Flashcards in insurance-linked securities Deck (10):
insurance-linked securities (ILS) are
I securities whose return depends on the occurrence of a specific insurance event, which can be either related to non-life (eg catastrophe bonds) or life risks. The ILS market has been in existence since the mid 1990s, when the first catastrophe bonds were issued.
From an insurer’s perspective, ILS offer
the ability to transfer risks from its balance sheet to investors in return for payment of a risk premium. Alternatives to transfer include retention or reinsurance. Depending on the structure of the ILS, other benefits to an insurer may include reduced capital requirements or acceleration of profit emergence from an insurance book.
Investors will hold ILS based on their
risk/return characteristics. These are likely to be particularly attractive at a portfolio level as insurance risks have weak correlations to equity and credit markets. Constructing a portfolio of ILS requires specialist expertise as it requires an understanding of the underlying insurance risks, and ILS structures can be complex. A number of ILS funds have been set up, which typically invest in a range of insurance risks or perils in order to generate a diversified return stream. However, there are tail risks that may result in the case of an extreme event that results in several perils across a wide area (eg a hurricane / tropical cyclone that causes significant coastal and inland damage).
Mechanism of Cat bond
the bondholders (Investors) purchase their bonds (Proceeds) from the SPV and will receive the risk-free rate (Floating rate) plus a risk premium (spread) for taking on the risk of the catastrophe being insured. The premiums paid by the insurer should reflect the likelihood and cost of the catastrophe being insured. This premium will effectively be passed on to the bondholders in the spread. If the catastrophe occurs, the payment from the SPV would assist the insurer recover losses, as all (or some) of the principal would pass to the insurer.
risk sharing in cat bonds
bondholders are effectively taking on the catastrophe risk previously borne by the insurer and receiving a higher expected return on their investment for bearing the risk.
The process for creating a catastrophe bond is:
1. The ceding insurance company establishes a special purpose vehicle in a tax efficient jurisdiction.
2. The SPV establishes a reinsurance agreement with the sponsoring insurance company.
3. The SPV issues a note to investors; this note has default provisions that mirror the terms of the reinsurance agreement.
4. The proceeds from the note sale are invested in money market instruments within a segregated collateral account.
5. If no trigger events occur during the risk period, the SPV returns the principal to investors with the final coupon payment. If trigger events occur, the assets of the SPV are first used to meet the insurer’s losses, before any return of principal (if any).
Protecting against extreme mortality loss
In 2005, Swiss Re transferred over $362m of extreme mortality risk to the capital markets using a 5-year catastrophe bond. According to the ratings agency, Standard & Poor’s (S&P), only a large event risk such as nuclear explosions in large cities in the 5 countries, a full-scale ground war or a major epidemic (eg a global flu pandemic) would cause a loss to the investors.
Earthquake risk for railways
In 2007, Munich Re structured a catastrophe bond on behalf of the East Japan Railway Company to transfer earthquake risk to the capital markets. The volume of bonds sold was $260m and the bonds were given a S&P rating of BB+. The trigger for paying out was based on the magnitude of the earthquake.
FIFA needed to take out insurance against the possibility that the 2006 World Cup tournament would be cancelled due to terrorism or other issues. However, conventional insurance companies were reluctant to provide such insurance. So, FIFA issued around $260m of catastrophe bonds to public investors. The deal was structured by Credit Suisse First Boston and the bonds were given an A3 rating by Moody. Under the arrangement, if the tournament went ahead, investors would earn a profit on their investment. However, if the tournament were to be cancelled, around three quarters of the bond principal would pass to FIFA to meet its loss.