Demystifying insurance linked securities

ILS can be used to hedge against a variety of risks, such as natural disasters, earthquakes, and cyber-attacks. One example of a commonly issued insurance-linked security is a catastrophe bond. This a bond which would help to cover losses in a specific location (i.e Florida) for specific types of risk (such as a hurricane). In the event of a major loss, investors would pay money to the insurer. In return for taking on the risk, investors are compensated with a coupon paid by the insurer.

How does an ILS work?

ILS are typically issued in the form of bonds or notes that are linked to an insurance risk. If the insured event occurs, the insurer, also called protection buyer, will receive a payout from the investor. If the insurance event does not occur until expiry of the ILS, the investor receives back their deposit capital. During the investment period, the investor is collecting the coupon in addition to the money market interest rate.

What are the benefits of ILS?

For insurers, they can use ILS to manage their risk exposures and improve their financial stability. As history has shown, too much concentration across geography or risk profiles can threaten the solvency of insurers. For example, the losses of Hurricane Andrew in 1992 and the San Francisco earthquake of 1906 led to several high-profile insurer bankruptcies. Hurricane Andrew and the resulting impact on the insurance market was a major catalyst for the creation of the first catastrophe bonds, offering capital market investors an opportunity to invest in insurance risk.

For investors, ILS can offer attractive returns with low correlation to traditional asset classes, such as stocks and bonds, providing diversification benefits and lowering the overall risk of an investment portfolio.

How does ILS compare to fixed income and equities?

ILS is an attractive investment for several reasons. ILS is typically less correlated to the broader market, which means that it can offer significant diversification benefits. Secondly, ILS can offer higher returns than traditional fixed income investments. In addition, ILS continues to perform well even in times of market turmoil such as during the financial crisis and the coronavirus pandemic.

1.     Diversification: ILS exposures are uncorrelated with stocks and high yield bonds. The correlation between the S&P 500 and the Swiss Re Cat Bond Index is -0.01 – the same holds for the US High Yield Bond ETF.

2.     Returns: Over the past 16 years, ILS has outperformed high yield bonds with returns much close to that of the S&P500. During this period, high yield bonds generated 94.8% total returns compared to 168.4% for the Swiss Re Cat Bond Total Return Index (a broad ILS market index representinga basket of catastrophe bonds). This was just 22.3% below the return for the S&P500, while exhibiting significantly lower volatility (4x lower than S&P500 and 3x lower than the high yield index). Thesse return characteristics result in a significantly higher Sharpe Ratio of 1.6 for ILS compared to the S&P 500 (0.52) and the High Yield Bond ETF (0.44).

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3.     Performance during market turmoil: During the Global Financial Crisis, while the S&P500 and U.S. High Yield bonds lost 46% and 18% of their respective value, in contrast ILS saw gains of 12%. We can observe a similar pattern during the COVID-19 shock in early 2020 – equities and high yield bond prices fell between 12% and 20% while the Cat Bond Index was able to gain 2%.

Challenges today

While the ILS market continues to experience growth, there are several key challenges to investors entering the asset class today. The complexity of understanding and assessing insurance risk has been a barrier to greater participation in the market. At CatX, we work to address this by providing access to cutting-edge third-party risk models. Users can run models directly on our platform, making it easier than ever before to understand insurance risk and identify investment opportunities.

Moreover, ILS investments historically have not been very liquid, making it challenging to adjust and manage positions. We are working towards improving liquidity in the sector by facilitating secondary transactions in addition to offering access to market makers.

Interested in exploring ILS in more detail?

CatX offers direct access to the ILS market for institutional investors and provides all relevant risk models and analytics for transactions, allowing new participants to fully understand the underlying risks.

Feel free to reach out to the team to discuss all our available investment opportunities in more detail.

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Data sources: Investing.com, iShares HYG, Bloomberg    

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