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The Actuary The magazine of the Institute & Faculty of Actuaries

Risk: Insurance-linked securities

Over the last few years, there has been much said about the convergence of the insurance industry with the capital markets. Such convergence has taken many forms and some have been more successful than others. Among them, insurance-linked securities (ILSs) have proven to be one of the most successful manifestations of this convergence; of how capital market technologies can find applications within the insurance industry and how insurance-related risk can be transferred to capital market investors. As of the end of 2009, there were approximately $36bn tradable ILSs — $12bn in non-life and $24bn in life risk.

In addition, while traded insurance-linked securities are the most visible, there are a number of other forms of placement of insurance risk into the capital markets, including private placements of insurance-linked transactions (club deals), sidecars on non-life insurance risk, insurance-linked derivatives, traded life insurance policies (life settlements) and collateralised reinsurance and industry loss warranties (ILWs).

The outstanding capacity deployed by capital market investors on the above mix of instruments was estimated to be above $50bn in 2009. After a decade of continuous growth, the ILS market is now at a stage of consolidation of its past successes and further expansion in its non-life component, despite the recent turmoil in the capital markets. However, it can be argued that the size of the market is still very small compared to its full potential. Greater transparency and understanding on various aspects of this market leading to a wider reach of originators and investors are essential in supporting the growth of this niche market.

Today’s situation is very much mixed and there is a huge contrast between the non-life and the life ILS market, especially in terms of the impact of the financial crisis. In the non-life sector, the credit crisis has had a limited impact, partly due to the structuring of the products, a dedicated investor base and a market discipline in terms of modelling and structuring. However, the life sector has been affected, mostly because of the features of the transactions and the nature of the underlying risks, with the majority of the transactions being wrapped or having embedded investment risks.

The issues and opportunities for insurance-linked investments
The non-life ILS market has performed relatively well in the turbulent capital markets of the last couple of years. Figure 1 shows the relative performance of ILSs (represented by the Swiss Re BB Cat Bond Total Return index), vis-À-vis comparable credit investments (using the 5 year iTraxx Crossover, representing BB credit) and equities (represented by the S&P 500 index). The performance of non-life ILSs has been affected only marginally and mainly starting from the bankruptcy of Lehman Brothers. Losses in the ILS index were recovered in a few months.

This performance can mainly be explained due to the following factors:
>> Dedicated ILS funds (funds investing solely in these instruments) represent a large portion of the ILS investor base and have suffered a proportionally much lower level of redemptions than other hedge fund types of funds during the financial crisis.
>> Non-dedicated ILS investors have liquidated the ILS collateral mostly at attractive secondary market values when compared to the levels of other securitised investments.
>> ILS structures were less exposed to structural risks than other investment types and losses directly linked to Lehman’s bankruptcy were limited to a relatively low number of transactions.

In summary, ILSs have proven to be a diversifying asset in an investor portfolio, having showed low correlation to the rest of the market in very testing times.

Changes in structure
Structural enhancements have also been introduced in the ILS market to further reduce the impact of losses from counterparties. In particular, enhancements were made around the collateral, which is kept by the special purpose investment vehicle in the ILS structure, and which guarantees the payment of the claim to the protection buyer or the repayment of the investments to the ILS investor.

In past structures, collateral was normally required to be in AAA-rated securities, with the total return of such collateral to be wrapped by a highly rated financial institution. In 2009, collateral structures were changed to be either in government debt, treasury money market funds or tri-party repo structures. The changes were welcomed by the market. New transactions were launched with protection being purchased by insurers, reinsurers and governments. New funds were raised by dedicated funds and ILS issuance in 2009 recovered to reach $3.4bn.

More investors are looking at this space — the risk is very clearly described to investors, the low correlation has been proven, the duration of the investments is short and returns are attractive and on a variable base, thus protecting investors against a spike in interest rates.

The life insurance securitisation market showed different characteristics — most of the life insurance securitisations were investment grade and a lot of those were also wrapped by monoline insurance companies. Dedicated ILS funds have invested in the few junior tranches of life insurance securitisations and some investment-grade tranches but the majority of the investor base consisted of traditional securitisation investors and monoline investors, which largely disappeared in 2008 and 2009.

As a consequence, traded life insurance securitisations have suffered in mark-to-market terms and no issuance had been seen until late 2009 when Swiss Re issued a new tranche of non-investment grade catastrophic mortality securitisation targeted mainly at the ILS investor community. Embedded-value securitisations and transactions used to provide capital under US Regulation XXX were carried out as private placements or as swaps. Renewed appetite for investment-grade securitised investments and greater availability of leverage will probably be necessary pre-conditions for the life insurance securitisation market to provide attractive terms to transaction sponsors compared with alternative sources of capital, such as hybrid debt or reinsurance.

The importance of longevity risk
Longevity risk has recently shown potential for the capital markets. A steady increase in life expectancy in Europe and North America has been observed since the 1960s. This represents an important risk for both pension funds and life insurers. Even though no ILSs related to longevity risk have yet been completed, the development of this market for other insurance risks has been experiencing a continuous growth for several years, encouraged by changes in the regulatory environment and the need for additional capital in the insurance industry.

Today, longevity-risk securitisation lies at the heart of many discussions and is widely seen as a potential solution for the future. Various developments have been seen over the past two years; even though there have been many private equity transactions, some public capital market transactions of mainly a derivative form have been completed.

Despite this limited activity to date, recent transactions have shown that the pricing expectations of protection buyers and capital market investors are coming closer. Longevity seems to meet the basic requirements of a successful market innovation but there are some important questions to consider, including the question of modelling and, as a consequence, pricing the underlying risk.

Insurance risk transfer to capital markets is here to stay, and will continue to grow alongside traditional reinsurance solutions.

Dr Pauline Barrieu is a reader at the London School of Economics’ Statistics department, with research interests in the interface problems between finance and insurance. Luca Albertini is chief executive officer of Leadenhall Capital Partners LLP and has over 16 years of securitisation experience. They are the authors of The Handbook of Insurance-Linked Securities (Wiley, July 2009)