Insurance-Linked Securities and Collateral: An Essential Overview

Insurance-linked securities (ILS) essentially enable insurers to transfer the risk from their balance sheet to capital market investors.

This provides them with the additional reinsurance capacity they need to cover catastrophe losses, while also enabling investors to directly participate in the insurance market, diversify their portfolio, and get a potentially higher return.

The ILS market's popularity is reflected in the fact that it, in the space of 30 years, has grown from a zero base to $185 billion, according to the Artemis Deal Directory, and it's continuing on that trajectory.

Just as the market has grown, so have the different types of ILS that investors can use.

Chief among them are catastrophe (cat) bonds. The other main ILS forms are collateralized reinsurance, sidecars, and industry loss warranties. There is also embedded value securitization, extreme mortality securitization, life settlements securitization, longevity swaps, and reserve funding securitization.

Mike Ramsey, managing director, corporate trust and agency services, at Wilmington Trust, said, "The ILS industry, including vehicles like cat bonds, sidecars, [industry loss warranties, or] ILWs, and collateralized reinsurance, plays a vital role in ensuring the overall needs of insurance consumers will be met—especially with large catastrophic perils like hurricanes, earthquakes, wildfires, etc. Without the extra capacity ILS investors bring to the table, insurance carriers would find it difficult to effectively cover many of these natural disasters.

"Although ILS can be risky, sophisticated investors in the ILS space employ many modeling experts to analyze data to help make prudent investment decisions which can bring better returns than typical capital markets," he continued.

Let's take a look at each type of ILS and how they work.

Catastrophe Bonds

Developed in response to a global shortage of reinsurance capacity following the 1992 hurricane season, cat bonds work in a similar way to a fixed-interest bond. The sponsor, usually an insurer, reinsurer, or public insurance authority such as the California Earthquake Authority or the Texas Windstorm Insurance Association, forms a special purpose vehicle (SPV) that issues the bonds to investors, thereby transferring the risk it assumes in insuring a particular catastrophe (either a specific event or certain magnitude of loss).

That SPV then invests the proceeds into a trust in the form of AAA-rated money market funds, short-term government securities, or cash for the duration of the bond and issues the sponsor with a reinsurance contract, with the risk being ceded to the buyer in the form of a security. Foreign governments and private companies also use sponsored cat bonds as a hedge against natural disasters.

If an event occurs that triggers a payout, the SPV uses the proceeds as collateral to reimburse the sponsor according to the terms of the transaction. If no event happens, on maturity, the buyer recovers their principal investment along with the agreed-upon interest provided by the premium paid and investment income received.

In some cases, however, cat bonds can be used to cover multiple events to reduce the chances that investors will lose all of their principal amount. Insurers can also transfer the risk to a reinsurer to protect their portfolio and minimize the liability.

Unlike traditional reinsurance, cat bonds aren't highly leveraged as their value is equal to the amount of insurance limits for sale. This enables investors to participate in them even if they don't have an insurer credit rating.

"Cat bonds are a useful substitute as a source of additional potential protection, particularly if the market conditions make it tough to get coverage for catastrophe risk," said Aaron Koch, principal and consulting actuary at Milliman.

Collateralized Reinsurance

Collateralized reinsurance is a reinsurance contract or program that is fully collateralized, typically by investors of third-party capital. Normally, the collateral is equal to the full reinsurance contract limit, minus the premiums.

The process is generally done using contract forms similar to traditional reinsurance contracts, thus removing some of the costs associated with establishing a cat bond. It also enables a wider range of risks to be transferred to the alternative capital market that traditionally haven't been included in cat bonds.

Then there are collateralized reinsurance investments (CRI). These privately structured securities or derivative transactions enable investors to access the return of the reinsurance market and again provide risk capital on a fully collateralized basis.

CRI are typically more customizable but less liquid investments than catastrophe bonds. CRI are often created by taking reinsurance contracts and transforming them using an offshore entity into securities that are bought and so collateralized. This side of the market is growing and allows investors to access much broader classes of insurance risk.

Sidecars

Sidecars are used by reinsurers to cede premiums to investors who put funds into the vehicle to ensure any claims that may arise are paid. Developed in response to hurricanes and other catastrophes to cover a broad range of perils and geographies, they also provide insurers and reinsurers with alternative capital to reduce earnings and capital volatility.

Acting as SPVs, sidecars came into their own in the aftermath of the 2005 storm season when the major rating agencies changed their modeling rules and raised capital requirements for insurers and reinsurers underwriting windstorm and other catastrophe risks. They are used to provide extra capacity in periods of increased market stress.

Typically done on a quota share agreement, the reinsurer assumes a portion of the cedents' underwriting risk in exchange for a like-percentage premium. Capitalized by equity, sidecars differ from traditional reinsurance as they are privately financed, the risks and risk period are defined and limited, they are typically limited to a single cedent, and they don't have an active management group or staff.

Mr. Koch said, "Collateralized reinsurance is essentially the ease of access option that any reinsurer who buys reinsurance can make use of. It has really helped bring many of the smaller, midmarket players to the market who couldn't afford to spend several hundreds or thousands of dollars just on documentation for a cat bond."

Industry Loss Warranties

Industry loss warranties (ILWs) are reinsurance or derivative insurance contracts with loss triggers based on industry thresholds. Buyers pay a premium for the ILW, and if losses exceed the threshold, a limit amount will be paid to them.

Like the other ILS instruments, collateral is held for the length of the ILW's term and, if there is no loss, released to the investor. Often written as a reinsurance contract, an ILW can sometimes have additional clauses that must be met for a payout to be made, such as, in addition to the industry loss, the buyer must also have experienced a specified amount of loss themselves.

There are different types of ILWs available. For example, live cat ILW contracts are traded while an event is occurring, often while a storm approaches landfall.

Dead cat ILWs can be bought and traded on an event that has already happened but where the final loss amount is not yet known. Backup covers can be arranged after an event has occurred to provide protection against follow-on events that certain catastrophes can cause, such as flooding or a fire following an event.

Collateral

Whatever the ILS format, funds need to be made available as collateral to ensure claims can be paid in the event of a loss. The grantor puts the funds into trust accounts, where they are held for the duration of the contract or until a claim is made that has to be paid.

Mr. Ramsey said, "Collateral plays an important role as it guarantees the cedent or insurance company that any claims triggered in a reinsurance contract can be paid by the reinsurer, thus reducing credit risk to the cedent. For nonadmitted insurance carriers, collateral equal to the amount being ceded is required to be posted for the carrier to receive Schedule F credit for reinsurance." 

Martin Ellis, SVP and manager, global and captive insurance group, at Comerica Bank, said, "For the ceding insurance carrier who is buying reinsurance, collateral assures that the funds will be there if they need them. Also, if the reinsurance is from a 'nonadmitted' carrier, it allows them to take credit for the reinsurance; otherwise, their regulators would require them to record the entire gross liability on their balance sheet." 

The different forms of ILS respond to triggers if an event happens or a threshold is surpassed. However, in some cases, particularly following a surge in catastrophes, collateral can become temporarily trapped or frozen until the claim is paid.

Mr. Ellis said, "There are various forms of acceptable collateral, but they should all be monitored. If the collateral is a letter of credit (LOC), the ceding carrier must approve the bank issuing the LOC and monitor its credit ratings to make sure it's still acceptable.

"In addition, the ceding carrier must approve the language in the LOC. If the collateral is a reinsurance trust, the ceding carrier must approve the language in the trust agreement and make sure the allowed investments are acceptable."

He continued, "They also need to monitor the market value of the investments in the trust to make sure they are sufficient to secure the related reinsurance obligation."

Added to that, often when a deal expires the funds are redeployed into another trust for another deal. If that is triggered, the money held in the trust isn't necessarily immediately available when the contract expires, meaning it's trapped or frozen.

Mr. Ramsey said, "One key issue that has been a topic lately is trapped collateral, which refers to collateral in a reinsurance contract that may be frozen or 'trapped' by a cedent when a catastrophic event triggers claims that may take some time to calculate. When this happens, collateral can be tied up until the event has been fully vetted.

"ILS fund managers have been working to address this issue though, most recently after Hurricane Ian, by setting up 'side pockets' to segregate assets tied to an event while allowing other capital to be reinvested in the ILS space."

Mr. Koch said, "If there has been a big loss but the insurer isn't sure how big it is, they will put up an estimate for how big they think it is. But a first estimate is only that, so they have built a contract provision which states it's going to hold back some additional safety margin collateral until the final figure is agreed upon and the claim is settled.

"This collateral is effectively sidelined while the insurer waits to see what the final outcome is. In the meantime, that money can't be used by the investor to redeploy into another risk-bearing asset."

Mr. Ramsey added, "The ILS market saw significant growth in 2023 propelled by a record number of cat bonds issued and a relatively strong year with good returns and no major natural catastrophe, unlike some previous years. With interest rates and money market fund yields holding steady due to the Federal Reserve's attack on inflation, I believe cat bonds will continue to grow their market share in ILS, and investors will find good value into 2025.

"The attractive returns and relative calm the industry enjoyed the past year has led to increased competition among reinsurers with increased capacity as the industry has become more attractive to new investors. This trend should bode well for insurance companies and consumers that rely on reinsurance coverage this year and hopefully into 2025," he said.