The turbulence on the financial markets this summer and the effects of the US subprime mortgage crisis have sent many investors seeking improved stability for their investment portfolio. As one of the truly uncorrelated asset classes yielding stable returns over the past years, insurance-linked securities (ILS) have gained broad interest from the investor community. The following article explains the basics of ILS investments, provides an overview of the ILS market and highlights the unique features of this asset class.
Insurance-linked securities
Insurance-linked securities (ILS) are fixed-income securities (bonds) with a pre-defined maturity through which the insurance industry passes on pure insurance risk to the financial markets. The bonds are issued by insurance and reinsurance companies as protection in the event of extreme insurance losses, for instance following severe natural catastrophes or a potential pandemic disease outbreak. In some cases, large industrial corporations may issue an ILS as a substitute for traditional insurance coverage (e.g., a power company issues an ILS as protection against losses to its landlines from an extreme windstorm).
The risk assumed by investors is related to a specific insurance loss (e.g., earthquake, mortality, airplane crash, etc.). For natural catastrophe ILS, the term ôCat Bondö is typically used. ILS transactions have their roots in asset backed securities (ABS) and typically pay an interest rate comprising two components:
ò Libor (usually three-month US dollar Libor)
ò Spread that reflects a premium in relation to the underlying insured risk
The risk premium is linked to the default probability of a bond, with higher default probabilities typically yielding higher premiums. While the Libor is adjusted periodically, the risk premium remains constant for the entire duration of the bond. The total performance of a bond is thus dependent on the reference money market rate over a given period. In addition, some Cat bonds are subject to seasonal price fluctuations in the form of mark-to-market price adjustments. This is due to the seasonality of covered events (for instance, US hurricanes only occur between July and November).
Prior to maturity of a Cat bond, two scenarios may develop: as long as no major natural catastrophes have occurred, Cat bonds are redeemed at 100% on the maturity date. Alternatively, if a catastrophic event of a pre-defined peril and within a specified region does occur, the bonds may default, and part or all of the capital is immediately transferred to the issuer of the bond. The issuer then uses this capital to pay its claims to policyholders.
Motivation of Insurers
The insurance industry is a highly competitive and yet strongly regulated environment. The market is greatly driven by premium income, as paid by the insured customer, with each company trying to write an everincreasing number of insurance policies. Since each policy written represents a financial liability on the balance sheet of an insurance company, this behavior puts more and more pressure on the capital base of a company. However, in order to protect private customers, the insurance industry is subject to regulatory authority.
Regulators annually review each individual insurer to assess whether the available capital reserved by the company is sufficient to live up to the ôpromiseö to pay out a specific sum in case an unexpected event occurs. In certain peak scenarios, such as a magnitude 8.0 earthquake in California or a category 5 hurricane in Florida, the available capital base of the insurance and reinsurance industry may no longer be deemed sufficient to cover the losses from extreme catastrophic events. Traditionally, the insurance industry has had three ways of mitigating the financial impact of extreme events:
ò Limiting the size of assumed business (i.e., write fewer or ôsmallerö insurance policies)
ò Increasing the capital base (by issuing additional equity or debt to the capital market)
ò Passing on part of the risk to another party by means of reinsurance
