Insurance-linked securities (ILS) refer to a broad class of structured notes contingent on insurance claims. In a typical ILS, a ceding insurer or reinsurer acting as sponsor enters into a reinsurance arrangement with an insurance special purpose vehicle (SPV) in relation to a defined insurance portfolio. An up-front reinsurance premium is paid by the sponsor to the SPV, who acts as intermediary to raise capital to finance the transaction through the issuance of securities from the SPV to investors. CAT bonds, or catastrophe bonds, are a particular type of ILS where investors receive their capital back in periodic principal and interest payments, as with any bond or fixed-income instrument.

Primary issuances of ILS contracts have reached new highs in 2024, continuing a trend of constant growth of the market since late the 2010s. New sponsors have entered the market throughout 2024, seeking alternative capacity to complement their traditional reinsurance programs.

Although still dominated by US perils, the ILS market has started to offer a variety of non-US-exposed securities. Non-US perils issued during 2024 include Japan windstorm and earthquake, Italy earthquake, Europe windstorm, Mexico windstorm and earthquake, and Jamaica windstorm. Non-NAT CAT perils—meaning risks unrelated to natural catastrophes—have also entered the market, such as mortality and morbidity risks, and, more recently, cyber risks and terrorism.

The appeal of ILS and CAT bonds

ILS and CAT bonds are appealing to insurers because of their ability to expand ceded and retrocessional reinsurance programs beyond traditional reinsurance markets. They also provide capacity for risks where risk-taking appetite is limited among traditional reinsurers. By means of increasing reinsurance capacity, the ILS market further contributes to increasing price competitiveness.

For insurers, the ILS market offers the possibility to better align their risk exposure with risk appetite by transferring to capital markets extreme risks that are not accepted by traditional reinsurers—or that are transferred to traditional reinsurers but at prohibitive prices. Capital relief can be achieved in this way, as augmenting risk capacity can result in diminishing capital requirements. ILS can also provide the service of liquidity through securitization of the value in force (VIF) embedded in long-term life portfolios, and can thus support capital fungibility and operational leverage.

For investors, the main benefits of ILS are related to profitability and diversification. ILS investors are typically institutional investors—such as hedge, pension and sovereign wealth funds—who have been increasingly engaging in ILS transactions as a means to access to securities offering comparatively high yields, and which, since they are contingent on insurance perils, additionally exhibit low correlation with traditional asset classes, such as equities and fixed income.

Challenges when structuring ILS transactions

A first challenge when structuring ILS transactions is the valuation of these generally illiquid instruments. Although a secondary market exists for CAT bonds, this is not the case for a majority of ILS contracts, which tend to lack this trading capability. As a consequence, there is no suitable mark-to-market price for most ILS transactions, which creates the need for investors to develop a mark-to-model valuation approach.

A main source of difficulty in developing mark-to-model valuation approaches originates in the lack of models of emerging perils such as cyber risk and terrorism. In the case of traditional NAT CAT risks, it can also originate due to evolving general conditions, such climate change. An additional source of difficulty arises due to aggregation clauses in ILS transactions covering multiple perils and regions across multiple business lines. All these difficulties call for substantial modelling resources, particularly in the days immediately following a major event, when projected ultimate losses are most uncertain.

Other challenges are rooted in contractual features, such as the need to accrue incurred-but-not-reported (IBNR) loss claims. In this case, the possibility exists that ILS contracts suffer losses from events that are not immediately known to investors. Investors that fail to incorporate IBNR with such ILS transactions are exposed to the risk of over-accruing profits at an early stage, only to face the need to recognize losses later on during the life of the contract—thus, providing inconsistent valuation over time.

Yet another challenge is the role of risks-attaching contracts. These are contracts that are accountable for a portion of losses on all policies underwritten by the cedent within a predetermined time frame. As a result, the valuation process becomes more complex, as the investor is accountable for losses after the expiration date of the contract, as long as the loss occurs on a policy underwritten during the contract period.

Looking forward: The key role of actuaries in ILS structuring and investing

ILS investors seeking to benefit from high yields and diversification are willing to expand their presence within the global reinsurance landscape. Although the expansion of the ILS market offers an opportunity to broaden the general reinsurance capacity for insurers, it also raises challenges around valuation, due to its complexity and the lack of standard statistical modelling for emerging perils. Additional complexities are introduced by ILS transactions due to specific contractual features, such as the managing of IBNR losses, and the conditions linked to contracts integrating multiple perils and regions across various lines of business. All of this creates the need to develop substantial modelling expertise.

Within this context, the role of actuaries arises as a key to successful ILS structuring. As consultants, Milliman’s actuarial experts help clients navigate this complex landscape by:

• Interpreting catastrophe model results and providing substitute modelling when established models are lacking—for example, for emerging risks such as cyber or terrorism
• Delivering independent reviews and robust mark-to-model valuations in the absence of liquid secondary markets
• Designing, validating and implementing tailored risk models for complex, multi-peril programs
• Supporting clients with compliance, reporting, and communication with regulators and investors

With our international experience and advanced actuarial tool kit, Milliman consultants provide comfort to both investors and regulators, ensuring that ILS transactions are valued on a fair and consistent basis. Our consultants help clients unlock the potential of the ILS market, manage risk effectively and achieve their strategic objectives.