ILS products, often seen in the form of catastrophe bonds (cat bonds), industry loss warranties and sidecars – which are financial structures established to allow investors to take on the risk and benefit from the return of specific books of insurance or reinsurance business – cover natural catastrophes such as hurricanes and earthquakes, life insurance, (including mortality and longevity) and man-made events such as fire and terrorism.
ILS returns are thus ‘event’ linked rather than correlated with risks associated with the wider financial markets as are found in traditional investment classes. Value is linked to the occurrence or non-occurrence of specific non-financial risks (e.g. Florida hurricanes). If there is no trigger event (i.e. no natural disaster before the maturity of the security, investors receive their principal investment in addition to any interest earned on the investment during the lifetime of the contract.
The ILS market has been very attractive for both insurers and investors. Insurers can offload risk and raise capital and life insurers can release the value in their policies by packaging them up and issuing them as assetbacked notes. The growing popularity of ILS as an asset class for institutional investors largely stems from the prospect of returns not correlated with equity markets and that investment in ILS provides diversification in an investment portfolio.
ILS fund structures are proving to be particularly attractive to pension funds because they offer the ability to improve a portfolio’s investment performance through uncorrelated investments. As pension funds and other new institutional investors become more familiar with the ILS market and associated risks, they have increasingly been allocating a larger percentage of their investment mandates into this area.