ILS in a Nutshell and Collateral in the ILS Market

In a chain of five links in a chain the third or middle link is broken at the top

October 17, 2018 |

In a chain of five links in a chain the third or middle link is broken at the top

Editor's note: recently caught up with a few members of Wilmington Trust's collateral team to find out about its expertise with collateral trusts and how it relates to the team's involvement in the insurance-linked securities (ILS) market. Read on to find out about the insurance-linked securities market and ILS collateral.

What Are Insurance-Linked Securities?

Insurance-linked securities are financial securitizations of insurance risks. They allow capital market investors to participate directly in the reinsurance market and are an attractive option for investors seeking diversification of their holdings and potentially higher rates of return than are available elsewhere. One of the most common uses for this approach is with catastrophe bonds. Catastrophe bonds were developed in the wake of a global shortage of reinsurance following the 1992 hurricane season and the 1994 Northridge earthquake, according to an October 2018 "Perspectives" report titled "What's Hot in Risk Financing," published in the International Risk Management Institute, Inc. (IRMI), publication Risk Financing

The same IRMI report said that other strategies adopted by reinsurers to increase capacity for catastrophic risks include property sidecars and collateralized retrocessions. Retrocessions are transactions in which a reinsurer transfers a risk or portfolio of risks to another reinsurer. Sidecars are used to add risk-bearing capacity in periods of increased market stress. Reinsurers cede premiums to investors who place sufficient funds in the vehicle to ensure any claims that arise are paid. They have been important tools since the 2005 storm season when the major rating agencies altered their modeling rules and raised the capital requirements for re/insurers underwriting windstorm and other catastrophe risks.

The Numbers

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Current numbers from Artemis show that ILS funds had combined assets under management of just over $100 billion as of mid-September, more than 20 percent of the total capital of the reinsurance market, according to the IRMI report.

Over the past 20 years, the ILS market has grown considerably, regarding both the volume of bonds issued and the total volume outstanding in the market. According to the Artemis Deal Directory, 1997 saw $785.5 million in newly issued securities and volume outstanding in the ILS market, an amount that 10 years later grew to more than $8.29 billion in new issue volume and nearly $15.88 billion in risk capital outstanding in 2007. The market saw a particular bump in issuance following the 2005 hurricane season with the sizable insurance industry losses resulting from Hurricanes Katrina, Rita, Wilma, and others. New issuance in 2006 jumped to more than $4.69 billion from nearly $2.49 billion a year earlier, then jumped the following year again to the 2007 total. 

More recently, new issues in 2016 provided more than $7.05 billion in new risk transfer capacity with a total outstanding market volume of nearly $26.82 billion. In 2017, new issue volume totaled a record-breaking $12.56 billion and $31.06 billion in risk capital outstanding. The ILS market continues to show robust growth in 2018. Artemis currently reports $11.88 billion in new issuance for the year, an amount that pushed total outstanding market volume to just shy of $37 billion. 

Market Transformation

According to IRMI, the increased supply of risk-taking capacity offered by the financial markets continues to put pressure on reinsurance pricing. It has also helped drive a wave of mergers and acquisitions as reinsurers diversify away from property catastrophe business. As the market continues to mature, investors are diversifying their holdings to include a range of other reinsurance-related instruments that go beyond ILS. The term "alternative capital" has become popular as a way to describe the phenomenon of "financial investors writing reinsurance" under a single umbrella.

In an August 2018 S&P Global Market Intelligence report titled How Reinsurers Have Learned To Align Third-party Capital with Their Needs, S&P said that the third-party capital brought into the reinsurance sector by ILS has resulted in a market transformation, particularly in the property catastrophe space.

Alternative capital has continued to grow despite 2017's three major hurricanes—Harvey, Irma, and Maria, the S&P report continued. "Investors, scenting the chance of increased returns, replaced capital that had been put aside as collateral to cover insured losses, enabling them to participate in the January 1, 2018, round of renewals. As a result, the price hikes the reinsurance industry has typically seen after previous catastrophe events were limited." 

The S&P report also said that even with increased competition and limited price increases, reinsurers have benefited from alternative capital influxes to optimize their own portfolios through the use of sidecars, catastrophe bonds, and collateralized reinsurance. "As a result, the retrocession market is increasingly dependent on third-party capital," according to S&P.

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ILS Definitions

Reinsurance sidecars, according to, are limited purpose reinsurance companies that provide insurers and reinsurers with alternative capital to reduce earnings and capital volatility developed in response to hurricanes and other catastrophes. Like traditional reinsurers, the sidecar reinsurer assumes a portion of the ceding company's underwriting risk (including losses and expenses) in exchange for a like-percentage premium (hence the term "sidecar").  The sidecar reinsurance agreement is typically a quota share agreement.

Sidecars are usually set up by an affiliated insurer or reinsurer and capitalized by equity and debt financing (often from hedge funds). The capital is invested and used to pay claims.

Sidecars differ from traditional reinsurance in that (1) they are privately financed, (2) they exist for a defined risk period and finite lifetime (usually 24 months or less), (3) their risks are defined and limited, (4) they are typically limited to a single cedent, and (5) they do not have an active management group or staff. Since they are tailored to a specific cedent's needs, capital is determined after modeling the risks.

A catastrophe bond is a derivative debt investment vehicle (special-purpose vehicle or insurer (SPV or SPI)) issued by insurers and reinsurers designed to raise investor capital to cover catastrophic loss events, according to "Cat" bonds are generally issued to cover either a specifically identified event (e.g., a Japanese earthquake) or the possibility of a certain magnitude of loss.

Unlike traditional reinsurance that is highly leveraged (i.e., reinsurance limits sold represent many multiples of a reinsurer's capital), cat bonds carry no such leverage since their value is equal to the amount of insurance limits for sale. This feature allows financial investors such as hedge funds to participate in cat bond deals despite not having an insurer credit rating.

According to Artemis, the cat bond investors' capital is deposited into a collateral account where it is invested for the duration of the bond. Then, "[I]f a qualifying event occurs which meets the trigger conditions to activate a payout, the SPV will liquidate collateral required to make the payment and reimburse the counterparty according to the terms of the catastrophe bond transaction. If no trigger event occurs then the collateral is liquidated at the end of the cat bond term and investors are repaid.”

Collateralized reinsurance, according to Artemis, is a "reinsurance contract or program which is fully-collateralized, typically … by investors or third-party capital.... Normally, the [collateral] is equal to the full reinsurance contract limit [less premiums]." Like other ILS alternative capital instruments, the collateralized reinsurance market "enables [institutional] investors to directly participate in the reinsurance market and provide a source of risk capital to cedents in the market" ... "without requiring a rating, [allowing investors] to receive the premiums as a return on their invested collateral."

Collateralized reinsurance is generally conducted on contract forms that are very similar to traditional reinsurance contracts with the resulting major impacts.

  • It removes some of the costs that make putting together a cat bond expensive (notably, registering the security and complying with other securities regulations), meaning that more ceding insurers/reinsurers (notably smaller ones) can more reasonably afford to use alternative capital partners for protection through this form.
  • These deals are generally conducted on a private basis—alternative capital investors have to receive access through the traditional reinsurance brokerage process, as opposed to simply buying the transactions on a marketplace.
  • It allows a much broader variety of risks (e.g., specialty risks) to be transferred to the alternative capital market that haven't traditionally been found in cat bonds.

As a result of the above factors, in terms of growth, collateralized reinsurance has been the leading instrument in the alternative capital space for the last 4–5 years.

Industry loss warranties (ILWs) are reinsurance or derivative insurance contracts with loss triggers that are based primarily on industry thresholds and not the insured's (frequently an insurer) own losses attached to specific events. In exchange for premium paid (to a reinsurer or hedge fund, for example), if losses exceed the threshold (trigger the industry loss warranty), a limit amount will be paid to the buyer. Similar to the other vehicles listed above, ILW collateral is held for the length of the instrument's term and is then released at the end if there is no loss.

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Whether it's a sidecar, a cat bond, collateralized reinsurance, or an industry loss warranty, funds need to be available, in the form of collateral, to ensure claims can be paid where there are losses. 

Enter Wilmington Trust.

Robert Quinn joined Wilmington Trust's Global Capital Market Division to lead the insurance collateral solutions business in 2014. Mr. Quinn said, "Where there's a need to hold collateral, Wilmington can do it because regardless of the business need for the collateral in the insurance space, the trust documentation is similar for most arrangements." 

In any situation requiring collateral to be posted, the "grantor" of the trust places cash or cash equivalents into trust accounts. They do this for cat bonds, industry loss warranties, retrocession agreements, traditional reinsurance, quota share, and sidecar reinsurance. Wilmington does this for fronted captive insurance programs, captive insurance programs that are required to post collateral to meet state regulatory requirements, and large deductible programs. In the ILS space, most of Wilmington Trust's collateral work has been in the ILW category.

Mr. Quinn explained, "Our role as trustee in the ILS space is very similar to that of a reinsurance arrangement or a fronted captive arrangement where there is a collateral requirement. Ultimately, the trust work is very similar in all situations regardless of the application. It's just the business behind the transaction that's a little bit different."

Wilmington recently developed the ability to service catastrophe bonds. A catastrophe bond collateral transaction involves an indentured trustee and a reinsurance trustee, according to Mr. Quinn. While Wilmington has always been able to act as the reinsurance trustee, it has recently developed capabilities to act as the indentured trustee for cat bonds.

What about "Trapped" Collateral?

Following a surge in natural disasters, such as those experienced in 2017, parametric (or predetermined) trigger arrangements associated with ILS instruments can result in collateral becoming temporarily "trapped" or "frozen" until insurance payments are made, according to Michael Ramsey, client development officer for Wilmington's insurance collateral solutions team, who joined the team in June 2018.

Mr. Quinn added that ILS funds raise money for the expressed intent or purpose of using it as collateral to pay claims where there are losses. When there are large cat events or multiple events, if no trigger event occurs then the collateral is liquidated at the end of the cat bond term and investors are repaid. Frequently, said Mr. Quinn, as soon as the deal expires, the cash is redeployed into another trust for another deal. Thus, if a triggering event happens, the money held in the trust (collateral) is not necessarily immediately available upon expiration of the contract (i.e., it is "frozen" or "trapped").

"And it is actually somewhat dramatic because ILS models build in what will be written January 1st as well as July 1st for all types of perils," according to Mr. Quinn. "So if the money from January is trapped it cannot be used as collateral for deals in the new year. And what we are seeing is a lot of trapped collateral. Once the trust pays out the claims, or it doesn't, that's when beneficiaries (cedents) release the collateral. Relative to 2017's catastrophe events, I think a lot of the collateral has been released at this point."

Mr. Ramsey added, "Since hurricane incidents were very low until last year, investors who normally would be in the capital markets use ILS as a way to diversify their portfolio or invest in something else they normally wouldn't have. So there were a lot of questions as to whether that would scare away the 'newcomer investors.' So far from what we've seen, this hasn't really been the case. Of course, the collateral may be trapped but there has been no problem getting more investors to participate. So it's a very robust industry that continues to grow even after the test of 2017."

Mr. Quinn said, "One reason that the reinsurance and ILS space has been so popular for so long is because for years, with traditional investments, the rates of return were so terribly low. The rates of return were almost a rounding error in people's eyes. So when they saw that with reinsurance, the rate they might get is so much higher, a lot of people jumped at it. Now that the markets are starting to correct themselves, if you will, the rates of return on other investments are starting to come up, we're still seeing a tremendous influx of money coming into the ILS space.”

"Some people would rather put their risk in the natural disaster market than in the capital markets with what's been going on with capital markets," said Mr. Ramsey.

Robert Quinn and Michael Ramsey

Many thanks to Wilmington Trust for contribution of time and insights. Pictured above are Mr. Quinn (left) and Mr. Ramsey. Photos are courtesy of Wilmington Trust. would also like to thank Aaron Koch, director, Insurance-Linked Securities Group, P&C Division, and consulting actuary with Milliman, for providing technical input on this article.

October 17, 2018