Introduction to Insurance Linked Securities

Insurance linked securities (ILS) are tradable, high-yield debt instruments that are used by companies – usually insurance and reinsurance companies – to transfer insurance risk to the capital markets. A large majority of the ILS market is composed of property catastrophe bonds (cat bonds), which are typically used as an alternative to buying traditional catastrophe reinsurance. Other types of insurance linked security include mortality bonds, longevity bonds and XXX bonds. The securities pay periodic coupons to the investor during the life of the bonds (cat bonds typically have a three-year maturity but can range from one to five years). The coupon consists of a risk free return (often three month treasuries) plus a spread that depends on the risk of default and market conditions at the time of issue. The principal is at risk following a trigger event that affects the sponsoring company. A semi-liquid secondary market exists which is facilitated by a number of specialist broker-dealers. Some of these firms issue weekly pricing sheets which include guidance on the current pricing level of outstanding bonds.

The ILS market

As at 30 June 2013, the total value of cat bonds on risk was at an all-time high of $17.5 billion. For investors, cat bonds are attractive because their returns are largely uncorrelated with other financial markets. They have also paid higher coupons than comparably-rated corporate instruments.

Structure

Cat bonds are issued by a special purpose vehicle (SPV), typically domiciled in Bermuda or the Cayman Islands. The bond is placed with institutional investors through investment banks and the SPV invests the proceeds in highly rated assets. The cat bond itself is issued as notes by the SPV. These notes are often given a rating by an agency, such as S&P, that will give guidance on the risk of default. The coupon that the notes pay out is funded by a combination of the 'risk free' returns generated by the collateral, along with premiums paid by the issuer. If no trigger event occurs during the life of the bond, the SPV returns the entire principal to the investor at maturity. If the bond is triggered, the SPV liquidates the assets and pays the sponsor all, or part, of the proceeds.

Legal form

Most insurance linked securities are structured to rely on rule 144A (more recently, ‘private’ cat bonds have been issued under Regulation D). This has limited the marketing process and meant that only Qualified Institutional Buyers with more than $100m of assets were able to invest. The American JOBS Act (2013) relaxes the marketing restrictions for both 144A and Reg D structures. It also opens up the possibility of bonds being distributed more widely than QIBs.

History

Issuers of insurance linked securities have maintained a steady pace of innovation since the structure was first conceived in the mid 1990s. As the asset class has become more mainstream, it has been used to hedge a growing range of risks.

1996   St Paul Re issues George Town Re, the first insurance linked security.

1997   The first ILS fund – Nephila – is formed as part of the broker Willis. American Skandia issued the first life bond. Tokio Marine creates the first parametric bond.

1998   Total issuance is greater than $1 billion of bonds for the first time.

2003  Glenworth issues the first XXX bond. Swiss Re issues the first extreme mortality bond.

2005   The first car insurance bond is issued by AXA

2007   Nephila issues Gamut Re – the first (and only) insurance linked collateralised debt obligation.

2008   Three bonds that used Lehman Brothers as their LIBOR swap counterparty are impaired during the financial crisis. Subsequent bonds have been subject to much tighter collateral conditions.

2010   Aetna sponsors the first health bond and Swiss Re sponsors the first longevity bond.

2011    Tornadoes in the US and an earthquake in Japan lead to two total defaults totalling $500m.

2013    Outstanding issuance approaches $20 billion.