Casualty insurance-linked securities (ILS) is a rapidly growing field offering a fascinating glimpse into the future of insurance risk financing.
ILS landscape
Originating in the 1990s, ILS is a risk financing innovation that created additional capacity for property catastrophe (CAT) risk when reinsurers were unwilling or unable to offer coverage. ILS allows institutional investors to gain exposure to particular types of insurance risk with well-understood characteristics that make them an attractive diversifier in a larger investment portfolio. In the absence of ILS, investors seeking insurance exposure would only be able to invest in an insurance company stock, which exposes the investor to market beta along with all the idiosyncratic risks that might impact the returns of a larger insurance organization. Only insurance-linked securities offer isolated exposure to zero-beta insurance risk.
Historically, while most ILS investors have been focused on property CAT risk, many are now turning their attention to casualty — in particular, non-CAT casualty risk. Casualty ILS are a diversifying asset that generates uncorrelated and low volatility returns with little risk of losing principle. In many ways, this is a more attractive risk than that of property CAT, which offers uncorrelated returns at the cost of higher volatility. As casualty business is longer-tailed than property business, premium and investor capital invested in casualty ILS can also earn investment income on float as claims arise over several years. The market for casualty risks, including both prospective casualty risk in the form of current-year premiums and retrospective casualty risk in the form of outstanding reserves, is on the order of hundreds of billions of dollars. So, the potential market for casualty ILS is significant.
Until recently, the majority of the market didn’t think casualty ILS was possible. This was mostly because of the misconception that investors were afraid of longer-tailed risk and due to challenges in creating securitization structures that would work for both insurers and investors. These issues have been overcome, and institutional investors such as pension funds, sovereign wealth funds, private credit, hedge funds and life insurers have begun to invest in the market. As of the publication of this article, a handful of market players have transacted billions of gross casualty premium,1 and exit paths have been proven through secondary transactions that provide liquidity to investors.
Use of casualty ILS
Many insurers and managing general agencies (MGAs) have attractive and diversified casualty insurance portfolios that ILS investors would gladly pay a fee to access. While many insurers today use ILS for risk management purposes — for example, for additional capacity on property CAT risk — more often than not, insurers are using casualty ILS as a capital management tool. At scale, this pattern of ILS usage has the potential to refinance the insurance industry. Insurers generally source capital via equity or debt. Securitization offers a third avenue to optimize capital that provides additional flexibility without diluting existing shareholders.
Why would an insurer securitize their casualty portfolio?
• Better management of underwriting cycles by sourcing flexible capital versus permanent capital (e.g., equity): During a soft market, an insurer reduces deployed capital to write a business that provides adequate returns. In a hard market, an insurer might choose to source additional capital via securitization to write more business to capture increased returns. Capital flexibility provided by ILS provides a solution to the “curse of permanent capital” that often motivates insurers to write uneconomical business, exacerbating market cycles.
• Source lower cost of capital: ILS investors provide capital to finance insurance risk-taking, and this matchmaking directly with investors who are interested in insurance risk is more efficient than the traditional way an insurance company is financed. This allows insurers to free up capital for growth, fund acquisition costs, source capital in light of regulatory changes or rating agency requirements and assist in risk retention.
• Increase shareholder value: When an insurer securitizes a portfolio, it takes a portion of its casualty risk and turns it into a stable fee-income, reducing earnings volatility, boosting return on equity, and increasing shareholder value. The more profitable the business that’s securitized, the more fee-income that’s generated. Capital-light, fee-generating businesses are more valuable than capital-heavy businesses. For example, typical insurance brokers enjoy much higher multiples than typical insurance companies. The economics and valuation of a capital-light insurer operating in a post-securitization world might be closer to the economics of a broker or an MGA than to a traditional insurer operating today.
• Low operational overhead: The typical casualty ILS arrangement is structured as a simple quota share reinsurance agreement that aligns primarily on statutory product lines and receives full capital credit as a reinsurance transaction. Reporting overhead is substantially reduced relative to traditional reinsurance, which can be more complex in nature, and therefore, have higher operational overhead.
Value to the insurance industry
The cost of holding risk on-balance sheet is high. It is difficult to flex capital with swings in market pricing. Insurance is generally viewed as lagging other industries, given its capital intensity, and securitization offers a solution. Securitization also provides diversification of capital counterparties and capital certainty (cash or cash-like instruments available in a trust account with the cedent as the beneficiary).
It’s hard to ignore the fact that there is potential to dramatically decrease the protection gap and foster innovation to partner with people and businesses to mitigate risk. Securitization facilitates access to global assets under management that far exceed capital allocated to the insurance industry today. With increased availability and efficiency of capital, securitization will increase the economic and societal impact of insurance.
Practical applications for actuaries
There are many actuaries today who support the placement of ILS transactions. This demand for actuarial support will continue to grow as the asset class expands. Investors are looking for:
• Consistency, objectivity and transparency from models that support transactions.
• Models that require little judgment from an analyst that can be easily backtested.
• Quick turnaround times and repeatable processes.
Ultimately, investors want standardization and transparency to make the asset class scalable. To model the risk, it’s been necessary to produce stochastic projected cash flows to onboard investors. To this end, my company has created a fully Bayesian modeling framework, which is available in our website’s library.
The return ILS investors see is a combination of underwriting profit and investment income, and so it’s necessary to model the timing of premium, claim payments and changes in loss reserves. Many of the modeling problems my company thinks about every day are also faced by insurers, and we are committed to sharing our techniques and insights with the actuarial community to elevate the standards of the profession as a whole. As this asset class grows, investors will look to third parties to help them understand and price the risks they hold. This is an exciting time to be in ILS as an actuary.
Jessica Schuler, ACAS, is a director at Ledger Investing, Inc., a tech-enabled insurance securitization marketplace focused on casualty and non-cat property risk.
