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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