Insurance-Linked Securities

Study guides: Exam DISC-RM, Exam 9, Exam GI-201

Insurance-Linked Securities (ILS) are financial instruments whose value depends on insurance losses — usually catastrophe losses — through which capital-market investors take insurance risk directly rather than through the shares of an insurer or reinsurer. The family covers cat bonds, sidecars, industry loss warranties, collateralised reinsurance and related derivatives.

$R_{\text{investor}} = r_{\text{collateral}} + s - \ell$

$s$ is the premium or spread received and $\ell$ the loss suffered, both as fractions of the capital posted; for a fully collateralised instrument $0 \leq \ell \leq 1$ . The expected excess return $s - E[\ell]$ is the price of the risk. Because catastrophe losses are nearly independent of financial markets, investors value that return as a diversifier.
The main forms:
- Cat bonds — notes issued by a special purpose reinsurer, tradable among institutional investors, typically multi-year, with indemnity, industry-index, modelled-loss or parametric triggers.
- Sidecars — special purpose vehicles through which a (re)insurer cedes premium and risk on a defined book, for example by a quota share, to outside investors whose funds are held as collateral. They are tactical instruments of limited duration, used in a hard market, and became very popular after Hurricane Katrina.
- Industry loss warranties (ILWs) — pay a fixed limit if an industry loss index exceeds a trigger. Written as reinsurance they add a second trigger on the buyer's own loss, which supplies the indemnity.
- Other risk-linked instruments — contingent capital such as a catastrophe equity put, an option to raise additional equity capital if losses exceed a predetermined level; the instruments have also spread to life insurance and annuities. Exchange-traded catastrophe options, offered on the Chicago Board of Trade from 1995, were among the first attempts, and trading ceased in 1999 for lack of demand.
Against traditional reinsurance: collateral replaces a reinsurer's promise, so there is no credit risk on the limit; capacity comes from capital markets; and index or parametric triggers trade moral hazard for basis risk. Cummins concludes that ILS complement reinsurance rather than replace it. See Securitization for the economic case.

A Sidecar's Return in Three Years A reinsurer cedes a $40\%$ quota share of its $\$250$ million property-catastrophe book to a sidecar for one year, receiving a $25\%$ ceding commission. Investors fund the sidecar with $\$300$ million held as collateral; its liability is limited to that collateral plus the premium it receives. Ignoring collateral yield, find the investors' return if the book's loss ratio is (a) $30\%$ , (b) $250\%$ , (c) $400\%$ .
Answer
 $\begin{align*} \text{Sidecar premium} &= 0.40 \times \$250\text{M} \times (1 - 0.25) \\ &= \$75\text{M} \\[4pt] \text{Ceded loss} &= 0.40 \times \$250\text{M} \times \text{LR} \\ &= \$100\text{M} \times \text{LR} \end{align*}$ 
(a) Loss $\$30$ M; profit $\$75\text{M} - \$30\text{M} = \$45\text{M}$ ; return $45/300 = 15.0\%$ .

(b) Loss $\$250$ M; profit $\$75\text{M} - \$250\text{M} = -\$175\text{M}$ ; return $-58.3\%$ .

(c) Loss $\$400$ M exceeds the sidecar's $\$375$ M of resources. Investors lose everything ( $-100\%$ ) and the sponsor bears the $\$25$ M excess.

The sponsor gains capacity and commission income without raising equity; the investors take the sponsor's underwriting, not just the hazard, because a quota share passes through its risk selection and pricing. And the cover is limited-recourse: beyond the collateral, the tail comes back to the sponsor.

Industry Loss Warranty: Two Triggers An insurer buys a $\$50$ million ILW in reinsurance form: it pays the full limit if U.S. hurricane industry losses reach $\$30$ billion and the buyer's own loss exceeds $\$1$ million. What does it pay if (a) industry losses are $\$34$ billion and the buyer's loss $\$220$ million; (b) industry $\$26$ billion, buyer $\$400$ million; (c) industry $\$34$ billion, buyer nothing?

Answer

(a) Both triggers met: $\$50$ million.

(b) Industry trigger missed: nothing, despite a heavy own loss — basis risk.

(c) Own-loss trigger missed: nothing.

The ILW is standardised protection against a market-wide event, with relatively low transaction costs. The own-loss trigger is what makes it indemnity, and regulators treat buying one with that trigger as a reinsurance purchase.