Understanding Insurance Backed Securities: Are They Like Mortgage Backed Securities?

While mortgage backed securities (MBS) have gained significant attention due to their role in the 2008 financial crisis, there are similar financial instruments that operate within the insurance industry. These are known as Insurance Backed Securities (IBS), particularly catastrophe bonds, which serve to pool and distribute insurance risks. In this article, we will explore IBS, their structure, and how they compare to MBS.

The Fundamentals of IBS

An IBS is a financial instrument that pools insurance risks and transfers them to investors. This process closely mirrors the concept of securitization, where a pool of privately issued loans or cash flow obligations are transferred to a trust and sold to investors. However, IBS have unique characteristics that distinguish them from other financial instruments such as MBS.

How IBS Work: Securitizing Insurance Risks

IBS are particularly relevant for catastrophic risks that are low probability but high impact. These risks are often difficult for individual insurance companies to absorb on their own and benefit significantly from diversification. IBS provide a secondary market for risk, allowing non-insurers to participate through the bond market.

Catastrophe Bonds: A Case Study

Catastrophe bonds (cat bonds) are an excellent example of IBS. Let's take a deep dive into how these instruments function using a stylized example.

Example Scenario

Imagine a pool of 100 property insurance policies covering 10 different cities. Each policy has a maximum loss of 1 billion dollars and a premium of 20 million. The insurance companies involved offer various levels of coverage:

Insurance Company A: Covers the first 800 million dollars and pays a claim if total losses exceed 200 million. Insurance Company C: Covers the first 100 million dollars, starting to pay the first dollar of losses. Bond Investors: Purchase 100 million dollars worth of cat bonds. If losses are under 100 million, they get their money back at maturity. Investors: Threat premium as a coupon and collateralize the ultimate potential liability.

In this scenario, the 20 million premium is distributed as follows:

10 million goes to Insurance Company C 6 million goes to Bond Investors as payout (this represents the yield) 4 million goes to Insurance Company A

It is important to note that this is a simplified example, and there could be various variations on this structure. This example illustrates how risk is effectively diversified and distributed among different parties.

Comparing IBS to MBS

While both IBS and MBS involve securitization, they operate in quite different markets and environments. MBS are based on mortgage loans and are more complex due to credit risk and default risk. In contrast, IBS primarily involve insurance risks, which are generally low probability but high impact.

Key Differences

Liquidity: MBS have higher liquidity due to the prevalence and acceptance of mortgage markets. IBS, on the other hand, have lower liquidity because the market is less developed and specialized. Risk Factors: MBS face credit risk and potential defaults. IBS, however, primarily deal with catastrophic events and are structured to mitigate the impact of such events. Regulatory Environment: MBS are subject to more rigorous regulations and oversight. IBS operate in a more specialized and less regulated environment, reflecting the unique nature of their underlying risks. Market Participants: MBS attract a wide range of investors, from retail to institutional. IBS primarily attract institutional investors due to their higher complexity and specialized nature.

Conclusion

Understanding IBS, particularly catastrophe bonds, is crucial for those interested in risk management and financial markets. While they share similarities with MBS in terms of securitization, IBS offer a unique approach to managing and distributing catastrophic risks. As the market for IBS continues to evolve, it is likely to become an increasingly important tool in the financial landscape.

Key Takeaways

IBS are financial instruments that pool and distribute insurance risks. Catastrophe bonds are an example of IBS, providing a secondary market for risk. IBS differ from MBS in terms of risk factors, regulatory environment, and market participants.

FAQs

What are Insurance Backed Securities (IBS)?

Insurance Backed Securities (IBS) are financial instruments that pool and distribute insurance risks. These risks are often catastrophic in nature, making them difficult for individual insurance companies to manage on their own. IBS provide a secondary market for these risks, allowing non-insurers to participate in the protection of these risks through the bond market.

How do Catastrophe Bonds Work?

Catastrophe bonds (cat bonds) pool insurance policies and diversify the risk among various parties. In a typical scenario, a pool of policies is created, and premium is distributed among insurance companies, bond investors, and an insurance company to collateralize the ultimate potential liability. If the actual losses exceed the allocated amount, the bond investors face the risk of losing their investment.

What are the Differences Between IBS and MBS?

The primary differences between Insurance Backed Securities (IBS) and Mortgage Backed Securities (MBS) lie in their risk factors, liquidity, regulatory environment, and market participants. MBS deal with mortgage loans and are subject to credit risk and default risk, whereas IBS focus on low probability, high impact risks such as natural disasters. IBS also have lower liquidity and a more specialized regulatory environment.