Insurance-linked securities (ILS) are financial instruments
issued by insurers and reinsurers to manage their exposure to low
frequency but high severity losses.
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
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.
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