Insurance-Linked Securities (ILS)
Encyclopedia
Insurance-linked securities (ILS) are broadly defined as financial instruments whose values are driven by insurance
loss events. Those such instruments that are linked to property losses due to natural catastrophe
s represent a unique asset class, the return from which is uncorrelated with that of the general financial market
.
One is by selling portfolios of insurance policies grouped into packages, to interested investors. The risk from low severity, high probability events can be diversified by writing a large number of similar policies. This reduces an insurer’s risk because should a policy default, then the loss is shared between a large number of investors.
The second way insurers profit on policies is by re-insuring them through other insurers. A reinsurance policy would allow a second insurer to share in the gain and potential loss of the policy, much like an investor
. The secondary insurer would share invested interest and risk. The reinsurance of policies offers additional risk capital and high returns for the policy originator, and minimizes their liability
, while also providing high returns for any secondary insurer.
created a new method for insurers to spread their risk and raise capital. Insurance-linked securities provide life insurance companies with the ability to transfer or spread their risk while releasing its value to the open market through asset-backed notes
.
This emerging market showed much potential and growth until the collapse of the CDO market
, with the effect disrupting the ILS market.
The collapse of sub-prime collateralized debt obligation
s, or CDOs, had a disastrous effect on all structured financial markets, including life insurance risk. The high complexity of life insurance securitization
is one of the reasons for the collapse of the insurance-linked securities market.
CAT bonds are very risky in general. Therefore, an insurer will try to minimize risk by writing many such policies. If an insurer charges a premium equal to the expected annual loss, it can stand to profit by those premiums by the law of large numbers
.
Another way insurance companies can spread their risk from CAT bonds is to transfer risk to another insurer, thereby re-insuring the original insurer’s portfolio and minimizing liability. A re-insurance policy could assume a loss of “$10 million above $50 million with 5% participation.” In this scenario, the secondary insurer pledges to pay the policy originator up to 95% of $10 million for any loss above $50 million.
Investors are attracted to these contracts because they are unrelated to financial markets. That is where the capital markets and insurance-linked securities meet, through derivative or security markets. CAT bonds are grouped by their level of risk and sold in portfolios in security markets. This makes re-insuring these contracts more attractive because it opens a whole market for them to be sold and for risk to be spread among many investors. It is much more attractive to write expensive, risky policies and share the risk with thousands of others than it is for one firm to assume total liability.
s include:
. Any interested parties will pay a premium to the SPV. The money from the premium and investment income will provide the interest payments owed to investors.
If there is no catastrophic event, 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.
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
loss events. Those such instruments that are linked to property losses due to natural catastrophe
Natural disaster
A natural disaster is the effect of a natural hazard . It leads to financial, environmental or human losses...
s represent a unique asset class, the return from which is uncorrelated with that of the general financial market
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
.
Overview
Insurance companies are in the business of assuming risk for individuals and institutions. They manage those risks by diversifying over a large number of policies, perils and geographic regions. There are two important ways insurers profit in this business.One is by selling portfolios of insurance policies grouped into packages, to interested investors. The risk from low severity, high probability events can be diversified by writing a large number of similar policies. This reduces an insurer’s risk because should a policy default, then the loss is shared between a large number of investors.
The second way insurers profit on policies is by re-insuring them through other insurers. A reinsurance policy would allow a second insurer to share in the gain and potential loss of the policy, much like an investor
Investor
An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...
. The secondary insurer would share invested interest and risk. The reinsurance of policies offers additional risk capital and high returns for the policy originator, and minimizes their liability
Legal liability
Legal liability is the legal bound obligation to pay debts.* In law a person is said to be legally liable when they are financially and legally responsible for something. Legal liability concerns both civil law and criminal law. See Strict liability. Under English law, with the passing of the Theft...
, while also providing high returns for any secondary insurer.
History
Since 2001, the market for insurance-linked securities has increased substantially, creating an industry with over $15 billion trading between capital market investors. The union of insurance risks with the capital marketCapital market
A capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
created a new method for insurers to spread their risk and raise capital. Insurance-linked securities provide life insurance companies with the ability to transfer or spread their risk while releasing its value to the open market through asset-backed notes
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
.
This emerging market showed much potential and growth until the collapse of the CDO market
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
, with the effect disrupting the ILS market.
The collapse of sub-prime collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
s, or CDOs, had a disastrous effect on all structured financial markets, including life insurance risk. The high complexity of life insurance securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
is one of the reasons for the collapse of the insurance-linked securities market.
Purpose
The market for insurance linked securities has been very attractive for investors and insurers. One portion of insurance linked securities is the reinsurance of high severity, low probability events known as CAT bonds, or catastrophe bonds. These include cover for natural disasters and other uncontrollable events. These policies are grouped by their assessed risk, and then re-insured by other insurers.CAT bonds are very risky in general. Therefore, an insurer will try to minimize risk by writing many such policies. If an insurer charges a premium equal to the expected annual loss, it can stand to profit by those premiums by the law of large numbers
Law of large numbers
In probability theory, the law of large numbers is a theorem that describes the result of performing the same experiment a large number of times...
.
Another way insurance companies can spread their risk from CAT bonds is to transfer risk to another insurer, thereby re-insuring the original insurer’s portfolio and minimizing liability. A re-insurance policy could assume a loss of “$10 million above $50 million with 5% participation.” In this scenario, the secondary insurer pledges to pay the policy originator up to 95% of $10 million for any loss above $50 million.
Investors are attracted to these contracts because they are unrelated to financial markets. That is where the capital markets and insurance-linked securities meet, through derivative or security markets. CAT bonds are grouped by their level of risk and sold in portfolios in security markets. This makes re-insuring these contracts more attractive because it opens a whole market for them to be sold and for risk to be spread among many investors. It is much more attractive to write expensive, risky policies and share the risk with thousands of others than it is for one firm to assume total liability.
Types
The most prevalent securitized insurance contracts exchanged in capital marketCapital market
A capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
s include:
- Longevity Swaps
- Life Settlements Securitization
- Embedded Value Securitization
- Extreme Mortality Securitization
- Reserve Funding Securitization
- Catastrophe bonds
Issuance
To issue an ILS in the security or derivative market, an insurer would first issue an SPV, or Special purpose vehicle. An SPV has two functions; it provides re-insurance for insurance companies and issues securities to investors. At first, an SPV deposits funds collected by investors into a trustMassachusetts business trust
A Massachusetts business trust is a legal trust set up for the purposes of business, but not necessarily one that is operated in The Commonwealth of Massachusetts. They may also be referred to as an unincorporated business organization or UBO. Business trusts may be established under the laws of...
. Any interested parties will pay a premium to the SPV. The money from the premium and investment income will provide the interest payments owed to investors.
If there is no catastrophic event, or trigger event
Parametric insurance
Parametric insurance is a type of insurance that does not indemnify the pure loss, but ex ante agrees to make a payment upon the occurrence of a triggering event. The triggering event is often a catastrophic natural event which may ordinarily precipitate a loss or a series of losses...
, 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.
Investors
This following specialized funds invest in ILS:- Clariden LeuClariden LeuClariden Leu is a Swiss private bank based in Zurich, Switzerland. Following the merger of the four Credit Suisse private banks: Clariden Bank, Bank Leu, Bank Hofmann, and BGP Banca di Gestione Patrimoniale together with the securities dealer Credit Suisse Fides on January 26, 2007, Clariden Leu is...
- Credit SuisseCredit SuisseThe Credit Suisse Group AG is a Swiss multinational financial services company headquartered in Zurich, with more than 250 branches in Switzerland and operations in more than 50 countries.-History:...
- Fermat Capital Management
- Goldman SachsGoldman SachsThe Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
Asset Management - Juniperus CapitalJuniperus CapitalJuniperus Capital Limited is a Bermuda-based hedge fund. It was incorporated in Bermuda on April 11, 2008. The investment management company became operational in May 2008....
- Twelve Capital