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An insurance-linked security (ILS) is a financial instrument whose value is driven by insurance loss events. Those such instruments that are linked to property losses due to natural catastrophes represent a unique asset class, the return from which is uncorrelated with that of the general financial market.
Insurance companies are in the business of assuming risk for individuals and institutions. They manage those risks by diversifying over a large number of policies, perils and geographic regions. There are two important ways insurers profit in this business.
One is by selling portfolios of insurance policies grouped into packages, to interested investors. The risk from low severity, high probability events can be diversified by writing a large number of similar policies. This reduces an insurer’s risk because should a policy default, then the loss is shared between a large number of investors. [1]
The second way insurers profit on policies is by re-insuring them through other insurers. A reinsurance policy would allow a second insurer to share in the gain and potential loss of the policy, much like an investor. The secondary insurer would share invested interest and risk. [2] The reinsurance of policies offers additional risk capital and high returns for the policy originator, and minimizes their liability, while also providing high returns for any secondary insurer. [2]
Since 2001, the market for insurance-linked securities has increased substantially, creating an industry with over $103 billion trading between capital market investors. [3] The union of insurance risks with the capital market created a new method for insurers to spread their risk and raise capital. Insurance-linked securities provide life insurance companies with the ability to transfer or spread their risk while releasing its value to the open market through asset-backed notes. [4]
This emerging market showed much potential and growth until the collapse of the CDO market, with the effect of disrupting the ILS market.
The collapse of sub-prime collateralized debt obligations, or CDOs, had a disastrous effect on all structured financial markets, including life insurance risk. The high complexity of life insurance securitization is one of the reasons for the collapse of the insurance-linked securities market. [4]
The market for insurance-linked securities has been very attractive for investors and insurers. One portion of insurance-linked securities is the reinsurance of high severity, low probability events known as CAT bonds, or catastrophe bonds. [1] These include cover for natural disasters and other uncontrollable events. These policies are grouped by their assessed risk, and then re-insured by other insurers. [4]
CAT bonds are very risky in general. Therefore, an insurer will try to minimize risk by writing many such policies. If an insurer charges a premium equal to the expected annual loss, it can stand to profit by those premiums by the law of large numbers.
Another way insurance companies can spread their risk from CAT bonds is to transfer risk to another insurer, thereby re-insuring the original insurer’s portfolio and minimizing liability. A re-insurance policy could assume a loss of “$10 million above $50 million with 5% participation.” In this scenario, the secondary insurer pledges to pay the policy originator up to 95% of $10 million for any loss above $50 million. [2]
Investors are attracted to these contracts because they are unrelated to financial markets. [4] That is where the capital markets and insurance-linked securities meet, through derivative or securities markets. CAT bonds are grouped by their level of risk and sold in portfolios in security markets. This makes re-insuring these contracts more attractive because it opens a whole market for them to be sold and for risk to be spread among many investors. It is much more attractive to write expensive, risky policies and share the risk with thousands of others than it is for one firm to assume total liability. [1]
The most prevalent securitized insurance contracts exchanged in capital markets include: [4]
To issue an ILS in the security or derivative market, an insurer would first issue an SPV, or Special purpose vehicle. An SPV has two functions; it provides re-insurance for insurance companies and issues securities to investors. At first, an SPV deposits funds collected by investors into a trust. Any interested parties will pay a premium to the SPV. The money from the premium and investment income will provide the interest payments owed to investors. [2]
If there is no catastrophic event, or trigger event, before the maturity date of the contract, investors will receive back their principal investment at maturity on top of the interest payments they have received. [2]
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to protect against the risk of a contingent or uncertain loss.
Lloyd's of London, generally known simply as Lloyd's, is an insurance and reinsurance market located in London, United Kingdom. Unlike most of its competitors in the industry, it is not an insurance company; rather, Lloyd's is a corporate body governed by the Lloyd's Act 1871 and subsequent Acts of Parliament. It operates as a partially-mutualised marketplace within which multiple financial backers, grouped in syndicates, come together to pool and spread risk. These underwriters, or "members", are a collection of both corporations and private individuals, the latter being traditionally known as "Names".
Terrorism insurance is insurance purchased by property owners to cover their potential losses and liabilities that might occur due to terrorist activities.
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Reinsurance is insurance that an insurance company purchases from another insurance company to insulate itself from the risk of a major claims event. With reinsurance, the company passes on ("cedes") some part of its own insurance liabilities to the other insurance company. The company that purchases the reinsurance policy is referred to as the "ceding company" or "cedent". The company issuing the reinsurance policy is referred to as the "reinsurer". In the classic case, reinsurance allows insurance companies to remain solvent after major claims events, such as major disasters like hurricanes or wildfires. In addition to its basic role in risk management, reinsurance is sometimes used to reduce the ceding company's capital requirements, or for tax mitigation or other purposes.
Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liability arising from such guarantee. An underwriting arrangement may be created in a number of situations including insurance, issues of security in a public offering, and bank lending, among others. The person or institution that agrees to sell a minimum number of securities of the company for commission is called the underwriter.
Structured finance is a sector of finance — specifically financial law — that manages leverage and risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of financial instruments.
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.
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Catastrophe modeling is the process of using computer-assisted calculations to estimate the losses that could be sustained due to a catastrophic event such as a hurricane or earthquake. Cat modeling is especially applicable to analyzing risks in the insurance industry and is at the confluence of actuarial science, engineering, meteorology, and seismology.
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Alternative risk transfer is the use of techniques other than traditional insurance and reinsurance to provide risk-bearing entities with coverage or protection. The field of alternative risk transfer grew out of a series of insurance capacity crises in the 1970s through 1990s that drove purchasers of traditional coverage to seek more robust ways to buy protection.
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Insurance law is the practice of law surrounding insurance, including insurance policies and claims. It can be broadly broken into three categories - regulation of the business of insurance; regulation of the content of insurance policies, especially with regard to consumer policies; and regulation of claim handling wise.
Bond insurance, also known as "financial guaranty insurance", is a type of insurance whereby an insurance company guarantees scheduled payments of interest and principal on a bond or other security in the event of a payment default by the issuer of the bond or security. It is a form of "credit enhancement" that generally results in the rating of the insured security being the higher of (i) the claims-paying rating of the insurer or (ii) the rating the bond would have without insurance.
A synthetic CDO is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage products, rather than a real mortgage security. The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments – as in the case of a regular or "cash" CDO—but from premiums paying for credit default swap "insurance" on the possibility of default of some defined set of "reference" securities—based on cash assets. The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.
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Russian National Reinsurance Company (RNRC) is the largest Russian reinsurance company. The Central Bank of Russia is a full shareholder of RNRC. The state-owned reinsurance company was established in 2016. RNRC is the largest in terms of the authorized share capital and second-largest in terms of paid-in capital on the domestic insurance market.