On one side, the SPV enters into a contract with a (re)insurance company receiving a premium for taking on some form of insurance risk. On the other, the SPV issues securities that are purchased by investors who in turn get the insurance risk premium from the SPV. Investors also receive some form of money market return given that the transaction is fully collateralised and this security collateral is invested in-short term or overnight assets.
By adding ILS to a portfolio, investors can benefit from a diversifying risk premium that generates potentially attractive returns that are not correlated to the economic cycle.
An ILS is known as a principal-at-risk security. If a major insurance event takes place, then the issuing SPV may not repay the principal so that it can instead fulfil the (re)insurance obligations to the protection buyer.
ILS mainly cover non-life and, to a lesser extent, life risks. On the non-life side, the main risks are natural catastrophes, such as hurricanes, earthquakes or winter storms. There are also some marine, aviation, mortgage insurance and terrorism exposures being transferred into capital markets. Embedded value, extreme mortality and healthcare risks are covered on the life side of the ILS market.
Benefits to investing in ILS: