Insurance Linked Securities

Background and Introduction

Insurance linked securities (ILS) is an umbrella term covering instruments that are designed to transfer insurance risks to the financial market. The performance of ILS is typically also linked to the possible occurrence of such insurance risks. ILS, in global financial markets, is not a novel concept and the earliest known issuance of ILS by reinsurance companies was in the US in 1992, in the aftermath of Hurricane Andrew. In fact, ILS has been used multiple times by reinsurance companies in the US when their capacities were severely affected by the occurrence of natural disasters like earthquakes and hurricanes and even man-made disasters like the World Trade Center bombing.

Therefore, it is probably no surprise that in keeping with the catastrophe theme, the most popular ILS products are Catastrophe (Cat) bonds, including variations like Cat swaps, Cat options, industry loss warranties, reinsurance sidecars, weather derivatives, etc. While Cat bonds remain the dominant type of ILS, there are also other non-Cat bond ILS in existence, such as those based on mortality rates, longevity, and medical-claim costs.

Reinsurance versus ILS

The traditional and still prevalent model of risk transfer in the insurance industry is reinsurance. In traditional reinsurance, insurance companies typically park their risks with a reinsurance company and in some cases even reinsurance companies warehouse their risks with other reinsurance companies (retrocession). The key element of reinsurance is that insurers/ reinsurers typically do not pass the risks inherent in the insurance policy to the capital market but hold them on their balance sheet. To pay claims under the terms of the insurance policy, both the primary insurer and the reinsurer need to maintain sufficient capital to account for adverse or catastrophic circumstances. The shareholders of the insurer/ reinsurer are the ultimate bearers of the risk of loss or the residual claimants after policyholder claims are satisfied. In traditional reinsurance, diversification takes place through internal risk pooling, for example holding diversified portfolios (i.e. insurer/ reinsurer companies investing small percentages like up to 10% in any one given corporate entity to minimise losses). This mitigates but does not completely eliminate the risk of loss.

If we compare with ILS, we would typically find that the risk of loss is almost completely transferred to the capital market with the insurers/ reinsurers typically setting up special purpose vehicles (SPV) (off balance sheet entities) to issue ILS to investors in the capital market. This gives the flavour of securitisation of insurance risks, which has some obvious advantages. Firstly, risks of losses due to natural disasters in a particular part of the world may be completely uncorrelated with other risks in the global economy. Unlike the Covid-19 pandemic, which resulted in economic recession almost all over the world, isolated natural disasters happening in Germany for example typically may not have much of an impact on the Indian or US economy. The economic forces that drive the securities market in say India or the US where the ILS investors are based thereby remain largely unaffected. This low co-variability with other investment risks also make the contracts attractive to investors for purposes of diversification, potentially permitting risks to be transferred at relatively low costs, in comparison with reinsurance[1]. Secondly, the equity capital of insurers and reinsurers is relatively miniscule as compared to the volume of securities traded each day in the capital market, thereby eliminating credit risks that can be inherent in the insurance industry. This direct market access also insulates an investor from general business risks, agency costs, regulatory costs, etc., of operating a reinsurance company and hence the risks may be transferred at a lower cost than using traditional equity capital. The tenures of ILS and reinsurance contracts are also different, with reinsurance contracts typically for one year, while ILS is spread over a much larger time period (such as five years).

The biggest drawback is the pricing of ILS. Typically covering catastrophic losses of insurers – the issue price of ILS is generally quite high. In traditional reinsurance, when risks are numerous and independent and losses small, the cost of capital tends to be low and close to the expected losses, which can be absorbed in the reinsurer’s balance sheet. For ILS, setting up an SPV and other compliance costs might outweigh the advantage of transferring risks to the market and hence it is used by insurers/ reinsurers usually for catastrophe loss management.

The Indian Position

The Insurance Regulatory and Development Authority of India (IRDAI), the Indian insurance regulator, does recognise Alternate Risk Transfers (ART) and defines ART in the IRDAI (Reinsurance) Regulations, 2018 (Reinsurance Regulations), as “…non-traditional structured reinsurance solutions that are tailored to specific needs and profile of an insurer or reinsurer.” ILS is the most common and widely used manner of Alternate Risk Transfer (ART) in the insurance industry worldwide and these terms are sometimes used interchangeably.

While the definition is broad and to some extent vague, it does give rise to some possible conclusions. Firstly, the IRDAI defines ART as a non-traditional structured ‘reinsurance’ solution, which gives rise to the assumption that the IRDAI does not see ART as an alternative to reinsurance, but rather as a form of reinsurance itself. This is a bit ironical since, as mentioned above, ART is vastly different from reinsurance. The other issue which may arise is that such ILS may be construed as reinsurance products and their interplay with “securities” as understood in the Indian capital market context and as regulated by the Securities and Exchange Board of India (SEBI) is unclear. Any issue of securities to the general public in India is governed by the SEBI and an issue of ILS would be no different. It would therefore be interesting to see the interplay between the two regulators, the SEBI and IRDAI, in governing ILS issuances.

The other thing that we notice from the definition above is that ILS can only be availed of by Indian insurance or reinsurance companies and therefore Indian corporates or institutional investors may not be able to function as sponsors of the ILS.

That being said, as per Regulation 8 of the Reinsurance Regulations, an Indian insurer (which includes an Indian reinsurer and Indian branch offices of foreign reinsurers) intending to adopt ART solutions will have to mandatorily submit them to the IRDAI and the IRDAI after necessary examination and on being satisfied with the type of ART solution can allow it on a case by case basis. Since the reinsurance programme of Indian insurers also includes catastrophic risk protection measures, ART may also find place in the reinsurance programme, which needs to be approved by the IRDAI.

In this context, IRDAI on December 8, 2004, had released a circular on the accounting treatment used in ART solutions. IRDAI noted that any ART solution would be subject to the “substance over form” principle. If the ART agreement is in the nature of reinsurance, coupled with a financing arrangement, then the components should be capable of separation and each element should be accounted for as per the Generally Accepted Accounting Principles (GAAP). In case the two components are not separable, the entire arrangement should be treated as a financial transaction and should be accounted for accordingly in the books of the Indian insurer/ reinsurer. The latter may burden the balance sheet of the Indian insurance company with undue liabilities and may not be desirable.

Concluding Remarks

While the IRDAI does recognise ART arrangements, it seems to have adopted a ‘watch and react’ attitude on the issue of ILS rather than proactively setting up a regulatory landscape for the same. In principle, while ART and reinsurance are serving the same purpose of mitigating risks for the insurer/ reinsurer, they are very different in approach, in terms of both the transfer of risks and even the tenure of the arrangement. However, they are not strictly substitutes and there can be an environment where both co-exist, with ART covering catastrophic risks, which hurt the balance sheet of insurance and reinsurance companies. Caution may need to be exercised in entering into ARTs in India since the IRDAI may recognise ART as just another form of reinsurance and not as a security per se.

Amidst the uncertainty, one thing is for certain – the regulatory landscape surrounding ILS and ART is dynamic and will definitely play a part in the development of the Indian reinsurance sector.


[1] Securitization, Insurance, and Reinsurance, J. David Cummins, Philippe Trainar, The Journal of Risk and Insurance, 2009, Vol. 76, No. 3, page 475

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Photo of Indranath Bishnu Indranath Bishnu

Partner in the general corporate practice at the Mumbai office of Cyril Amarchand Mangaldas. Indranath advises on foreign direct investments, mergers and acquisitions and joint ventures and specializes in the Insurance industry. He has advised multiple corporations, both Indian and foreign, in relation…

Partner in the general corporate practice at the Mumbai office of Cyril Amarchand Mangaldas. Indranath advises on foreign direct investments, mergers and acquisitions and joint ventures and specializes in the Insurance industry. He has advised multiple corporations, both Indian and foreign, in relation to the establishment, operation, management and control of insurance companies in India. Pursuant to the amendments of the Insurance Act as well as the Foreign Investment Policy relating to the insurance sector in 2015, Indranath has been involved in multiple deals involving the entry, exit and increase of ownership of stakeholders in the said sector.

He also advises on mergers and acquisitions in other financial services sectors such as mutual funds, credit information companies, commercial banks, credit card companies, and payment and settlement systems. Other sectors that he has advised in include civil aviation, retail, consumer goods and services, and real estate. He can be reached at indranath.bishnu@cyrilshroff.com

Photo of Soumyadipta Chanda Soumyadipta Chanda

Principal Associate in the General Corporate Practice at the Mumbai office of Cyril Amarchand Mangaldas. Soumyadipta advises domestic and foreign public and private companies on their mergers & acquisitions, joint ventures, corporate restructuring, and foreign investments, with a special focus on the insurance…

Principal Associate in the General Corporate Practice at the Mumbai office of Cyril Amarchand Mangaldas. Soumyadipta advises domestic and foreign public and private companies on their mergers & acquisitions, joint ventures, corporate restructuring, and foreign investments, with a special focus on the insurance and financial services sector. He can be reached at soumyadipta.chanda@cyrilshroff.com