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Insurance-Linked Securities

Last Updated 10/19/2021

Insurance-linked securities (ILS) are products of the rapid development of financial innovation and the convergence of the insurance industry and the capital markets. The securitization model has been employed by insurers eager to transfer risk and use new sources of capital market funding. ILS, both from the life and property/casualty (P/C) sectors, hold great appeal for investors.

While catastrophe bonds (cat bonds) remain the dominant type of outstanding ILS, there are also other non-cat bond ILS in existence, such as those based on mortality rates, longevity, and medical claim costs.

According to the Artemis Deal Directory, in Q4 2019, cat bond and ILS issuance reached $3.3 billion, which is $1.1 billion above the 10-year average for Q4. The $3.3 billion of total new risk capital issued in Q4 came from 15 transactions, consisting of 28 tranches of notes. Since 2015, only once has issuance in Q4 exceeded the $2 billion mark, so it is impressive that it is now more than $3 billion. Combined with the previous three quarters of the year, Q4 2019 issuance took the total outstanding market size to a record end-of-year high of $41 billion.

Despite falling over $2.7 billion year-over-year, issuance levels remained above the $10 billion mark for the third consecutive year. At $11.1 billion, cat bond and ILS issuance in 2019 was the third highest ever recorded according to Artemis’ data.

International multi-peril deals accounted for the largest slice of Q4 issuance, at $1.33 billion, or 40% of total issuance. Given the recent expansion of mortgage risk in the space, two mortgage ILS deals came to market in Q4, accounting for approximately 27% of issuance.

At about $219 million, the average transaction size of Q4 2019 issuance is slightly below the 10-year Q4 average. In terms of the number of transactions brought to market, the 15 issued in Q4 2019 is above the 10-year average of 10 and higher than 14 reported a year earlier. For the sixth year running, the majority of cat bond and ILS issuance came to market in the first half of the year, in terms of the size of transactions and the number of deals. Thirty-eight separate transactions were issued in the opening six months of the year, amounting to approximately $6.4 billion.

Catastrophe Bonds
Cat bonds are a segment of the ILS market. They are used by P/C insurers and reinsurers to transfer major risks on their books, such as for hurricanes, windstorms, and earthquakes, to capital market investors, reducing their overall reinsurance costs while freeing up capital to underwrite new insurance business. Cat bonds are structured so payment of interest or principal to the reporting insurance company depends on the occurrence of a catastrophe event of a defined magnitude or causes an aggregate insurance loss more than a stipulated amount.

The risk inherent in cat bonds is a key reason these securities are of relatively short duration, typically maturing in three to five years. Since the cat bond market's inception, 10 transactions have resulted in a loss of principal to investors out of the more than 300 transactions that have come to market in its nearly 20-year history. Of these 10 historical losses, six were the result of insured loss events and four were related to credit events in the vehicle's collateral due to the collapse of the firm responsible for guaranteeing the bond's collateral. Although it was once the most commonly used collateral structure, the collateral structure used in the deals that incurred credit-related losses, called total return swaps, is not used in any outstanding cat bond. Treasury money market funds are currently the most popular collateral solution, followed by similar investment-grade securities.

Cat bonds remain a useful diversifying risk tool for investors' portfolios and a valuable risk transfer tool for sponsoring insurance companies. As interest rates are at historic lows, investors continue to look for yield in alternative asset classes. The spreads available in the high-yield markets highlight the attraction of the ILS market, which has been the beneficiary of large inflows from institutional investors. The lower interest rate environment has caused returns to decline, similar to other fixed-income asset classes. Lower interest rates for ILS are generally still marginally higher than similar corporates in this market characterized by persistent low-interest rates.

Insurers, in addition to being issuers of these securities, can and do invest in them on a limited basis. Insurance companies purchase these securities to diversify their portfolios. Typically, insurers are not expected to invest in a cat bond if they are already exposed to the peril in question in their primary business.

Another structure for transferring catastrophe risk to investors is the sidecar, which became very popular in the aftermath of Hurricane Katrina. Sidecars are deployed mainly by reinsurers following major catastrophes to add risk-bearing capacity in periods of increased market stress. Sidecars are special-purpose vehicles through which reinsurers cede premiums associated with a book of business to investors who place sufficient funds in the vehicle to ensure claims are paid if they arise. In contrast to cat bonds, which are structured as long-term instruments covering a broad array of perils and geographies, sidecars are tactical instruments of limited duration during a hard market.

As severe natural catastrophes become more frequent due to changing climate conditions, insurers and reinsurers may boost their issuance of cat bonds and sidecars as additional protection from the risk of incurring solvency-threatening losses.

As part of regulatory efforts to help manage catastrophe risk, the NAIC and state insurance regulators have developed a comprehensive national plan that incorporates new risk management techniques with a solid foundation of solvency and consumer protection inherent in state insurance regulation.

Life Insurance Securitization
Life insurance securitization is also a segment of the ILS market. Mortality and longevity risk securitizations fulfill a similar function for life insurers as cat bonds and sidecars do for P/C insurance and reinsurance companies; i.e., the transfer of risk to the capital markets.

Extreme risks of increasing mortality rates due to natural catastrophes and pandemics could present a challenge to a life insurer's solvency. A jump in mortality rates would adversely affect the amount and timing of death benefits an insurer must pay. Longevity risk is the other side of mortality risk. A rise in longevity rates would increase cash outflows due to more annuity payments.

Apart from transferring mortality risk, life insurance companies have employed securitization techniques to: 1) monetize the embedded value of a particular block of business in order to fund acquisition or demutualization costs; and 2) fund the extra reserves required by Model Regulation XXX and the Valuation of Life Insurance Policies Model Regulation (#830). Often, a captive insurance company is at the center of Model Regulation XXX life securitization structures, and it is used as a repository for the funds that were available from the securitization.