In our current economic climate, uncertainty still permeates the fabric of the financial market like smoke. Alternative investment options that would normally be an attractive choice are tainted by the reason the market sank in the first place. Thanks to the fevered-pitch investing that led to the eventual meltdown of the mortgage-backed securities market, investors are exercising caution in the alternatives market.
That's not necessarily a bad thing. Yet, in the quest to be prudent, investors may be missing out on an opportunity that has, at least historically, provided high return for a risk that, while not small by any means, can be navigated perhaps more easily than most. That is the premise behind insurance-linked securities (ILS), which contain various alternative investing vehicles that focus on high-severity, low-probability loss events, such as natural catastrophes.
Even after the financial meltdown, when linking securities to anything causes investors to pause, ILS are different. Catastrophe bonds, "cat bonds" in industry parlance and one of the main investment vehicles in the ILS market, were created in the mid-1990s as a response to the large losses insurers suffered from natural catastrophes.
Hurricane Andrew in 1992 and the 1994 Northridge earthquake were unlike anything the industry had seen before, and cat bonds were designed as risk transfer vehicles to help insurers hedge their bets. The bonds are issued by insurers and then purchased by investors, who stand to gain the stated return, which is usually high.
But these high returns are a product of the high risk inherent to the underlying triggers. Storms and earthquakes happen, and while major disasters are rare, the losses can be astronomical. As a result, cat bonds are rated below investment grade.
This is an expected and accepted rating for those who invest in the market, however, because ILS link their value to non-financial risks that are mostly uncorrelated with the larger economy. For investors, they are a means of diversifying their portfolio. For the insurers that issue the securities, they are a means of hedging the risky exposures they have already underwritten.
Cat bonds are just one of the investment options, or "special purpose vehicles," under the ILS umbrella. Another is the capacity-building sidecar, which is a reinsurance structure that allows investors to take on risks and returns on a particular book of business.
Also increasing in popularity is the insurance loss warranty (ILW), an investment that allows buyers to pay premiums for the potential return should an event occur that exceeds a particular trigger amount. For example, one could purchase an ILW for a limit of $10 million "attaching at" $3 billion that would pay out should total industry losses top the trigger amount of $3 billion.
Thanks to some significant catastrophic events, insurance-linked securities have begun to gain momentum in the investment world. According to a 2009 white paper, "Development in the Insurance-linked Securities Life Market," the market has grown to more than $35 billion, with $15 billion in securities issued to capital market investors and another $20 billion in private placements between life insurers and banks.
The ILS market is generating interest of late thanks in large part to recent storms that have hit the Eastern seaboard, says Connecticut Insurance Department Commissioner Thomas Leonardi. "When you have large catastrophes, the market becomes very interested," said Leonardi. "It's a normal reaction to what's happened."
With renewed interest and money pouring in, most predict that market volume will continue to grow, should no major events occur. This has been the trend. According to reports by Willis Capital Markets & Advisory and Swiss Re, 2011 saw a $4. …