Insurance Linked Securities are interest-bearing securities, which pay claims against a special purpose entity (SPV), wherein the special purpose funds are used to purchase insurance risks exclusively through reinsurance agreements and securitized assets. Sellers in such transactions are usually insurance companies that make their insurance risks tradable. The asset classes include catastrophe bonds, life bonds and collateralized debt obligations .
With the securitization of risks by means of insurance-linked securities, the insurance industry has since the early 1990s found ways of risk management and refinancing . The volumes have grown steadily over the years until the intensification of the financial crisis of 2008.
Risks from disasters and changes in mortality and burden of newly opened businesses were transferred to the capital markets. Future premium flows were financed through securitization and allowing the insurance companies more efficient allocation of capital.
Methods of risk transfer
The insurance industry has a wide array of business types to cover risks as shown in Finance Insurance Training. Some types of risk such as counterparty risk, credit risk and mortgage risks are also taken in one form or another by banks. Other types of risk such as mortality, longevity insurance or disasters are specific.
For the risk transfer, there are the traditional methods of reinsurance and retrocession. Alternative risk transfer was also developed in recent years with different instruments. Alternatively, the transfer of risk does not take place as with traditional methods within the insurance sector, but between insurance companies and the capital market. A branch of the alternative risk transfer known as the insurance securitization (Finance Insurance Training).
Types of Insurance Linked Securities
Catastrophe bonds are the most popular form of securitization of insurance. They cover storm and earthquake risks caused by natural disasters. Latest innovations include securitization of auto insurance and coverage for credit risk portfolios.
Collateralized debt obligations are a special form of insurance linked securitization. They are bundled with subordinated bonds and reinsurance receivables risks.
The control of the insurance and investment risks is done through asset liability management. Duration and convexity are important variables in this context. Hybrid bonds are issued through collateralized debt obligations to raise capital.
Rating agencies, and bond insurers
Rating agencies assess the likelihood that the structures will make their interest and principal payments properly. Monolines afford additional collateral in the form of insurance of interest and principal payments of the securities. Traditional fixed income investors invest in new asset classes of insurance-linked risks that are virtually uncorrelated with other instruments.
In the context of modern portfolio management, they have a high priority. The design of triggers (trigger payment mechanisms in case of damage) have an influence on the yield of the structures.