Insurance Linked Securities

This article provides a brief introduction to insurance-linked securities (ILS) as an asset class in order to lay the foundation for the more thorough treatment of individual types of ILS in the rest of the blog. It explains the reasons for transferring insurance risks to the capital markets and the benefits this transfer provides both to the insurance industry and to the investors.
The types of insurance risk transferred to the capital markets are also briefly discussed.

INSURANCE-LINKED SECURITIES DEFINED

In the article Investing in insurance risk, we defined insurance-linked securities as financial instruments, other than traditional equity and debt securities issued by insurance companies,
that carry insurance risk or a type of risk that is closely related to it.
Examples of the risks included in ILS are those associated with property
catastrophe, mortality, longevity and insurance loss reserve adequacy. ILS
can also include many of the traditional risks such as market, credit and
interest-rate risks, but it is the inclusion of a significant degree of insurance
risk that defines them.

The term “risk-linked securities” is occasionally used instead of ILS,
sometimes to highlight a broader spectrum of insurance-linked securities –
for example, weather derivatives, which do not have a direct relationship to
any actual insurance losses, but serve the purpose of transferring to the
capital markets risks very similar to those taken on by insurance companies.

In some cases, the distinction between insurance-linked and other securities
becomes blurred; but generally a security is labelled an ILS if it resembles
one of the standard types of insurance-linked securities.

Insurance risks involved in insurance-linked securities cover the whole
range of insurance-related risks, from property-casualty insurance to life
insurance. The wide variety of insurance risks embedded in ILS is reflected
in the multitude of types of insurance-linked securities.

TYPES OF INSURANCE-LINKED SECURITIES

While catastrophe bonds are the best known insurance-linked securities, the
ILS universe is much broader than that. Products range from alternatives to
reinsurance coverage, to securities that can be constructed only with the use
of capital markets. The following infographic, presents ILS characterised by the
degree of catastrophe risk being transferred to the capital markets and by the
type of insurance risk. The list is far from complete: only the main types of
insurance-linked securities are shown.

Categorisation of insurance-linked securities is partly dependent on the
reasons the insurance risk is being transferred to the capital markets by
insurance companies or other entities.

Reasons for transferring insurance risk to the capital markets

Insurance risk can be transferred to investors for a number of different
reasons. Some of these reasons are described below. There is significant
overlap since a transaction can accomplish more than one objective.

TRANSFER OF CATASTROPHE RISK. 

Insurance and reinsurance companies are limited in the amount of true catastrophe risk they can assume. A largescale catastrophe, either natural or manmade, has the potential of
wiping out the surplus (shareholder equity) of many companies at the
same time. It can even start a spiral of insolvencies or downgrades if
several reinsurance companies fail, and the reinsurance recoverables
remain uncollectable.

Prudently managed insurance and reinsurance
companies are aware of this risk and either partially transfer it to other
parties or choose not to assume it at all, leaving some exposures uninsured.
Since the total shareholder funds of the insurance industry are
dwarfed by the size of the capital markets, it makes perfect sense to
transfer the true catastrophe risk to investors.

This can be done in the form of cat bonds, industry loss warranties, reinsurance sidecars, catastrophe
derivatives, collateralised reinsurance of catastrophe risk, or
contingent capital securities. Catastrophe risk also exists in life insurance
– for example, in the case of a jump in mortality due to a pandemic
event. Such risk can be transferred to the capital markets primarily in
the form of cat mortality bonds and cat mortality derivatives.

SUBSTITUTE FOR TRADITIONAL REINSURANCE. 

Limited risk capacity leads to higher reinsurance rates, which in some cases results in capital markets
solutions being more efficient in terms of cost. Given the additional
advantages provided by some insurance-linked securities (for example, the ability to lock in the cost of protection for more than one year, and limited credit risk), capital markets solutions can be an important part of the overall risk management programme, acting as both a substitute for
and a complement to traditional reinsurance.

Avoiding overexposure to a few reinsurers and thus lowering credit risk is of particular importance.
Investor-provided collateralised reinsurance, insurance derivatives, and
industry loss warranties are all examples of insurance-linked securities
that fall in this category.

RELIEVING CAPITAL STRAIN. 

In the absence of distressed conditions, insurance
companies can still experience capital strain when they grow too fast
or when regulations require them to hold capital significantly in excess of
the levels necessary from the economic point of view.

An example of a capital markets solution driven by this rationale is XXX and AXXX securitisation.
In this case, US regulations require that reserves for some life insurance products be maintained at levels significantly in excess of what most consider economically reasonable. This requirement results in considerable strain on insurance companies’ capital; XXX and AXXX securitisation
or private investment solutions help alleviate this strain.Value-in-force securitisation or monetisation can also provide additional capital, either to eliminate a shortfall or to be used for other purposes such
as mergers and acquisitions.

TURNING LIFE INSURANCE INTO TRADABLE INSTRUMENT. 

Life settlements developed as a way for policyholders to monetise the value of their existing life
insurance policies when they are no longer needed, when they cannot be
afforded or when the benefit of immediate monetisation outweighs the
advantages of keeping the policies.

From the economic point of view, a life insurance policy is a security and thus can be traded. Once a life insurance policy is bought by investors, it then can be resold more than once.
Portfolios of life settlements can be separately managed or securitised.
Managing portfolios of life settlements can benefit from the use of another
type of ILS, longevity derivative instruments, that could hedge the
longevity risk of such portfolios.

LONG-TERM LONGEVITY RISK TRANSFER. 

Capital markets solutions can be utilised to address the risk of greater-than-anticipated longevity. Pension funds and some annuity providers are among the entities exposed to this
risk. In the case of pension funds, longevity improvements in excess of
expectations can lead to significant shortfalls. Longevity derivatives and
longevity bonds are examples of instruments that can transfer this risk to
the capital markets.

The list illustrates some of the reasons why insurance risks would be transferred
to the capital markets, along with a few types of insurance-linked
securities used for this purpose. There are a number of additional reasons,
including more efficient capital management, reducing earnings volatility of
insurance companies, addressing rating agency concerns, managing credit
risk and many others; again, these often overlap.

Reasons for investing in insurance-linked securities

While there is a multitude of reasons why insurance companies and other
entities might want to transfer insurance risk, conceptually the reasons why
investors might want to accept it are much simpler.

Adding an ILS to an investment portfolio may be beneficial if it improves
the risk–return profile of the portfolio. Consequently, the analysis of
whether an ILS investment makes sense is quite similar to the analysis of
investing in any other security. If the marginal impact of adding an insurance-
linked security to the portfolio improves its risk–return profile more
than available alternatives, the investment probably makes sense.

In even simpler terms, investors find insurance-linked securities attractive
because they provide yield, diversification or both. Given the constant
search for extra yield and diversification opportunities, it is natural for
investors to consider this asset class, with all of its unique characteristics.

Structurers of insurance-linked securities are mindful of the fact that
investor needs should be satisfied, and they take this into account when
deciding on the best ILS structure to transfer an insurance risk to the capital
markets.

YIELD AND DIVERSIFICATION OFFERED BY INSURANCE-LINKED SECURITIES

Investors look to insurance-linked securities primarily for yield or diversification.
Diversification in particular has been publicised as a unique advantage of ILS. Insurance-linked securities do offer a type of diversification not available through exposure to other assets. For many types of ILS, especially cat bonds and similar instruments, this is a critical advantage that
makes this asset class so important.

The experience of 2008 shows that, when almost all asset classes are down, even those that historically have had low correlation, the importance of the low correlation that stays low even in the
tail of the probability distribution becomes clearly evident.

The “zero-beta” assets

Many insurance-linked securities provide a unique type of diversification
through exposure to “pure” insurance risk. While this is often their main
attraction to investors, it does not mean they are completely uncorrelated
with the rest of the financial markets.

Statements have been made repeatedly that ILS, in particular life settlements
and cat bonds, are zero-beta assets and have no correlation with the
markets at all. While the correlation between some types of ILS and the
financial markets might be weak, it does exist, and the zero-beta claims are
not valid. They are particularly unfounded where they are repeated most
often – in the case of life settlements, which are clearly exposed to the
interest rate and a host of other risks.

Yield generation

Insurance-linked securities often provide yield opportunities in excess of
those implied by their risk level. The yield can be a very important benefit
of these securities and can become an alpha generator for an investment
portfolio.

Part of the reason for the extra yield is the market inefficiency and the
unfamiliarity of investors with these securities. The market is still small, and
expertise in ILS analysis is hard to find in the investment community. Over
time, the markets will surely become more efficient, and excess returns will
diminish or disappear.

This, however, is likely to be a very long process.
Some ILS offering what appears to be high return on a risk-adjusted basis
might in reality be much riskier than expected by investors lacking sufficient
expertise in this space. Some of the ILS appear deceptively simple, and an
investor without deep expertise in this asset class can be lured into making
poor investment decisions.

Efficient frontier

The ability to invest in insurance-linked securities can have the effect of
shifting the efficient frontier for an investor. The limited correlation of ILS
returns with other assets enhances diversification options, and the new efficient
frontier may then have lower risk for the same level of return, or higher
return for the same level of risk.

This is the exotic beta appeal of this asset class as it provides exposure to a risk factor with low correlation with the rest of the financial markets. It is important that the efficient frontier mentioned above does not have to be defined within the mean-variance optimisation framework. In fact, the in the more sophisticated framework that takes into account events in the
tail of the probability distribution. value of adding ILS to an investment portfolio can be even more apparent in the more sophisticated framework that takes into account events in the
tail of the probability distribution.

MARKET DYNAMICS

Despite its relatively small size to date, the ILS market is very dynamic and
constantly changing. New instruments appear, or the existing ones
suddenly grow in prominence, while others fade into obscurity, more or less
in direct response to changing market conditions. Meanwhile there is a
gradual, ongoing process of education and acceptance of this new asset
class.

Not all of the developments have been smooth and the growth has been
uneven. An example of such a change in the ILS market is the redesign of
the cat bond structure to minimise the credit risk of this security. This was
done in response to the realisation, driven by the events surrounding the
bankruptcy of Lehman Brothers in 2008, that credit risk is present and can
play a significant role in these securities.

Another example is the uneven development of the life settlements market, which has been affected by problems specific to this asset class as well as by the general availability of
risk capital in the changing investment environment.

A further example is the painfully slow development of the longevity transfer market, despite the
seemingly obvious need for it. Finally, exchange-traded catastrophe derivatives
first appeared in the early 1990s but were unable to gain traction; now
they have been reintroduced to address the growing needs of both hedgers
and sellers of protection.

Demand for and supply of insurance-linked securities differ by the type
of ILS and change over time, even for the same type of ILS. For example,
reinsurance sidecars made a sudden appearance in the aftermath of the 2005
Katrina–Rita–Wilma hurricane season; they addressed an urgent need and
then quietly decreased in importance.

The existence of dedicated ILS funds brings another interesting element into the dynamics of this market, since they are effectively the source of captive capital that provides a guaranteed
level of demand for some insurance-linked securities.
The financial crisis of 2007–2009 was a good test of the ILS market, as it
allowed market participants to identify weaknesses of some of the ILS structures.
More importantly, it underscored the general benefits of investing in
most types of insurance-linked securities that provide both yield and diversification
opportunities. It also drew attention to the need for proper expertise in the analysis of these financial instruments.

The convergence between the insurance and capital markets is occurring slowly but steadily. Securitisation of insurance risk is an important part of
this process. It addresses the needs of both the holders of insurance risk and
the investors, and there is every expectation that the insurance-linked securities
market will continue to grow and develop.

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Introduction to Investing in Insurance Risk

This article provides a brief overview of concepts that are fairly obvious to most professionals in the investment and insurance field but may be unfamiliar to other readers. In addition, insurance risk is
presented through an uncommon perspective that sheds light on its unique characteristics and corresponding investment considerations.

Investing in Risk

There are no truly riskless assets. We always invest in risk. We might do it
in the form of stocks, corporate bonds, real estate or treasuries, but ultimately
the investment performance of these securities is predicated on their
risks. We invest because we expect to earn a return commensurate with the
risk we take in investing. In fact, we want the return to be higher than what
the risk profile of an investment would imply.

Insurance Risk is good

It is too simplistic to say that “risk is bad”, and to think that it is something
we want to avoid or minimise. Investing is always about risk. In fact,
investors actively search for risk to invest in. As long as the compensation
for taking on the risk is appropriate, the investment usually makes sense.

A good investor is not the one who avoids risk; with excessive focus on
avoiding risk such an investor will also strip out his return. A good investor
is the one who invests in securities that together generate high risk-adjusted
return appropriate to the investor’s goals.

A good investor is certainly riskaverse, but only in the sense of not being willing to accept risk without proper compensation. As obvious as such statements may seem, the idea of
seeking risk makes some uncomfortable. An investor must recognise that
risk is good as long as it is the right kind of risk, the returns are commensurate
with it and the overall investment objectives are satisfied. The portfolio approach to investing is important to every investor.

A pension fund might have allocations to individual asset classes and benefit from the diversification it provides. The benefits of diversification explain why investments with low correlation to others are at a premium and being sought after. Certain types of insurance risk possess this desired quality of
having low correlation with other asset classes.

WHAT IS INSURANCE RISK

Insurance risk lacks a clear, unambiguous definition. It is generally defined
as the risk being taken on by insurance companies in selling insurance
protection. This could be interpreted in a very broad sense to include all
risks faced by an insurance company in the course of its operations.

So it could be said that investing in insurance risk is the same as investing in an
insurance company. Considered in this broad sense, insurance risk includes
all traditional investment risks – market, credit, operational and others – as
well as the insurance risk defined in a more narrow way – that of insurance
claims (obligations under insurance policies) being greater than expected, or
greater than a certain level that the insurance company wants or is
permitted to take.

Even this definition is imprecise, since all the risks are intermingled and cannot be fully decomposed into individual elements. The more narrowly defined type of insurance risk would apply in cases of
higher-than-anticipated losses due to factors such as random statistical fluctuations
in the number of insurance claims or their severity, natural
catastrophes or man-made disasters, spikes in mortality or fundamental
shifts in longevity, and many others.

Often such types of insurance risk either cannot be transferred to investors
purely through the traditional equity or debt instruments issued by insurance
companies, or are best transferred to capital markets in a different fashion.
Insurance-linked securities (ILS) are structured to transfer to investors this
type of risk, and are specifically designed to address unique issues of insurance
companies. Most have to do with the transfer of “pure” insurance risk
where other risks are excluded orminimised.

They afford investors exposure to risks that are different from those embedded in the traditional securities and that are often only weakly uncorrelated to the behaviour of the financial
markets.

INSURANCE MARKETS

Before considering securities that are in some way linked or related to insurance,
it is instructive to take a look at the insurance markets in general.
Insurance markets have many unique features not found in other industries.
Insurance companies are highly leveraged enterprises in the sense that their assets-to-shareholder equity ratio tends to be very high – particularly for life insurance companies and property-casualty companies in long-tail lines of business.

While the degree of leverage across the capital markets has been going down (in some cases considerably), the insurance industry remains an exception. The diverse offerings of insurance companies comprise two main categories: life and health insurance, and property-casualty insurance (referred to as general insurance in many parts of the world). Though these two categories
of insurance are quite distinct, some companies handle both life and
property-casualty insurance.

In describing insurance markets, it is also important to note that insurance
is one of the most heavily regulated industries, a fact that, by itself, introduces
a broad set of constraints and risks not found in other sectors.
Moreover, the regulation to which insurance companies are subject is not uniform among jurisdictions, contributing to the fragmented nature of the insurance marketplace.

Some jurisdictions impose price regulation and so insurance companies are not free to raise insurance rates on some of their products. In extreme cases, companies unable to raise rates for this reason
have decided to exit certain products lines, but have encountered additional
regulatory constraints, making this exit difficult. Few industries have to deal
with such issues.

Another phenomenon specific to the insurance industry is the underwriting
cycle; it pertains primarily to property-casualty insurance, and, to a
lesser degree, to health insurance. Insurance companies as a group go
through periods of charging customers rates that are too low, leading to
rates of return dropping below the required level (referred to as “soft”
markets); followed by periods when the companies are able to raise their
rates to the level where they generate rates of return in excess of the
minimum required (“hard” markets).

This cycle does not have a simple logical explanation and is seen by many as evidence of how inefficient the insurance markets are. Arguably, no other sector has such a clearly
pronounced profitability cycle, with the possible sad example of the airline
industry.

While many factors drive the underwriting cycle – changes in
macroeconomic conditions, shock events resulting from investment losses
or losses due to natural catastrophes, the fear of losing customer relationships,
and many others – it is also recognised that some of the factors are
purely psychological (such as the herd mentality).

Predicting the next turn in the insurance underwriting cycle is a favourite pastime of the sell-side
equity analysts who cover the insurance sector. The underwriting cycle To sum up, insurance markets are unique because of a variety of factors, including fragmentation, particularly strict regulatory requirements, unusual risk and a significant degree of inefficiency. Deep understanding of
such industry dynamics is a prerequisite to analysing many securities issued
by this industry.

SECURITIES ISSUED BY INSURANCE COMPANIES

Insurance companies issue some of the same types of securities as do most
companies in other industries. We can invest in insurance through common
stock, debt or preferred stock.

The analysis of the common stock of insurance
companies is based on the general principles of equity analysis, while
taking into account also the specific features of the insurance industry. Other
types of securities issued by insurance companies are not found in most
other sectors.

An example would be surplus notes, which are securities
similar to the trust-preferreds issued by banks. The securities issued by
insurance companies are a relatively small part of the global capital markets,
reaching at most 3% of their total size. In the US, insurance companies provide two types of financial statements: traditional statements based on the Generally Accepted Accounting Principles (GAAP), and statutory statements mandated by insurance regulators.

The volume of information contained in these statements is greater
than what would typically be available for a company in another industry.
Detailed exhibits provide a wealth of additional information. Both the
GAAP and the statutory statements, along with other data released by
insurance companies, help investors analyse the companies and value the
securities they issue. The availability of the additional information,
however, does not make the analysis easier and the uncertainty lower.

There are too many industry-specific issues that make the analysis different from
that of other companies, and these issues present unique challenges. In the
simplified analytical framework, we may often wonder why price-to-book
ratios of insurance companies exhibit idiosyncratic behaviour, and what
drives the difference in the price-to-book and other ratios between companies
that appear to be rather similar based on their balance sheets, income
statements and the business they conduct. Only a deeper level of analysis
can answer such questions.

We may think that diversification can be achieved simply by investing in
stocks or bonds issued by insurance companies, since they contain the
“pure” insurance risk such as that of losses related to natural catastrophes or
changes in mortality rates. However, these risks are rarely the main drivers
of insurance stock performance. For most insurance companies, the main
component of their profits stems not from underwriting income but from the investment returns on their asset portfolios.

This explains why insurance companies, with their huge balance sheets and assets invested mostly in
bonds and stocks, are heavily exposed to market risk. Life insurance stocks
are seen by many as a beta play, as opposed to an uncorrelated asset.
Figure 1.1 overleaf illustrates the performance of the Dow Jones US
Insurance Index relative to the S&P 500 Index and the Dow Jones Industrial
Average.

Correlation of the insurance index returns with the markets for the
time period illustrated in Figure 1.1 was 80%, showing that investing in
insurance stocks in and of itself does not necessarily provide diversification,
because insurance companies are, to a significant degree, leveraged investment
vehicles.

Warren Buffett puts it in slightly different terms by using the concept of
float: “Float is money we hold but don’t own. In an insurance operation, float
arises because premiums are received before losses are paid, an interval that
sometimes extends over many years.During that time, the insurer invests the
money.”

This statement, repeated with minor variations in numerous annual
letters by Buffett to the shareholders of Berkshire Hathaway, explains both
the concept of leverage in insurance and why many insurance stocks have a
high degree of correlation with the financial markets.

INSURANCE-LINKED SECURITIES

ILS are defined as financial instruments, other than traditional equity and
debt securities issued by insurance companies, which carry insurance risk or
a type of risk that is closely related to it. Examples of the risks included in
insurance-linked securities are property-catastrophe risk, mortality,
longevity and insurance loss reserve adequacy. ILS can also include many of the traditional risks such as market, credit and interest rate risks, but it is the inclusion of the significant degree of insurance risk that defines them.

The seemingly irrelevant question of what asset category ILS belong to is
important. ILSs are normally classified as alternatives, but they come in many shapes and forms even for the same type of risk. These securities can be structured as fixed income instruments or as equities. Some ILS come in the form of derivatives while others most closely resemble private equity
investments. A dedicated ILS fund can be limited to investing in only catastrophe
bonds or have a broader mandate of investing in various types of insurance-linked securities and types of insurance risks they contain.

The fund mandate determines how an investment in the fund itself is classified – whether it necessarily falls in the category of alternatives and, if the answer
is positive, where it is placed within that category. The uncertainty as to the
appropriate allocation bucket exists even in the cases of direct investment
rather than that through a fund.

The classification may affect the flow of funds to ILS and insurance linked
strategies since they are relatively new and have not earned standard
allocations afforded to the more traditional asset classes and investment
strategies. The size of the insurance-linked securities markets is very small relative to that of the global financial markets, and even relative to the total value of
securities issued by insurance-related entities.

While exact figures are not available, the total size of the traded insurance risk (ILS), even when broadly defined and including both property-casualty- and mortality/longevity linked
securities, does not exceed US$70 billion. The following figure shows estimates
of the insurance-linked securities markets in relation to the broader financial
markets.

Notes: Derivatives, whose total notional amount is a multiple of the stock and bond markets
combined, are not included. Estimates are as of 2009 and are based on data from the Bank for
International Settlements, SIFMA, World Federation of Exchanges, World Bank, Milken
Institute, World Economic Forum, LISA, Conning, and McKinsey. Only publicly traded
securities are considered in estimating the size of the global financial markets. 

There are no adjustments for the cases of one public company owning stock of another publicly traded company. Securities that have connection to the insurance industry are broadly defined and
include those issued by companies involved in other businesses in addition to insurance. A
broad definition of insurance-linked securities is used to include such types of ILS as life
settlements and industry loss warranties. Most private deals that can be reasonably character -
ised as ILS-type transactions are also included.

standard investment analysis used for most other industry sectors. The
specialised expertise is a significant source of competitive advantage in the
investment analysis of insurance equities and debt.
 
Investing in securities issued by insurance companies does not provide
the diversification that might be expected from exposure to the risks of
insurance losses being greater than expected due to the fluctuations in the
frequency or severity of insurance claims, changes in mortality rates, or
other risks unique to the insurance industry. 

In investing in corporate securities issued by insurance companies, most of the risks are not “pure”
insurance risks but risks common to the financial markets. This explains the
high degree of correlation between the investment performance of the insurance
sector and the markets as a whole.

Search for uncorrelated return

Investors never stop their search for assets that improve the performance of
their investment portfolios, either through extra yield or through exposure
to uncorrelated assets. The value of truly low correlation with the markets
became painfully obvious during the financial crisis that started in 2007. By the end of 2008 all correlation assumptions broke down, and assets with historically low correlation all of a sudden started moving in sync. They were all moving in the same direction – down – and so were the supposedly diversified investment portfolios. Having investments with low beta generally
improves portfolio risk-adjusted returns and contributes to the goal of
capital preservation.

Insurance-linked securities as a portfolio diversifier

While insurance-linked securities are not zero-beta assets, they do represent
a valuable and effective form of diversification. Many of them provide exposure
to risks that have a low degree of correlation with the rest of the
financial markets, while still generating a very competitive yield. 

Securities such as cat bonds issued after 2008, designed with an express intent to strip
away, as much as possible, all risks besides the true insurance risk of natural
catastrophes, provide a good illustration of this diversification.
 
A storm on Wall Street might shake the very foundation of financial
markets, but it is not going to lead to a hurricane in Florida or an earthquake
in California. A catastrophe bond is not going be triggered because of the
condition of the markets. The relatively low degree of correlation with
market risk is the greatest advantage of insurance-linked securities, and for this reason insurance-linked securities can be an important component of
most investment portfolios.

 

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