Understanding Insurance Linked Securities
Updated: Feb 5, 2018
Insurers often buy reinsurance to limit catastrophic loss, but there is an alternative. Cedents may transfer risk through the capital markets by issuing catastrophe bonds or other insurance linked securities. In a content-filled 30 minute presentation, Liberty Mutual Insurance’ Steven Morris explained the options for a cedent looking to access capital markets in lieu (or supplementation) of traditional reinsurance: a catastrophe (or cat) bond offering, a sidecar offering, or a securities offering involving collateralized reinsurance, a segregated account, or other customized structure.
Cat bond and other securities offerings enable a cedent to access debt (and even equity) capital markets to transfer catastrophic loss risk. The main advantages for the cedent are flexibility and diversification away from traditional reinsurance, particularly during periods when reinsurance premiums are rising. The main disadvantage is cost. Each option involves a complex and expensive corporate transaction and/or securities offering, often managed through a separate SPV or “special purpose vehicle” corporate structure.
Cedents (and even large corporate insureds) can structure cat bond offerings in multiple ways to fit their needs. Cat bonds can be structured to reimburse the cedent following one of several formulas -- indemnity, modeled loss, indexed to industry loss, parametric risk-sharing, and parametric index. On one end of the spectrum, parametric bonds pay a fixed amount in the event of a catastrophe based on a defined metric such as wind speed without any need of proving specific property losses. On the other end of the spectrum, indemnity bonds trigger and reimburse in a manner much closer to traditional reinsurance contracts.
Cat Bonds and other cat risk investment vehicles pose significant risks for investors, so they are primarily marketed to hedge funds and other large institutional investors. Large, sophisticated investors benefit from diversification away from equity and traditional debt investments and the relatively high interest rate return in periods when a catastrophe does not trigger the reimbursement obligation while insurers benefit from an alternative to traditional reinsurance.
Mr. Harrington is a partner in the Boston office of Robins Kaplan LLP. He can be reached at JHarrington@RobinsKaplan.com.
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