The market for Insurance Linked Securities has proved very attractive for investors and insurers because they represent a unique asset or investment class – like riding the waves, the success of the investment is entirely uncorrelated with the general stock market.

One aspect of Insurance Linked Securities (ILS) is the reinsurance of high severity, low probability events known as catastrophe (CAT) bonds. CAT bonds include cover for natural disasters and other uncontrollable events. They account for around 40% of all ILS securities and can include, for example, insurance losses arising from hurricanes, tidal waves or earthquakes.

Since CAT bonds are risky by their very nature, an insurance company will minimise its risk by spreading its participation across many such policies. Another way insurance companies can spread their risk from CAT bonds is to transfer some of the risk to another insurer by re-insuring the original insurer’s portfolio thereby minimising their own liability.

For example, a re-insurance policy could assume a loss of ‘$10 million above $50 million with 20% participation’. In this scenario, the secondary insurer pledges to pay the original insurance company up to 80% of $10 million for any loss incurred above $50 million.

The reason investors are attracted to these contracts is because they are unrelated to financial markets. And this is where the capital markets and insurance-linked securities meet, through derivatives or securities markets. It’s much more prudent to write risky policies and share the risk with others than it is for a single firm to assume total liability.

The Insurance Linked Securities market accounts for 15% of the global property catastrophe reinsurance capacity, with Bermuda acting as a central player in this convergence between capital markets and traditional reinsurers. It’s estimated that Bermuda alone lays claim to about a third of the global CAT bond market.

Funds and ILS coalesce around potential ‘trigger points’ (such as an insured earthquake in the US) when a Bermuda-based fund invests directly into an ILS vehicle, and that vehicle in turn uses the invested capital to reinsure the risks of a third party insurer. Fund managers like investing in ILS because it gives them much-valued diversity, including non-correlation with their other exposure/investments in the stock market.

As it continues to grow and mature, the ILS market has seen increased interest from a broadening range of investors including pension funds, institutional investors and private equity funds; and, as standardisation of the market develops, we can expect to see greater use of ILS in portfolio diversification.

See also: An Introduction to Mutual Funds and Hedge Funds

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