Insurance-Linked Securities, or ILS, are a range of financial products that seek to diversify insurance risk through the capital markets. Such products range from CAT bonds to mortality and longevity swaps and afford investors a chance to add some seriously uncorrelated assets to their portfolios.
Q. So we often hear from Richard about various tail risks facing the economy, and I guess that Insurance Linked Securities are a way some of those risks get addressed in the markets.
A. Yes. ILS refer to a range of products that essentially connect insurance type risks with the capital markets. We talked about CAT bonds from a previous buzzword segment, but there are several others, including extreme mortality and longevity swaps, reserve securitization, and life insurance settlement trading.
Q. So is this a major trend? Is it a big deal?
A. It definitely is. The entire insurance industry evolved as the first way to spread risks around in a capital-efficient way; but the capital markets are now catching up, and there is an explosion of activity in breaking risks down into the investors best capable of pricing them: insurers, reinsurers, hedge funds, banks, are all very busy with these issues these days.
Q. For average investors, though, what does it mean?
A. Opportunities for really uncorrelated investments. You can earn returns based on the occurance or non-occurance of events unrelated to market developments, and generally without regard to the kinds of illiquidity and leverage risks that lots of investment strategies share. You could invest in some of the capital market products, or in hedge funds that specialize in this sort of thing, of which there are several.
Q. So, getting specific, we’ve talked about CAT bonds before, so let’s look at a different example. What’s a longevity swap?
A. This is a way for pension plans to lay off the risks of their beneficiaries living too long. Very obviously, these plans invest based on actuarial assumptions about lifespan of a large number of people. But just as obviously, people are often living a lot longer than those actuarial tables have been predicting. Plans can lay this risk off in swaps, which have the rather morbid characteristic of paying off if not enough people die in a given year.
Q. Lovely! Next time we’ll pick a different example.