With ratings agency Fitch Ratings recently publishing an update of its methodology for rating insurance-linked securities (ILS), now is a good time to explore the rise of ILS from an unconventional form of risk transfer to the conventional method of transferring risk from insurers to the capital markets.

The rise in ILS structures began in 1992 when Hurricane Andrew made landfall in Florida causing billions of dollars in insured losses.

The resulting shortage of reinsurance capacity prompted investigations into new ways of transferring catastrophe risk outside the traditional reinsurance market, which was suffering from cost and capacity limitations. Insurers turned to the capital markets through the securitisation of natural catastrophe risk.

Since then, the first ILS issuance happened in the non-life insurance sector in the form of a catastrophe bond. The ILS market has evolved significantly over the last decade in terms of sophistication and innovation as insurers are finding new ways to securitise more perils.

The ILS market now consists of asset-based and derivative-based securitisations from both the non-life and life insurance markets. These securitisations allow insurers to offload risk and raise capital; they also allow life insurers to unlock the value in their policies by packaging them and issuing them as asset-backed notes.

The influx of capital has been the main catalyst for the growth of the ILS market. Many investors are now developing their own modeling and due diligence capabilities to support these developments, and cedents are now directing deals as a way of securing more competitive prices.

Some of the more common ILS structures in today’s market are:

• Catastrophe Bonds: The capital market alternative to traditional catastrophe reinsurance that use fully-collaterised special purpose insurers (as defined in the Insurance Act 1978) to transfer a defined set of risks from an insurer to capital market investors. Initially, catastrophe bonds were structured to offer high yields for investors with high risk appetites and only covered a single peril. Nowadays catastrophe bonds tend to cover a multitude of perils and are structured as low risk/investment grade by offering over-collateralisation or guarantees from third-party insurers.

• Reinsurance Sidecars: Fully-collaterised special purpose insurers created to purchase some, or all, of an insurance policy in order to share in the profits and risks. The ceding insurer or reinsurer, who cedes risk to the reinsurance sidecar, normally pays its premiums for the coverage up-front allowing investors to profit from the premium return with their collateral exposed for the duration of the underlying reinsurance contracts. Reinsurance sidecars used to be formed as joint ventures between existing insurance or reinsurance companies, but increasingly have been used as a convenient deployment vehicle for third-party capital in the reinsurance underwriting business.

• Contingent Capital Structures: These offer insurers the option to raise capital during a defined commitment period based upon the occurrence of a qualifying event. Should the qualifying event occur, investors provide the insurer with capital determined by the amount of catastrophic loss and if no catastrophic event occurs, there is no exchange of funds. Because low-probability, high-severity event insurance tends to be scarce or uneconomic, contingent capital can be a cost-efficient solution for a company needing liquidity relief.

• Extreme Mortality Bonds: These enable the issuer to protect itself from large deviations in longevity or mortality due to deaths from disease, war, terrorism or natural catastrophes. These bonds are structured similarly to other asset-backed securities, with deviations in mortality serving as the trigger.

• Longevity Swaps: These transfer the risk of pension scheme members living longer than expected from pension schemes to an insurer or bank provider.

• Industry Loss Warranties: These are reinsurance contracts whose payouts are linked to a predetermined trigger of estimated insurance industry losses rather than their own losses from a specified event. They are essentially swap contracts.

ILS, once considered to be an alternative form of risk transfer, is now a mainstream method of transferring risk from insurers to the capital markets.

However, while rising to prominence, its spread has been limited. Geographically, it has failed to infiltrate the rapidly expanding markets of the Middle East, Africa, Asia, and South America.

These markets have a wide variety of insurable risks arising from drought, terrorism, and oil mining perils, among other things. The next expansion for ILS, therefore, should be lateral.

While Fitch’s ILS methodology updates had no effect on ratings, we can hope that, in addition to seeing more ILS structures in expanding markets, developed markets like the United States will start to produce more investment grade ILS to cover the terrorism risk associated with the staging of events like the Super Bowl or New Year’s Eve in Times Square.

In today’s climate, catastrophe bonds to cover cancellation exposure of these large events should be commonplace.

Lawyer Gary Harris is an Associate and a member of the Corporate and Commercial Practice Group at Appleby. A copy of his column can be found on the Appleby website at www.applebyglobal.com.

This column should not be used as a substitute for professional legal advice. Before proceeding with any matters discussed here, persons are advised to consult with a lawyer.