ILS: A Lone Wolf Among Securities, A Boon For Cat Covers

The ongoing pandemic stoked large corrections in equity, commodity and debt markets as players grappled with the full extent of its impact. At such times, insurance linked securities (ILS) are a boon, being mostly uncorrelated to mainstream financial markets. Since natural catastrophic ILS are driven by disaster events, there is no direct link to credit or economic cycle.

ILS has been around a few decades, having originated post Hurricane Andrew (1992), which cost the industry $15.5 billion and led to (re)insurers transferring risk and premiums to the capital market. The market has grown to approximately $90-$100 billion. A third of this is tradeable catastrophe bonds with the rest in illiquid, privately traded, collateralized reinsurance transactions. ILS has been largely immune to Covid-19 as majority of risks transferred cover natural perils.

ILS investors act as a (re)insurance company, accepting premiums in exchange for the risk of a loss. If triggering events do not develop, investors enjoys a periodic coupon payment from insurance premiums and principal repayment at the tenure end. If an event does occur, all or part of the principal is used to pay insured losses and coupon payments cease or reduce; at maturity the principal repayment is adjusted.

Traditionally, ILS are used as cover for property catastrophe (CAT) type events. Characterized by low frequency yet high severity events, CAT bonds offer high returns during years with few events. But, owing to the randomness and severity of natural disasters, there is potential for sizable losses.

ILS risk-return potential is assessed from modelled frequency and severity of insured events. Investor demand and RI industry’s need for external capital impact premiums. In periods of strong investor demand, the return potential may be lower and higher when reinsurers need more external capital, typically after a large industry loss. The below chart shows annual calendar returns for the Swiss Re Global Cat Bond Index from 2002.


Amid the pandemic, the recent completion of the California Earthquake Authority’s (CEA) latest catastrophe bond is evidence of the health of the ILS market and investor commitment. The CEA protects more than one million policyholders in California against earthquakes, enhancing its claims pay-ability with capacity from global capital markets.

A couple of start-ups making waves in ILS are Ledger Investing and Vesttoo.

Ledger Investing, an ILS focused insurtech that recently raised $10 mil Series A, directly connects risk with available pool from capital markets and ILS investors. Its first transaction was a portfolio securitization of non-standard passenger auto insurance, between an MGA and AIG owned ILS fund manager. It also connected auto and workers compensation risks originated by more than fifteen MGAs to capital from the ILS market.

Similarly, Vesttoo lets carriers transfer actuarial risks to the capital market. Their AI-based technology performs quality and risk assessment to provide insurers with a risk management solution that offers on-the-spot capital. Multistrat, an RI investment facilitator, completed a $150 million casualty linked security transaction, with a $50 million stop-loss forming one layer, using Vesttoo’s risk transfer platform and services in structuring, arranging and placing the transaction.

As climate change induced natural catastrophes continue to rise, a deepening ILS market will bring more capacity. New risks are emerging in the ILS market such as a Swiss investment bank bringing operational risk insurance to the market or a motor insurer transferring its third party liability book. Decorrelation might be no longer a given. At the same time, better technology is making placements and servicing a lot more seamless than ever before.

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