Insurance-Linked Securities

Last Updated: 10/25/2023

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 2022, cat bond and ILS issuance fell to $1.6 billion, which is roughly $560 million below the 10-year average for Q4. The $1.6 billion of total new risk capital issued in Q4 came from 15 transactions, consisting of 18 tranches of notes. In the last ten years, only one issuance in Q4 (2018) hasn't exceeded the $1.5 billion mark. Combined with the previous three quarters of the year, Q4 2022 issuance took the total outstanding market size to a high of $37.9 billion.

In 2022, issuance levels remained above the $10 billion mark for the sixth consecutive year. At $10.5 billion, cat bond and ILS issuance in 2022 was not a record year, but was still above the decade average of roughly $9.7 billion, according to Artemis’ data.

Traditional 144a property catastrophe bonds made up the majority of Q4 issuance, at $1.37 billion, or 87% of total issuance. Reversing last years trends, no mortgage deals were issued during this quarter, though a single deal brought $150 million of non-cat risk to the market.

At about $105 million, the average transaction size of Q4 2022 issuance is down from last year and well below the 10-year Q4 average. In terms of the number of transactions brought to market, the 15 issued in Q4 2022 is slightly above the average for the quarter, but much lower than 24 issued in Q1. 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. 51 separate transactions were issued in the opening six months of the year, amounting to approximately $8.7 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. 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. And as interest rates have risen, cat bonds haven't been deeply impacted, as they are generally issued as floating-rate securities.

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.

Sidecars
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.

The NAIC's Valuation of Securities (E) Task Force is tasked with providing regulatory leadership and expertise for the NAIC’s credit assessment process for insurer-owned securities, as well as produce insightful and actionable research and analysis regarding insurer investments.