This is a city by the water where property owners are vulnerable to natural disasters (mainly hurricanes and storm surge). While the probability of a natural disaster occuring is low, when events do occur they can be extremely destructive. Therefore, property owners are keen to protect themselves by taking out catastrophe risk insurance.
Insurance companies would have liked to issue a hurricane insurance policy to each of these property owners in exchange for a premium. However they are not able to do so because there is an aggregation of risk: ie if a hurricane strikes there is a high likelihood that all these properties could be damaged and hence the insurer may not have the money to pay all the claims.
Insurance companies turn to reinsurance companies and buy insurance as a means of transferring and managing risk. Insurance companies pay a reinsurance premium. In return, the reinsurance company will step in and pay a share of the claims in the event a hurricane occurs.
In 1992, Hurricane Andrew hit Florida and Louisiana. At the time, Andrew was the most costly disaster in history to hit the USA. Even though insurance companies were reinsured, the loss put pressure on both insurance and reinsurance companies. Eleven insurance companies filed for bankruptcy and several others only just survived. Worst off were policyholders, who faced escalating insurance premiums as re/insurers became more reluctant to provide insurance in Florida and withdrew their capacity.
There was a significant need to source more capital to transfer the risk of natural disasters. The solution was to turn to the capital market, which is many times larger than the insurance and reinsurance industry.
Inspired by this strong unmet demand for capital, investment banks turned their considerable resources to converting re/insurance risks into a new asset class.
Insurance-Linked Securities (ILS) was born as a new, specialist asset class to transfer insurance and reinsurance risks to the capital markets
To offer protection against natural disasters, re/insurance companies can access capital from investors by issuing an insurance-linked security, an investment instrument similar to a bond.
Similar to the coupon received by a bondholder, the ILS investor receives a premium in return for pledging capital to back up the protection provided by insurers and reinsurers.
At the end of the insured period, if the insured event (hurricane, earthquake, flood, etc.) did not occur, the capital is returned to the investor. The investor also receives the premium as a return on his investment. If the event occurs, the investor may lose some or all of his capital. However with proper diversification, the possible loss of capital can be mitigated.
Policyholders are able to get protection for a premium
ILS enables the Insurance and Reinsurance companies to transfer catastrophe risks to the capital market
Investors receive a return on their ILS investment
As the asset class evolved, various ILS structures have been introduced
to transfer reinsurance risks to the capital market.
Insurance- Linked Securities is a specialist asset class that:
You could not easily access in the past
Has historically offered consistent returns with low volatility
Offers low correlation to other asset classes and financial markets
Neither the general state of the economy, nor the behaviour of financial market investors, can influence the occurrence of a natural disaster.
Vice versa. A massive insurance event may impact the global economy, but it is unlikely to be significant or long term. Even Hurricanes Katrina, Rita and Wilma in 2005, which collectively caused nearly $60 billion in insured losses that year, had minimal stock market impact.
Low correlation to other asset classes and financial markets is one of the key benefits ILS has to offer.
ILS portfolios may experience short-term return volatility due to specific loss events. However historical data shows volatility is not as severe as in other asset classes. The end result has been a much lower maximum drawdown compared to those of equities and corporate bonds.
Despite several large natural disasters as per the chart below, the ILS asset class has
averaged a very impressive 8.33% compound annual growth rate.
Source: Eurekahedge ILS Advisers Index
“The Eurekahedge ILS Advisers Index tracks the performance of participating Insurance-Linked Investment funds. It is the first benchmark that allows a comparison between different insurance-linked securities fund managers in the insurance-linked securities, reinsurance and catastrophe bond investment space. The index includes funds that allocate at least 70% of their assets to non-life risk.”