Insurance-linked securities

Insurance-linked securities (ILS) are broadly defined as financial instruments whose values are 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.

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. 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.

Since 2001, the market for insurance-linked securities has increased substantially, creating an industry with over $15 billion trading between capital market investors. 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.

This emerging market showed much potential and growth until the collapse of the CDO market, with the effect 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.

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Wikipedia