Insurance Linked Securities (ILS) are financial instruments whose fundamental value is determined by insurance losses, caused by natural catastrophes such as major earthquakes and hurricanes. As the returns of ILS are primarily driven by natural catastrophes, when carefully structured, they are generally uncorrelated with the overall financial market, making ILS an attractive asset class for capital market investors.
Investors are often attracted to Insurance Linked Securities due to their low correlation with traditional capital markets assets.
To issue an ILS in the security or derivative market, a Special Purpose Vehicle (SPV) is initially issued. This provides the reinsurance for insurance companies and issues securities to investors. The SPV then deposits funds collected by investors into a trust. Any interested parties will pay a premium to the SPV. The amount invested and additional investment income provides the interest payments to investors. Should their not be a catastrophic or trigger event before the maturity date of the contract, investors will receive back their principal investment at maturity on top of the interest payments they have received.
Direct reinsurance is insurance for insurance companies and can be provided for any portfolio of business. The most traditional form is catastrophe insurance, whereby an insurance company buys protection from a reinsurance company, who issues a reinsurance contract which transfers the risk on an indemnity basis.
Retro(cession) cover in its simplest form is insurance for a reinsurance company, and protects them against losses arising from catastrophic events. Generally the cover is purchased by the reinsurance company from another reinsurance company, and is very similar to direct reinsurance for insurance companies. The cover is provided on an indemnity basis and transfers risk from one reinsurer to another. It is typically the most volatile market in terms of price movement and availability.
Catastrophe reinsurance in its simplest form is insurance for those insurance companies who have a portfolio of natural catastrophe business. Reinsuring these risks can help to manage earnings volatility and reduce the amount of capital needs to support exposures.
Cat Bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They emerged from a need by insurance companies to alleviate some of the risk they would face if a major catastrophe event occurred. In short, they are insurance for insurance and reinsurance companies, and are provided by issuing bonds on to investors. Most Cat Bonds are structured to offer insurers the benefit of fully collateralized reinsurance, which significantly mitigates the credit risk an issuer would normally accept from rated counterparties in the reinsurance market. They are generally categorized into 4 basic trigger types.
Cat Bonds are generally categorized into 4 basic trigger types:
Industry Loss Warranties, or ILWs, are a type of reinsurance contract through which one party will purchase protection based on the total losses arising from a catastrophic event to the entire insurance industry rather than their own losses. The industry loss therefore triggers the pay-out. Industry insurance losses are calculated and reported by a thirty party index provider. The first contracts of this type were traded in 1980s.
Specific types of ILWs are: