Insurance-Linked Securities: Asset-Backed Bonds

Asset-backed securities (ABS) are a type of financial investment that is collateralized by a pool of assets. They are typically backed by non-mortgage assets such as credit card receivables, auto loans, student loans, and equipment leases. ABS are created when a company sells its loans or debts to a financial institution, which then packages them into a portfolio to sell to investors. This process, known as securitization, allows the issuer to raise cash and get riskier assets off their books. ABS are an alternative investment for income-oriented investors, offering a steady stream of interest. They have proven to be stable investments, attracting many investors, including insurance companies.

Credit risk

To manage this credit risk, ABS use a senior-subordinate structure, also known as credit tranching. This structure ensures that the subordinate or junior tranches absorb all the losses up to their value before the senior tranches experience any losses. The senior tranche, typically the largest, is designed to be more attractive to investors with an investment-grade rating, while the subordinate tranches have higher yields due to the increased risk.

Prepayment risk

The prepayment risk can be mitigated through tranching structures, which help distribute the risk. Investors can choose a tranche based on their risk tolerance. Additionally, models such as the Public Securities Association (PSA) Standard Prepayment Model can be used to forecast prepayment risk in MBS. This model assumes a steadily rising constant prepayment rate (CPR) over the first 30 months, followed by a level CPR.

Another way to assess prepayment risk is through the weighted average life (WAL) statistic, which measures the effective maturity of an MBS. The WAL takes into account the impact of principal paydowns over the lifetime of the security. It helps investors make more realistic predictions about the yield and term of an MBS, reducing the inherent prepayment risk.

Furthermore, the difference between prepayment and refinancing should be noted. Prepayment occurs when a borrower has extra funds to pay off the loan, while refinancing happens when interest rates fall, prompting borrowers to refinance their mortgages to take advantage of lower rates.

Insurance-linked securities

The term insurance-linked security (ILS) encompasses the ILS asset class, which consists of catastrophe bonds, collateralised reinsurance instruments, and other forms of risk-linked securitisation. ILS are investment assets generally thought to have little to no correlation with the wider financial markets as their value is linked to insurance-related, non-financial risks such as natural disasters, other insurable specialty risks, and life and health insurance risks including mortality or longevity.

ILS are sold to investors, and their value is affected by an insured loss event. They allow insurance and reinsurance carriers to transfer risk to the capital markets and raise capital or capacity. They also allow life insurers to release the value in their policies by packaging them and issuing them as asset-backed notes.

The market for ILS emerged in the mid-1990s as a mechanism for insurance and reinsurance companies to access the deepest and most liquid pool of capital available, the global capital markets. Now an established alternative asset class, ILS are typically invested in by large institutional investors such as pension funds, sovereign wealth funds, multi-asset investment firms, and funds, endowments, as well as some family office investors.

ILS are also used by some large corporates to access insurance capacity from the capital markets, as well as by governments to secure disaster risk financing. The most prevalent securitised insurance contracts exchanged in capital markets include embedded value securitisation, extreme mortality securitisation, life settlements securitisation, reserve funding securitisation, and fully collateralised reinsurance.

Catastrophe bonds, or "cat" bonds, are the best-known part of the ILS market. These instruments are more conventionally tradeable and normally have a lifespan of between three and five years. Cat bonds are a segment of the ILS market and are used by insurers and reinsurers to transfer major risks on their books, such as hurricanes, windstorms, and earthquakes, to capital market investors, reducing their overall reinsurance costs while freeing up capital to underwrite new insurance business.

Securitization

• A company or originator holds a group of assets, such as mortgages or personal loans, on its balance sheet.
• The originator decides to remove these assets from its balance sheet and sells them to an issuer.
• The issuer creates tradable securities with a stake in the assets in the portfolio.
• Investors buy the new securities for a specified rate of return and take on the role of the lender.

Asset-Backed Securities (ABS) are a type of financial investment that is collateralized by an underlying pool of assets. These assets typically generate cash flow from debt instruments such as loans, leases, credit card balances, or receivables. ABS can take the form of a bond or note, paying a fixed rate of income for a set period until maturity.

Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) are considered types of ABS. MBS are formed by pooling together mortgages exclusively, while ABS consist of any other type of loan or debt instrument, including home equity loans, auto loans, credit card receivables, and student loans.

The process of securitization for ABS involves the following steps:

• A lender or company with loans or income-producing assets earmarks a group of these assets.
• The assets are sold to an investment bank or financial institution.
• The financial institution pools the assets with similar ones from other sellers.
• A special purpose vehicle (SPV) or special purpose entity (SPE) is established to acquire, package, and issue the assets as a single security.
• The issuer sells these securities, typically to institutional investors.
• Investors receive fixed or floating-rate payments from a trustee account funded by the cash flows generated by the portfolio of assets.

The benefits of securitization include:

• Improved liquidity and reduced liquidity risk in the financial system.
• Enhanced profitability for banks by separating loan origination from financing and reducing capital requirements.
• Increased access to funding for borrowers.
• Higher risk-adjusted returns for investors.
• Alternative means of funding operations for companies.

However, it's important to note that securitization also carries risks, including the inherent credit risk of the loans and receivables backing the ABS. The financial crisis of 2007-2008 highlighted some of the potential flaws in the securitization process, such as the lack of incentive for loan originators to maintain underwriting standards.

Collateral

The collateral for an ABS can consist of a diverse range of assets, including loans, leases, royalties, and receivables. These assets are typically illiquid and cannot be easily sold on their own. By pooling these assets together, issuers can create a financial instrument that is more attractive to investors. Common types of assets used as collateral for ABS include:

• Home equity loans
• Automobile loans
• Credit card receivables
• Student loans
• Bank loans
• Aircraft landing slots
• Toll roads
• Cell tower leases
• Equipment leases

The process of pooling assets into an ABS is known as securitization. Securitization allows issuers to raise cash by selling their loans or other debts to a financial institution, which then packages them into a portfolio to sell to investors. Securitization also enables issuers to get riskier assets off their books, thereby reducing their credit risk.

For investors, ABS provide an opportunity to invest in a diverse range of income-generating assets, including some exotic ones that are not available through other investments. ABS also offer a steady stream of interest income, similar to bonds, making them attractive to income-oriented investors.

Frequently asked questions