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Insurance Linked Securities: Bridging the Disaster Gap

Thursday, March 08, 2018

Having demonstrated their value following the 2017 hurricane season, the market for insurance-linked securities, including cat bonds, is set to grow substantially this year.

The close of 2017 marks the end of one of the worst years for insured disasters in recent history. Three major hurricanes in quick succession – Hurricanes Harvey, Irma and Maria – wreaked havoc in the Caribbean, Puerto Rico and the US with devastating winds, extreme rainfall and resultant flooding. These events happened at the same time as powerful earthquakes in Mexico and were followed by unprecedented wildfires in California. Together these disasters affected the lives and livelihoods of millions of people and led to some of the largest insurance industry losses to date. It is estimated that the total property insurance market losses for 2017 will exceed USD 100 billion globally, making it, in absolute terms, one of the worst insurance loss years on record1. The economic losses for the events of 2017 will sadly far outweigh the insured losses, including in the mainland US with one of the most developed insurance markets in the world2,3. This means the cost of the uninsured portion of losses will fall to governments, corporations and individuals to manage.

2017 not only highlighted a lack of insurance penetration in both emerging and developed economies, but also the (re)insurance industry’s gross under-preparedness to meet the cost of the potential catastrophic disasters that are insured4. This ‘disaster gap’ as it is known is large and growing. Figure 1 shows how the total global reinsurance capacity of USD 350 billion is spread roughly equally across insured risk exposures, with approximately USD 20 to USD 30 billion of reinsurance capital for any given peril5. The grey triangle in the chart reflects an estimated USD 500 billion plus structural disaster gap between the traditional reinsurance capital base and the global exposure to catastrophe risk, comprised of insured and underinsured risks. As replacement costs continue to rise, and as populations and property continue to concentrate in peak risk zones such as coastlines, this global gap is set to double every 10 years.

Figure 1: ILS filling the gap left by the reinsurance industry6


Source: Fermat Capital Research, Applied Insurance Research, Guy Carpenter, Aon Benfield Securities.

The additional capital required to meet this growing gap between insured coverage and the expected losses from potentially devastating and highly remote catastrophes is larger than the (re)insurance industry currently has on hand and requires a solution outside of the traditional (re)insurance arena. Responding to this need, at a time when investors are searching for both yield and non-correlated investments in market conditions where increasing interconnectedness makes finding assets with truly diverse return streams challenging, capital markets solutions are bridging this structural gap.

Collectively known as Insurance Linked Securities (ILS), this new class of instruments offers investors robust mechanisms to execute, and potentially trade, investments which provide capital to the (re)insurance market. Some of the better-known subsets of ILS include collateralised reinsurance contracts, side cars, Industry Loss Warranties and catastrophe (cat) bonds. While different in form, these instruments function similarly to traditional reinsurance and typically offer investors attractive yields in return for accepting a share of well modelled risk exposures within the disaster gap, which means bearing the risk of losses should defined events occur. Cat bonds, for example, are primarily used to assist (re)insurance companies with the aftermath of very low frequency/extreme loss scenarios and are increasingly also being used by companies and governments to manage extreme risk events7.

A specialist segment of the investment management industry has developed the expertise to model and price cat bonds and other ILS instruments accurately to construct an asset class which offers yield-driven returns above commensurate levels of risk. Typically carrying a similar level of risk to high yield debt, a key reason for including them within broadly diversified portfolios is that they have a fundamentally different set of return drivers to traditional assets: by focusing the risk exposure on a narrow, well-modelled and understood aspect of the underlying insured risk, broader market or operational risks associated with investing in the equity of (re)insurance companies are removed8. By matching each dollar of risk with the appropriate dollar of capital, investors are rewarded with an inherently stable yield in the absence of a major catastrophe while also adding the benefit of genuine diversification from more traditional return sources.

Having demonstrated their value in 2017, ILS represent a permanent and growing source of capital for managing the world’s risks. In the aftermath of losses, the ILS market is set to grow, with the cat bond market size alone expected to increase by 20% in 20189. By providing a structural capital solution to the (re)insurance industry these securities are helping to close the disaster gap by supporting the growth and the efficient functioning of the global (re)insurance marketplace. In doing so they provide a measurable beneficial impact on the quality of people’s lives, while generating attractive and truly uncorrelated risk-adjusted returns for investors.

Figure 2: ILS Market Growth10


Source: Fermat Capital and Aon Benfield Securities.

1 Swiss Re, December 2017: Previous notable high loss years are 2005 (the year Hurricane Katrina devastated New Orleans) and 2011 (with earthquakes in New Zealand and Japan followed by severe flooding in Thailand).
Swiss Re, December 2017: 
3 Hurricane Harvey Highlights Protection Gap, Aon Benfield, September 2017:
4 In this note we use the term (re)insurance to refer collectively to insurance companies and reinsurance companies, that is companies that provide insurance to insurance companies.
5 Source: Fermat Capital Research
6 Source: Fermat Capital Research, Applied Insurance Research, Guy Carpenter, Aon Benfield Securities. For illustrative purposes only. Diagram is incomplete and not to scale. Peril-region key: FLW, US Southeast hurricane; NYW, US Northeast hurricane; TXW, US Gulf Coast hurricane; CAQ, California earthquake; NMQ, US Central earthquake; FRW, French windstorm; DEW, German windstorm; UKW, UK windstorm; JPQ, Japanese earthquake; JPW, Japanese typhoon; AUQ, Australian earthquake; AUW, Australian cyclone; UKF, UK flood; MXQ, Mexico earthquake
7 In recent years the Metropolitan Transportation Authority (MTA) of New York and the World Bank, on behalf of numerous governments, have issued catastrophe bonds.
8 The (re)insurance industry has developed a deep understanding of the potential exposure to insured losses from natural events of varying severities such as hurricanes and earthquakes, with numerous third-party modelling firms offering independent portfolio analyses.
9 Source: Fermat Capital Research
10 Source: Fermat Capital and Aon Benfield Securities. Data as of 22 Jun 2017, estimated through 30 Jun 2017.

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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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