ILS Overview

The ILS asset class started with the first broader market cat bonds issued in the mid 90's. It was Swiss Re, which was being more and more required by its clients to assume increasing amounts of US exposures (hurricane and earthquake) in order to receive the other perils from around the world. It needed the other perils to build its diverse reinsurance portfolio and therefore had an increasing problem with peak US exposures which consumed increasing amounts of capital due to their high concentration in the portfolio.

Swiss Re could not turn to the reinsurance markets – it was the second largest reinsurer at the time, not far behind Munich Re, which was Swiss Re’s main competitor and also had high concentrations of US risks. Swiss Re saw the solution as the capital markets – they had no US event risk and a huge portfolio in which to diversify it away. Swiss Re was more than happy to pay high prices to cede the risk due to the high capital relief it would receive, still allowing it to cede the risk at high prices whilst improving the return on allocated capital.

Certain large US primary carriers also feared that the reinsurance market was struggling to provide all the required capacity for their exposures. They therefore required a deeper market with greater capacity to assume their exposures (the capital markets) whilst in addition reducing counterparty credit risk which was increasingly linked to their own exposures within the traditional reinsurer portfolios.

Cat Bonds were the mechanism designed to transfer the cat risk to the capital markets and so ILS was born.

Since the early days ILS has grown and comprises not only cat bonds but also collateralized reinsurance in both ILW (Industry Loss Warranty) and UNL (Ultimate Net Loss, i.e. indemnity reinsurance) forms and make up a ca. $65bn market today. Current predictions are that it could again double in size in the next 5 – 10 years.

Attractive Returns

Cat Bonds have produced a steady return over time as is shown by the Swiss Re Global Cat Bond Price Index. Since January 2002 the index has produced an annual IRR of 8.35%. This is an IRR of close to double that of the S&P 500 during the same period.

Low Correlation

Cat Bonds are unlike other investments – their performance is not driven by normal econometric drivers. Unless a major ‘physical’ event occurs in the world, regardless of what happens in the financial markets, an ‘Event-Linked Securities’ portfolio will provide investors with a positive return.

Strong Growth

The Cat Bond market began to grow exponentially until 2008. The credit crisis slowed down issuance with the general uncertainty in all financial markets. From 2012 onwards new issuance fast outstripped maturity making the market the biggest it has ever been and further expected to grow.

Concentration Risk

A very high proportion of Cat Bonds are exposed to US risks (predominantly hurricane and earthquake) and are therefore highly correlated to each other. Investors may ask themselves if a monolithic US Hurricane exposure is acceptable (“black or white”) or whether investment in a diversified ILS portfolio is preferred.