What are Insurance Linked Securities?

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.

What benefit can Insurance Linked Securities provide to Investors?

Investors are often attracted to Insurance Linked Securities due to their low correlation with traditional capital markets assets.

How are Insurance Linked Securities issued?

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.

What is Direct Reinsurance?

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.

What is Retrocession / Retro Cover?

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.

What is Catastrophe Risk?

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.

What are Catastrophe Bonds?

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.

What are the basic trigger types for Catastrophe Bonds?

Cat Bonds are generally categorized into 4 basic trigger types:

  • Indemnity: triggered by the issuer's actual losses so the sponsor is indemnified, as if they had purchased traditional catastrophe reinsurance
  • Index to industry loss: triggered when the insurance industry loss from a certain peril reaches a specified threshold
  • Modeled Loss: triggered when there is a larger event and modelled losses are above a specified threshold
  • Parametric - triggered when there are natural events within the parameters set out by the contract. For example, a hurricane bond could be indexed to wind speed above an agreed level at a number of locations. Should wind speeds be recorded above this level at those locations, the bond is triggered
  • Parametric Index: triggered when a certain set of conditions are met (as above) but are linked to the losses the issuer may face as a result of the natural conditions
What are Industry Loss Warranties?

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:

  • Live Cat - contracts which are traded whilst an event is in progress
  • Dead Cat - contracts which are traded on an event that has already occurred by total industry losses are not yet known
  • Back-Up Covers - contract provide protection for events that occur following the catastrophe.