What Are Insurance-Linked Securities?

Insurance-linked securities (ILS) are derivative or securities instruments linked to insurance risks. ILS value is influenced by an insured loss event underlying the security. This securitization model was born of efforts by the insurance industry to develop an additional source of insurance and reinsurance capacity by transferring traditionally insurable risks to the capital markets. As the ILS market has developed, it has provided an alternative source of risk capital, most often for property catastrophe risks such as windstorm and earthquake. The ILS market has also been employed for life insurance exposures such as mortality and longevity risk.

These financial instruments have proven popular with the institutional investment community, which prizes their healthy returns. Because ILS value typically is not tied to broader financial markets, investors see them as a means of diversifying their portfolios beyond their typical securities. The industry has seen the development of ILS-specific investment funds, and there is also a growing secondary market for the securities where investors may resell the bonds.

Insurance-linked securities also provide capital markets investors a way to participate in the insurance and reinsurance markets beyond buying company stocks.

How Do Insurance-Linked Securities Work?

Through the ILS transaction, investors essentially provide coverage for the event underlying the securities, providing the issuer capital up front with the securities' ultimate value determined by any insured losses resulting from the covered event.

Catastrophe bonds are the best known and most common form of ILS. The first ostensible cat bonds were issued in the 1990s to transfer natural catastrophe risks to investors as insurers and reinsurers sought additional sources of capacity following events like Hurricane Andrew and California's Northridge Earthquake.

In a typical "cat" bond structure, the bonds' sponsor—usually an insurer, a reinsurer, or a public insurance authority such as the Texas Windstorm Insurance Association or the California Earthquake Authority—forms a special purpose reinsurance vehicle (SPRV) that issues the bonds to investors, invests the proceeds, and provides a reinsurance contract to the sponsor. The specifics of the bond transaction essentially cede the specified risk to the bonds' buyers. If the designated underlying event occurs, the SPRV uses the bond proceeds to reimburse the cat bonds' sponsor according to the terms of the bond transaction. If no triggering event occurs, bond investors recover their principal along with the agreed-upon interest.

Many insurance-linked securities are structured in multiple tranches that provide investors a variety of risk versus return alternatives. In some cat bond issues, for example, various tranches might put increasing percentages of bondholders' principal at risk in exchange for greater yield, up to a tranche that puts all principal at risk in exchange for the highest potential yield. In general, the returns on insurance-linked securities are significantly higher than those on similar corporate bonds. Meanwhile, of the hundreds of cat bonds issued to date, only a handful have resulted in a loss of investors' principal.

The bonds can be structured to respond to a variety of triggers, based on the nature of the risk and the issuers' needs. For example, the bonds may feature an indemnity trigger based on an insurer's book of business, triggering if the insurer's losses, due to the specified event, exceed a designated level. Index-based triggers respond if industry losses, due to a designated event in the specified area, exceed a predefined level. A parametric trigger occurs when an event meets certain specified parameters, such as earthquake location and intensity.

In selecting a trigger, the ILS sponsor must consider basis risk—the possibility that its actual loss experience might differ from what it recovers for the transaction. Also, accurate modeling is an essential element of insurance-linked securities to structure the transaction in a way that effectively provides the coverage the issuer intends.

While the durations of most cat bonds and other insurance-linked securities tend to be short—1 to 2 years is typical—in recent years some have come to market with longer durations of 3 years or more, likely reflecting the market's growing maturity and investors' increased confidence in the instruments.

Evolution and Growth of Insurance-Linked Securities

Over the past 20 years, the ILS market has grown considerably, both regarding 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. The ILS market continued to show robust growth in 2017. Artemis reports $8.15 billion in new issuance for the first 6 months of the year, an amount that pushed total outstanding market volume beyond $29 billion. On its own, this makes 2017's new ILS issuance volume the third largest on record behind more than $9.09 billion issued in 2014 and more than $8.29 billion issued in 2007. ILS issuance for the first half of 2017 exceeded issuance for the same period in any prior year and is approaching record first-quarter new issue volume.

As the ILS market has grown, it has evolved in both the types of risks transferred to the capital markets and in terms of how deals are structured to meet investor demand. Now, with decades of history behind it, a solid track record of performance, robust investor interest in the asset class, and continued demand for risk capital, the ILS market seems likely to continue to grow in the years ahead.