Why ILS and cat bonds are weathering the current market volatility

Insurance-linked securities and cat bonds are proving remarkably resilient amid the Covid-19 crisis.

Apart from its devastating human effect, the Covid-19 pandemic has decimated economies around the world, large and small, and ushered in a likely global recession.  

In a time of general market turmoil, insurance-linked securities (ILS) and natural catastrophe (cat) bonds have proved themselves to be impressively resilient. We take a look at why this is, what ILS and cat bonds are, and why they’ve been mostly unaffected by the current market volatility.  

What are cat bonds and insurance-linked securities (ILS)?

Insurance linked securities in general are perceived as a way for companies to buy protection against the risk of a particular event. This means they are most often, but not always, used by insurance or reinsurance entities. Another interesting example of ILS is for high-payouts reinsurance in the lottery industry, where they will activate should a win over a certain monetary value take place.  

Unlike other asset classes, ILS are governed by happenings in the natural and physical world rather than the business and financial world. Cat bonds are one form of Insurance Linked Security. And as the name ‘natural catastrophe’ bond implies, the issuer of the bond only receives funding from it in the event of a prespecified natural disaster, such as a hurricane, tornado, earthquake, or wildfires in a particular region.  

Around one third of the ILS market is made up of cat bonds, which typically come with a life span of three to five years. The remainder cover other kinds of insurance perils – such as aviation crashes, terrorist and cyber-attacks – are non-tradeable, and normally have a one-year lifespan.  

Should the insured event actually take place, investor capital which has been placed in a segregated collateral account means that dedicated funds are available to cover the payment. This approach practically eliminates the credit risk associated with other reinsurance assets.

The current ILS market is estimated to fall between the $90 billion and $100 billion range, and they have been available to investors for roughly 30 years as of 2020. 

Why have ILS remained so stable during Covid-19?

Because they are related to natural phenomena, ILS and cat bonds remain unaffected when major market fluctuations hit. During a disaster like the Covid-19 pandemic we are faced with now, interest rates, currencies and stock prices can fluctuate wildly – but the insurance trigger events ILS and cat bonds are linked with have not occurred. 

This means that while many other asset classes might be seeing massive volatility regardless of the industry, sector, or geographical region they fall in, insurance-linked securities are still delivering reliable performance. It’s important to note that this was also the case for insurance linked securities during the 2008 Global Financial Crisis.  

It’s easy to see why these kinds of less correlated bonds and securities can be so useful in terms of diversifying a portfolio by reducing dependency on just one market. They don’t fluctuate when traditional asset classes such as equities would, and have strong collateral structures in place backed by a supranational organization like the World Bank.  

Exceptions:

Of course there are ILS and cat bonds which are affected by the pandemic. These, for the most part, are cat bond programs which offer coverage in the case of large upswings in mortality rates or a significant rise in the number of medical benefit claims being made – both of which have sadly come to pass with Covid-19. 

One notable example is the IBRD Capital-At-Risk notes 111-112 cat bond from the World Bank’s Pandemic Financing Facility. Unsurprisingly, all of the bonds trigger conditions have been met, with an expected payout loss of around $132.5 million being projected.

Insurance Linked Securities post-Covid-19

Despite being an over the counter asset, cat bonds have an active secondary market which makes them extremely liquid. And because they can be cashed in easily, this liquidity will likely make them even more attractive to several sectors going forward. 

Institutions such as pension funds, which are generally heavily invested privately in long-term holdings, may find them especially useful. Insurance linked securities and catastrophe bonds could be utilised as a way to free up cash without selling valuable assets which would likely bounce back once the market settles and becomes less volatile again.

In contrast to many other asset classes, ILS offer investors less drawdown and more volatility, both in recent times and historically – and while continuing to deliver appealing returns. It is highly likely that the Covid-19 crisis will greatly increase future appetite for pandemic-specific coverage, as recent events have brought the potential economic losses associated with these kinds of disasters into sharp relief.