Insurance Linked Securities (ILS) is an asset class that transfers (re)insurance risks to the capital market. To investors, the asset class offers returns fundamentally uncorrelated to equity markets, interest rates and credit risk. For people and companies in areas exposed to natural catastrophe risk ILS can contribute to improved insurance protection, enable investments in property and provide capital for disaster relief and reconstruction after natural catastrophes. Importantly ILS can also support investment in initiatives to improve resilience to natural catastrophes
A valued asset class for risk transfer and diversification
Insurance-linked securities (ILS) are products that transfer insurance risk from (re)insurers and organisations to the capital markets.
The market has grown significantly since the 1990s as a function of increased regulatory capital requirements mandatory to the insurance industry and increased economic values in areas exposed to natural catastrophe risk. The product range covers industry loss warrants (ILW), collateralised reinsurance, side cars and ILS based on mortality rates, medical claim costs and longevity.
Catastrophe bonds are broadly known by institutional investors as a source of returns uncorrelated to equity markets, interest rates and credit risk. The ILS market provides more than 15% of global reinsurance capital, or in excess of USD 90 billion.
The liquid category of ILS
Catastrophe bonds (commonly abbreviated to cat bonds) is a liquid category of the asset class ILS. Cat bonds are a tool for asset managers to diversify portfolios and a risk transfer tool for insurers. Cat bonds are generally aligned with climate change and environmental, social and governance (ESG) investing by large institutions.
As interest rates are historically low investors are increasingly looking at cat bonds in the search for yield. Cat bonds’ collateral is secure in a collateral account invested in primarily U.S. Treasury bills and equivalent securities such as instruments issued by the World Bank.
The bond holder receives a coupon based on the interest rate of the collateral and the risk premium for carrying the insurance risk. If a predefined insurance event occurs the insurance company will collect all or part of the principal value of the security. If no predefined event occurs the bond holder will collect the principal.
A source of uncorrelated returns
Unlike other ILS instruments, cat bonds are securitised and can be traded on a secondary market. ILW and collateralised reinsurance cannot be traded and are private transactions. Cat bonds are floating rate securities that transfer predominantly risk of natural events.
The return profile for most cat bonds is in the interval of 5 – 10% p.a. As fixed income instruments they offer returns independent of equity market risk, interest rate risk and credit risk.