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Insurance-Linked Investments: Herding Cats and Other Insurance-Linked Risks

It is not always easy to tell what someone means when they talk about ‘insurance-linked investments’ – but distinctions are imperative because the various components of this complex market present very different risk and return profiles.

Let us take the most commonly-used term – ‘insurance-linked securities’. Often shortened to ‘ILS’, this is what most investors are sold by the industry involved in insurance-linked investment. But the term tends to be used to cover two very different markets: catastrophe bonds ( or ‘cat’ bonds for short); and traded life settlements. We cover both markets in this report, looking at supply-and-demand dynamics in the former and controversies over pricing of risk in the latter.

Any reader will soon pick up that one involves taking non-life insurance risks (receiving premiums in exchange for occasional, fairly predictable large losses); and the other involves buying life insurance risk (paying premiums in exchange for a one-off, fairly unpredictable return).

Arguably, only the catastrophe risk represents a genuine insurance risk premium, and its risk profile has more in common with options-based financial market ‘insurance’ strategies than with traded life settlements – an idea that we pursue further in this report.

But even if we dig further into the catastrophe market itself, the differences are complex. The insurance-linked securities tend to be focused on ‘peak perils’, with their own very specific risk-return characteristics determined largely by the nature of the insurance industry; but most of the capacity is in non-securitised reinsurance, which offers a different risk-return potential again. Which should investors favour – one, the other, or both?

Continued

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