GIM8261 | Reinsurance and other forms of risk transfer: financial reinsurance and alternative risk transfer (ART): insurance linked securities overview

Insurance Linked Securities (ILS) are an alternative form of risk transfer for insurers and reinsurers. In contrast to conventional cover arranged with a reinsurance company, they offer insurers and reinsurers a means of transferring risk to the capital markets. ILS have helped to expand the capacity of the reinsurance market and provide protection buyers with cover which is generally less exposed to counter-party default. For investors, ILS deals have offered attractive returns, and because ILS performance is considered to be uncorrelated with the economic cycle, they have provided helpful diversification for investment portfolios. Use of ILS has grown very significantly in recent years and is now an established part of the global reinsurance and risk mitigation market.

An ILS deal typically involves an insurer or reinsurer (hereafter referred to as the ‘cedant’) transferring specified risks to an insurance special purpose vehicle (ISPV). The terms of this arrangement are governed by contracts for risk transfer. The cedant pays a reinsurance premium to the ISPV, in return the ISPV pays a commission to the cedant. The ISPV issues securities to investors to raise sufficient capital to cover the insurance risk it has taken on, and investors receive a return for putting their capital at risk. Capital, minus any payments to the cedant triggered by the contract for risk transfer, is returned to investors at the end of the contract period. The rights of investors are always subordinated to the rights of the cedant under the contract for risk transfer.

ILS deals also typically include arrangements for the safe holding of capital as collateral to meet obligations to the protection buyer. It is common for ILS structures to include a trustee which is responsible for holding and investing the collateral, and for ensuring that any payments to the cedant or investors are made in line with the requirements of the contract for risk transfer.