Analyzing InsuranceLinked Securities

Insurancelinked securities can benefit both issuers and investors they supply insurance and reinsurance companies with additional risk capital at reasonable prices with little or no credit risk, and supply excess returns to investors that are uncorrelated with the returns of other financial assets. This article explains the terminology of insurance and reinsurance, the structure of insurancelinked securities, and provides an overview of major transactions. First, there is a discussion of how stochastic catastrophe modeling has been applied to assess the risk of natural catastrophes, including the reliability and validation of the risk models. Second, the authors compare the riskadjusted returns of recent securitizations on the basis of relative value. Compared with highyield bonds, catastrophe CAT bonds have wide spreads and very attractive Sharpe ratios. In fact, the riskadjusted returns on CAT bonds dominate highyield bonds. Furthermore, since natural catastrophe risk is essentially uncorrelated with market risk, high expected excess returns make CAT bonds highalpha assets. The authors illustrate this point and show that a relatively small allocation of insurancelinked securities within a fixed income portfolio can enhance the expected return and simultaneously decrease risk, without significantly changing the skewness and kurtosis of the return distribution.