What are insurance-linked securities (ILS), and how do catastrophe bonds transfer risk from insurers to capital markets?

Insurance-linked securities (ILS) are financial instruments whose value is tied to insurance loss events rather than traditional financial risk factors. The most prominent ILS are catastrophe (cat) bonds, which allow insurers and reinsurers to transfer peak catastrophe risk to capital market investors.

Structure of a Cat Bond

A sponsoring insurer (the "cedent") creates a special purpose vehicle (SPV) that:

1. Issues notes to capital market investors (the principal goes into a collateral trust)
2. Enters into a reinsurance contract with the cedent
3. Pays investors a coupon = risk-free rate + a risk premium (typically 3-12%)
4. If a qualifying catastrophe occurs, some or all collateral is released to the cedent; investors lose principal

Trigger Types

Example: Coastal Re 2026-1

Brookhaven Insurance sponsors a $350 million cat bond through Coastal Re Ltd. to cover Florida hurricane losses above $2 billion. The bond uses a parametric trigger: central pressure below 940 mb making landfall between Key West and Jacksonville. Investors receive SOFR + 7.25% annually. If no qualifying hurricane occurs during the 3-year term, investors receive full principal at maturity.

Why Investors Accept the Risk

1. Diversification — cat bond returns have near-zero correlation with equity, credit, and interest rate markets
2. Attractive risk premium — spreads of 5-12% above risk-free compensate for tail risk
3. Short duration — most cat bonds mature in 2-4 years
4. Transparent modeling — third-party catastrophe models (AIR, RMS) provide expected loss estimates

Exam Tip: FRM questions often test the trade-off between basis risk and moral hazard across trigger types — indemnity triggers have low basis risk but higher moral hazard, while parametric triggers have the opposite profile.

For more on alternative risk transfer, check our FRM Part I materials.