Insurance-linked securities (ILS) is an umbrella term for financial instruments where the return is linked to insurance or reinsurance losses rather than the performance of financial markets. The key characteristic is low correlation to equities and credit — making ILS a genuine diversifier in institutional portfolios.
The ILS asset class
ILS encompasses several distinct structures, each with different risk profiles and liquidity characteristics:
- Catastrophe bonds — publicly listed, rated notes. Most liquid form of ILS. Typically 3-year maturity.
- Collateralised reinsurance — private quota share or excess-of-loss contracts where an ILS fund acts as reinsurer, posting 100% collateral. Illiquid but higher return.
- Sidecars — special purpose vehicles that take a proportional share of a reinsurer's book. Typically one year, closed-end.
- Industry loss warranties (ILWs) — binary contracts that pay out when industry losses from an event exceed a threshold. Often used for hedging.
- Reinsurance swaps and longevity swaps — structured products linked to mortality or longevity experience.
Who issues ILS
Primary insurers and reinsurers use ILS to transfer peak risk to capital markets. Major sponsors include Munich Re, Swiss Re, Zurich, AIG, USAA, and national catastrophe schemes such as FEMA's National Flood Insurance Program and the California Earthquake Authority. Increasingly, corporate entities with large catastrophe exposures (utilities, national governments) issue directly.
Who invests in ILS
Dedicated ILS funds manage the majority of capital — firms like Nephila Capital (now part of Gallagher Re), Twelve Capital, LGT ILS Partners, Securis Investment Partners, and Leadenhall Capital. Pension funds, sovereign wealth funds, family offices, and endowments allocate to ILS through these managers or directly into cat bonds via the 144A market.
Returns and risk
ILS returns come from two sources: the risk premium (the 'spread' above risk-free) and collateral yield. In the current rate environment, total expected returns for diversified ILS portfolios have risen significantly. The Swiss Re Cat Bond Total Return Index has averaged approximately 7-9% annually over the past decade, though individual years with major events (2017, 2022) saw meaningful losses.
Why ILS matters for reinsurance
ILS capital now represents roughly 15-20% of global reinsurance capacity. It plays an especially important role in peak zones — US hurricane, US earthquake, and Japan earthquake — where traditional reinsurers are capacity-constrained. When reinsurance pricing hardens after major events, ILS capital tends to flow in rapidly, acting as a market stabiliser.