversification. The occurrence of an earthquake or windstorm is largely unrelated to the economic cycle, so returns have low correlation with shares and bonds. Coupons include a premium well above the expected loss. For sponsors, ILS provide multi-year cover at a fixed price, an additional source of capacity for peak risks, and collateralised protection. Regulatory regimes such as Solvency II recognise properly structured risk transfer in reducing the solvency capital requirement. Reinsurers themselves use the market for retrocession, and public bodies, including catastrophe pools and the World Bank on behalf of member countries, have sponsored bonds for disaster relief.

Bermuda is the largest centre for ILS vehicles and listings, with other domiciles including the Cayman Islands, Ireland, Guernsey, Singapore and the United Kingdom, each with a specific legal regime for insurance special purpose vehicles. Securities are sold privately to institutional investors. Outstanding catastrophe bonds amount to tens of billions of US dollars, and total alternative capital is larger still. Pricing follows the reinsurance cycle: spreads widen after years of heavy losses and narrow as capital returns.

The principal risk is the insured event itself, and losses can be total. Catastrophe models, on which pricing relies, are uncertain, and climate change raises questions about whether historical data understates future losses from storms, floods and wildfires. After large events, collateral may be held back for years while claims develop, leaving investors unable to redeploy capital; this affected many funds after the hurricanes of 2017. Valuation of private contracts is difficult, liquidity is limited, and the claim that returns are uncorrelated was tested when market stress coincided with loss events. Critics also argue that capital market investors may withdraw after losses, making the capacity less dependable than that of a traditional reinsurer under a treaty reinsurance relationship.