Insurance-Linked Securities

Where there is uncertainty, there are always bets—the question is who wins. From horse racing to the price of gold, people have always speculated on uncertainty. Insurance-linked securities (ILS) are financial instruments that allow investors to speculate on a variety of events, including catastrophes such as hurricanes, earthquakes and pandemics.

The global market for ILS first developed in the mid-1990s. These products are generally not offered directly to individual retail investors. But various funds, including mutual funds and closed-end funds, have purchased or are authorized to purchase them on behalf of individual investors.

Insurance-linked securities may offer higher interest rates than similarly rated corporate bonds. But, if a triggering catastrophic event occurs, holders can lose most or all their principal and unpaid interest payments.

What Are Insurance-Linked Securities?

One common type of insurance-linked securities, which will illustrate many of their characteristics, are "catastrophe bonds"—"cat bonds" for short. If a "sponsor," such as an insurance company or reinsurance company (a company that insures insurance companies), wants to transfer some or all of the risk it assumes in insuring a catastrophe, it can set up a separate legal structure—commonly known as a special purpose vehicle (SPV). Foreign governments and private companies also have sponsored cat bonds as a hedge against natural disasters.

The SPV issues cat bonds and typically invests the proceeds from the bond issuance in low-risk securities (the collateral). The earnings on these low-risk securities, as well as insurance premiums paid to the sponsor, are used to make periodic, variable rate interest payments to investors.

As long as the natural disaster covered by the bond—whether a windstorm in Europe or an earthquake in California—does not occur during the time investors own the bond, investors will receive their interest payments and, when the bond matures, their principal back from the collateral. Most cat bonds generally mature in three years, although terms range from one to five years, depending on the bond.

If the event does occur, however, the sponsor's right to the collateral is "triggered." This means the sponsor receives the collateral, instead of investors receiving it when the bond matures, causing investors to lose most—or all—of their principal and unpaid interest payments. When this happens, the SPV might also have the right to extend the maturity of the bonds to verify that the trigger did occur or to process and audit insurance claims. Depending on the bond, the extension can last anywhere from three months to two years or more. In some cases, cat bonds cover multiple events to reduce the chances that investors will lose all their principal.

Because cat bond holders face potentially huge losses, cat bonds are typically rated "non-investment grade" by credit rating agencies such as Fitch, Moody's and S&P. Non-investment grade bonds are also known as "high yield" or "junk" bonds. These ratings agencies, as well as sponsors and underwriters of cat bonds, rely heavily on a handful of firms that specialize in modeling natural disasters. These catastrophe risk modeling firms employ meteorologists, seismologists, statisticians, and other experts who use large databases of historical or simulated data to estimate the probabilities and potential financial damage of natural disasters.

Trigger Happy

Each cat bond has its own triggering event(s), which is(are) spelled out in the bond's offering documents but may only be available to purchasers or potential purchasers. Different types of triggers have developed, some of which are listed below. Bear in mind that the question of whether a triggering event occurred—or the true meaning of a triggering event—can be complex and could wind up being litigated and require a ruling from a court. This in turn may add additional uncertainty to the way these securities perform. For example, although now a distant memory, there were property insurance lawsuits following 9/11 that centered on whether the attacks on the World Trade Center counted as one occurrence or two.

Type of Trigger	Description
Parametric	Bond is triggered if specific, objective "parameters" are met—for example, wind speed at a pre-specified location for a hurricane-linked bond, or ground acceleration at a pre-specified location for an earthquake-linked bond. The most transparent and easiest to verify of the triggers. Presents the least potential for a sponsor to influence the bond's performance. Typically pays a lower yield than other trigger types, as it may not cover all of sponsor's losses (aka “basis risk”)
Modeled Loss	Sponsor's "exposure," or expected loss, is calculated by computer models that use objective data, such as actual wind speeds or ground acceleration. Bond is triggered if the sponsor's estimated losses exceeds a specified dollar amount. Allows for faster verification than the industry-loss or indemnity triggers described below. Heavy reliance on computer modeling to determine when the trigger has occurred.
Industry-Loss Index	Bond is triggered when the amount of the overall industry loss from an event, usually determined by an independent third party, exceeds a certain amount. Minimal potential for a sponsor to influence the bond's performance, as the index is based on industry-wide losses for each event. Typically pays a somewhat higher yield than for parametric triggers. Compared to parametric and modeled loss triggers, needs a relatively long period of time to compute the final amount of industry loss, leading to uncertainty for investors.
Indemnity	Bond is triggered when the sponsor's actual underwritten loss on specific insurance policies exceeds a predetermined amount. For example, sponsor's insurance claims resulting from a Florida hurricane may need to exceed $1 billion to the sponsor before investors lose their principal. Typically pays the highest yield of the different trigger types, as it provides the best protection to the sponsor. Presents the most potential for the sponsor to influence bond performance, as payouts are based on the individual policy claims against the sponsor and the way the sponsor settles those claims A long period of time can be needed to calculate total loss claims, leading to uncertainty for investors.
Hybrid	Created by combining any of the above triggers, especially for cat bonds that cover multiple events. Useful for bonds linked to multiple events and can be structured to cushion investors' losses and/or enhance yield potential. Depending on the components of the hybrid trigger, can be complicated and difficult to understand or verify.

Reasons Given for Holding Them

Some of the reasons given for investing in cat bonds are their high yields and their lack of correlation with other asset classes in the financial markets.

• High Yields: Cat bonds can pay much higher interest rates than similarly rated traditional corporate bonds, whose investors are not exposed to catastrophe modeling risk (see below).
• Diversification: Cat bonds are also pitched to fund managers as a good way to diversify a portfolio because their performance is not related to that of other asset classes in the financial markets. The thinking is that even if stocks and bonds are in a bear market, the value of cat bonds shouldn't be affected. Bear in mind, though, that the effect of natural disasters on financial markets is not well-studied or foreseeable, and that past performance is no guarantee of future returns.

Also remember that cat bonds provide diversification benefits only if they are a limited portion of a portfolio that is otherwise invested in marketable securities and other assets, and if the cat bonds are not all linked to the same event. For instance, a mutual fund will gain limited diversification benefits from buying relatively large positions in five bonds that all cover earthquakes in California.

Know When to Walk Away

As with any financial instrument, cat bonds also present risks.

• The Credit Cliff: A cat bond can cause investors rapidly to lose most or all of their principal and any unpaid interest if a triggering event occurs. The high yield will not make investors whole if the triggering event actually occurs.
• Modeling Risk: Prices, yields and ratings of cat bonds rely almost exclusively on complex computer modeling techniques, which in turn are extremely sensitive to the data used in the models. The quality and quantity of data vary depending on the peril and region being modeled (e.g., incorporating climate change).
• Liquidity Risk: Secondary trading for cat bonds is limited, so in a pinch an investor may not be able to sell. In addition, the secondary transactions that do occur are privately negotiated, so pricing information is not generally available to the public. Remember also that the maturity of some cat bonds can be extended during the worst possible time—when a trigger may have occurred. This can cause the bonds' value to plummet, making them even harder to sell.
• Unregistered Investments: Most cat bonds are issued in what are called Rule 144A offerings, which are available only to large institutional investors and are not subject to the SEC's registration and disclosure requirements. As a result, many of the normal investor protections that are common to most traditional registered investments are missing. For example, issuers of cat bonds are not required to file a registration statement or periodic reports with the SEC, unlike issuers of registered bonds. While general prohibitions against securities fraud apply to Rule 144A offerings, the lack of public disclosure may make it difficult for both individuals and fund managers to obtain and evaluate the information used to price and structure cat bonds.

Other Insurance-Linked Securities

Some ILS feature only one class of securities. Others issuance can offer several classes, or "tranches," which vary in payment terms, coupon rates and credit ratings. These terms are generally dictated by the bonds' offering documents.

To complicate matters further, some ILS have been packaged into securities known as collateralized risk obligations (CROs). These CROs contain ILS sponsored by a number of insurers. This can minimize the risk to the investor of complete loss of principal—or it can multiply losses if the ILS in the CRO are not properly diversified. In addition, while most ILS have a maturity of three years, CROs can have much longer terms.

You may also hear about "sidecars" in the ILS world. These are like "mini" insurance or reinsurance companies that allow institutional investors to participate directly in the profits and risks of certain catastrophe policies written by an insurer or reinsurer. Sidecars are similar to the SPVs that issue cat bonds, but often are privately negotiated and issue both equity and debt.

Derivative instruments are also part of the ILS landscape. These instruments allow one party (the protection buyer) to pay a fixed premium in exchange for an agreement by the other party (the protection seller) to pay a lump sum if a specified catastrophe event occurs—typically based on a Parametric or Industry Loss Index. These contracts are traded privately among dealers and institutional investors in the over-the-counter market. Again, while individual investors generally cannot participate in these particular types of derivative contracts directly, they could own them indirectly through mutual funds or other financial instruments that invest in these contracts.

How to Protect Yourself

Since individual retail investors generally cannot invest directly in ILS, you will want to find out whether any funds you own invest in them. Check your fund's prospectus and statement of additional information (SAI) to see whether your fund is authorized to invest in ILS—including CROs and derivatives—and if so, how much. You can typically find this information under the headings "Investment Objectives" or "Investment Policies."

When you read these documents, consider whether the fund manager has adequate resources and expertise to evaluate the risks of ILS and whether they are a sound investment. Does the fund manager have an educational background or work experience, such as in the insurance industry, that would allow him/her to understand the quantitative and forecasting methods used in building computer models for event-linked securities? If not, does the fund manager employ a third-party consultant who does (or at the very least license the appropriate 3^rd-party risk modeling software)? In your prospectus or SAI, look under the heading "Management of the Fund." If you need more information, you may have to research other sources, for example on the Internet.

To learn what securities your fund owns, and how much, you can look up the fund's holdings in its annual report or semi-annual report to shareholders. It is important that a fund's ILS are diversified in terms of type of risk and geographic location, and that they comprise a limited part of the portfolio.

You can obtain free copies of the fund's prospectus, SAI, annual report, or semi-annual report by visiting the fund's website or calling its customer service line. You can also obtain a fund's prospectus using the SEC's website.