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Christoph Brer*

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A Primer on Insurance-Linked Securities

Table of Contents
I. Introduction
II. The case for ILS
1. Basic considerations
2. The protection buyers perspective
3. The protection sellers (investors) perspective
4. Potential drawbacks
III. The workings of ILS
1. Transforming insurance exposure into securities
2. Risk Transfer
2.1 Basic considerations
2.2 (Re)Insurance vs. derivative
2.3 Documentation
3. Transformer
3.1 Function
3.2 Segregated cell concept
4. Collateral
5. Issuance and placement of securities
5.1 Basic considerations
5.2 Primary market
5.3 Secondary market
IV. Access to ILS
V. Conclusion

insurance securitisation which essentially transform

insurance risk into tradable securities. 3 However, as a
more accurate reflection of the most significant developments in a convergence context, it is proposed that
ILS be, more broadly, referred to as a concept centering around financial instruments, whose pay-off and
value depend on the performance of genuine insurancerelated risks.4 This contribution offers a general review
of ILS, elaborates on the generic mechanics of ILS and
places a special emphasis on exploring the legal framework within which ILS operate.

II. The case for ILS

1. Basic considerations
Fundamentally, ILS are financial facilities which allow
for matching the demand of parties who desire to layoff risks (protection buyers) with the supply of dedicated risk transfer capacity provided by investors (protection sellers) seeking exposure to insurance risk. 5

I. Introduction
The convergence of (re)insurance and capital markets
has been a driving force of financial innovation1 and also
set the stage for the creation of insurance-linked securities (ILS)2. While ILS effectively bridge (re)insurance
and capital markets in numerous ways, the term ILS has
been almost exclusively used to describe techniques of

*
1

Dr. iur. Christoph Brer, MBA Chicago Booth, Partner, Twelve

Capital AG.
Such convergence refers to risk financing arrangements in an insurance risk context effectively bridging (re)insurance and capital markets. (Re)Insurers have long been interacting with capital
markets for capital raising and financial risk hedging purposes
and have been acting as significant investors.
Key drivers have been the increase in exposure and frequency of
catastrophe risk, advances in computing techniques and de-regulation, see J. David Cummins/Mary A. Weiss, Convergence of
Insurance and Financial Markets: Hybrid and Securitized RiskTransfer Solutions, Journal of Risk and Insurance, Vol. 76, Issue 3
2009, 493f.; Urs Ramseier/Daniel Grieger, Insurance-Linked
Securities als neue Anlageklasse, Absolut Report No. 42, 2008,
47ff.

Traded insurance-linked securities have indeed been the most

headline-catching form of risk transfer to capital markets, see
Pauline Barrieu/Luca Albertini, Introduction, in: Barrieu/
Albertini (eds.), The Handbook of Insurance-Linked Securities,
Chichester, 2009, 1; Jonathan Spry, Non-Life Insurance Securitization: Market Overview, Background and Evolution, in: Barrieu/Albertini (eds.), The Handbook of Insurance-Linked Securities, Chichester, 2009, 9.
In contrast, traditional insurance-linked investments such as (re)
insurance stock and bonds do not offer access to pure insurance
risk, see also II.3 below. ILS may be seen as a subset of Alternative
Risk Transfer (ART) as a discipline integrating (re)insurance and
banking/capital markets. For a brief overview of alternative risk
financing techniques see Paul Whrmann/Christoph Brer,
The Alternative Running of Risks, in: Finance Today, London
2002, 181 f.
The use of the terms of supply and demand is a matter of perspective and semantics as risks packaged as ILS can also be looked at
as representing the supply for investors demand for exposure to
insurance-related risks.

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2. The protection buyers perspective

In order to increase corporate value, both corporations
and (re)insurers engage in risk taking activities and are
concerned with risk and capital management. 6 In this
context, risk-based capital structure management is a
key driver. 7

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Christoph Brer A Primer on Insurance-Linked Securities

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Insured values in general and in catastrophe-prone areas in particular have been growing over the past decades
and both the observed severity and frequency of large
events have increased, a development which is expected to continue against the background of the climate
change and continued value accumulation. 8 Growing
concerns about the risk of pandemics in an increasingly
interdependent world9 also indicate significant capacity
needs, as does longevity and the enormous financing requirements of a growing and aging population10 . Traditional insurance and financing techniques have proved
to be reasonably robust in the past. However, their limitations and inefficiencies are obvious when it comes to
financing peak exposures and absorb losses going forward. From a protection buyers perspective, the most
prominent driver of convergence has been constraints
on risk financing capacity. For ILS, tapping the capital
markets as a source of much needed additional capacity
for peak exposures has been a primary focus.11
The credit risk quality of risk transfer arrangements has
been another key consideration.12 Strictly speaking, a
traditional risk transfer facility translates underwriting risk into credit risk. The risk is only laid-off to the
extent that the protection seller is able and willing to
pay according to terms and conditions of the risk transfer agreement if and when actual losses occur. ILS, as a
rule, are structured to offer bankruptcy remote capacPaul Whrmann/Christoph Brer, Captives, in: Lane (ed.),
Alternative Risk Strategies, London 2002, 181.
7
Christoph Brer, Contingent Capital, Diss. Zrich 2009 (=Schweizer Schriften zum Finanzmarktrecht 93), N33 ff.; Christopher L. Culp/Kevin J. ODonnell, Catastrophe Reinsurance
and Risk Capital in the Wake of the Credit Crisis, Chicago 2009,
2ff.; Neil A. Doherty, Integrated Risk Management, New York
2000, 332ff., also referring to Modigliani and Miller.
8
Ramseier/Grieger (FN 2), 47, 49; Insa Adena/Clemens B.
Booth/Georg Rindermann, Primary Insurers Perspective,
in: Toplek (ed.), Convergence of Capital and Insurance Markets,
St. Gallen 2009, 79; Kenneth J. Bock/Manfred W. Seitz, Reinsurance versus other Risk-Transfer Instruments The Reinsurers Perspective, in: Lane (ed.), Alternative Risk Strategies,
London 2002, 15 f.
9
Ramseier/Grieger (FN2), 47, 49; Adena/Booth/Rindermann
(FN8), 79.
10 Ramseier/Grieger (FN2), 47; Bock/Seitz (FN8), 17.
11 J. David Cummins/David Lalonde/Richard D. Philips, Managing Risk Using Index-Linked Catastrophic Loss Securities,
in: Lane (ed.), Alternative Risk Strategies, London 2002, 19 ff.;
Torsten Jeworrek/Dirk Schfer/Beat Holliger, in: Toplek
(ed.), Convergence of Capital and Insurance Markets, St. Gallen
2009, 22; Swiss Re, sigma 1/2003, 12.
12 Jeworrek/Schfer/Holliger (FN 11), 26; Morton Lane,
Genuine Alpha, Perfect Security Reaffirming ILS Rationales,
Wilmette 2009, 6; Swiss Re, sigma 1/2003, 13.

ity in the form of collateralized covers.13 Most notably,

this feature integrates well with risk-based capital requirements and supervisory concepts such as the Swiss
Solvency Test (SST) or the EUs forthcoming Solvency
II regime.14 In essence, these approaches take an economic perspective and allow capturing both the actual
underwriting and counterparty credit risk dimension in
the context of determining on-balance capital relief effects of risk transfer solutions.15 Therefore, a risk-based
view on capital structure management underscores a
systematic advantage of ILS over traditional risk transfer techniques.
Additional considerations supporting ILS as a risk financing tool are their ability to offer multi-year arrangements providing thus for stable capacity16 and to
serve as a diversifying source of risk transfer-related
financing17. The latter has been of renewed importance
as the latest financial turmoil again dramatically illustrated that, at times, the access of corporations and (re)
insurers to equity or debt capital markets for financing
purposes may be severely restricted or even closed.
These motivations should continue to drive the use of
ILS as an instrument for risk and capital management.
As such, ILS clearly form an important component of
a firms capital structure going forward. However, ILS
will only complement existing financing approaches
rather than substitute for them.
3. The protection sellers (investors)
perspective
The performance of insurance risk is largely independent from the return drivers of traditional and alternative
asset classes.18 As a consequence, investments in insurance exposure are fundamentally attractive and can be

13

14

15

16

17

18

Admittedly, ILS structures should be considered bankruptcy remote rather than credit risk free. As a matter of fact, four structures suffered from the demise of Lehman Brothers in September
2008, in that a Lehman Brothers subsidiary acting as the total
return swap provider in connection with the assets held in collateral trust defaulted and made a structural weakness of earlier cat
bonds apparent as credit risk was introduced to supposedly pure
insurance exposure investments.
Ramseier/Grieger (FN2), 49.
Further, risk-based capital regimes routinely take into account
market risk as well as operational risk, not only in quantitative,
but also in qualitative terms.
Jeworrek/Schfer/Holliger (FN11), 29.
Brer (FN 7), N 111, in the context of contingent capital. The
drivers behind the emergence of ILS are also interrelated as illustrated by the fact that diversifying the sources of risk financing
also provides a means to address credit risk concentration relief
to (re)insurance companies in the context of their management of
reinsurance receivables which is heavily influenced by a relatively
low number of counterparties supporting significant amounts
of incurred and potential claims. See also Ramseier/Grieger
(FN2), 49.
Urs Ramseier/Daniel Grieger/Shao Jue Woo, Implementing
ILS in a Diversified Pension Fund Portfolio, in: Toplek (ed.), Convergence of Capital and Insurance Markets, St. Gallen 2009, 116 f.

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seen as a genuine source of alpha.19 The inclusion of an

asset class which exhibits positive expected returns and
little correlation to an existing investment portfolio
favorably impacts on that portfolios risk/return profile. Insurance exposure thus also serves as a diversifier
helping to reduce overall portfolio volatility. 20

4. Potential drawbacks

Access to pure insurance risk was by and large unavailable prior to the advent of ILS. Historically, putting
aside structures permitting individual names to invest
in insurance ventures via Lloyds of London, the only
way for investors to access insurance exposure was to
purchase (re)insurance stocks and bonds. 21 However,
such investments do not offer pure exposure to insurance risks. Additional parameters such as market risk,
credit risk, operational risks and management risks determine the actual performance. 22 Moreover, rather than
being purely fact-driven, the value of listed securities is
also heavily influenced by investors perceptions and
conduct probably best described by behavioral finance.

A possible reservation of prospective ILS investors is

the asset classs potential relative illiquidity. First, reflecting the early stage of the ILS development, the
investor base is still relatively small. Considering that
many investors adhere to a buy-and-hold strategy when
investing in ILS, this may adversely impact on secondary market liquidity. 27 It is worth noting though that
the relatively short duration of many ILS may limit
investors liquidity needs. Nevertheless, at the time of
most severe financial market and liquidity stress in autumn 2008, ILS proved to be fairly liquid even if at the
expense of somewhat wider bid-ask spreads. 28 Second,
depending on format, some ILS structures are illiquid
per se. (Re)Insurance or specific derivative transactions
may not be traded easily. Illiquid transactions, however,
offer appealing diversification and return benefits.

Conversely, ILS allow for diversifying genuine insurance investments offering attractive risk adjusted returns23 over the course of a (re)insurance cycle provided
that potential credit risk exposures are carefully isolated. 24 Another compelling feature of ILS is the potential
for true intra-asset class diversification. 25 There are,
if ever, only limited spill-over effects among different
types of perils. Also, leaving aside pandemic as a risk
which may spread globally, exposures are usually independent in terms of geography as events are locally
confined. Thus, adverse events actually occurring are
contained and allow for superior diversification within an ILS portfolio even though many risks covered
by ILS exhibit fat tail features i.e. significant extreme
event potential. Provided strict event limit management
is implemented, ILS can exploit intra-asset class noncorrelation characteristics and thus can serve well as an
overall portfolio stabilizer. Diversification within traditional and other alternative asset class portfolios though
is largely determined by the economic environment. 26

19

20
21

22

23

24

25
26

Lane (FN12), passim.

Ramseier/Grieger/Woo (FN18), 116.
Swiss Re sigma 4/2009, 4.
Ramseier/Grieger (FN2), 49. See also the risk-based capital parameters under Solvency II and the Swiss Solvency Test which effectively mirror such exposures.
Historically, ILS provided superior risk-adjusted returns compared to traditional investments. Partly, however, excess returns
are explained by a now shrinking novelty premium associated
with ILS instruments, Ramseier/Grieger/Woo (FN18), 118ff.
Clearly, ILS offer fundamentally uncorrelated investment opportunities. However, they may not always be insulated from wider
market dynamics. ILS, faring well during the recent financial
market dislocations, proved to be fairly liquid and, as such, were
used as facilities to generate cash by forced sellers managing massive de-leveraging processes, causing some limited downward
pressure on ILS secondary market prices.
Ramseier/Grieger/Woo (FN18), 119.
Ramseier/Grieger/Woo (FN18), 119.

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The exposures underlying the majority of insurance securitisation transactions executed to date have exhibited
a strong bias towards US perils. 29 This clearly highlights
the use of ILS as a response to pressing capacity needs.
At the same time, such US-centricity does not only pose
challenges to ILS investors seeking diversification, 30 but
also reinforces the need to manage event risk 31. Accordingly, risk and exposure management in an ILS context
rely, amongst other things, on event and peril limits
as key parameters. 32 Meanwhile, there are still limitations to diversification given the heavy US share of the
available ILS in easily tradable format, demonstrating
the value of accessing additional diversifying perils via
privately negotiated, rather illiquid transactions. 33 This
shows that balancing diversification, liquidity and return are fundamental trade-offs for ILS investors. 34

27

28

29

30
31

32
33

34

Henning Ludolphs/Michael Pickel, Future Trends and Developments, in: Toplek (ed.), Convergence of Capital and Insurance Markets, St. Gallen 2009, 63.
Sbastien Dirren, Integrating ILS into Institutional Asset Management, in: Toplek (ed.), Convergence of Capital and Insurance
Markets, St. Gallen 2009, 135; Ludolphs/Pickel (FN27), 63.
Ramseier/Grieger/Woo (FN18), 122.
Ramseier/Grieger/Woo (FN18), 123.
Dirren (FN28), 135.
Ramseier/Grieger/Woo (FN18), 122.
Ramseier/Grieger/Woo (FN18), 123.
Ramseier/Grieger/Woo (FN18), 120.

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Even though ILS have seen an impressive development

in recent years, the market is still in its infancy. In order
to facilitate further growth, the industry will need to
address some potential drawbacks associated with ILS.

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Delivering on the promise to offer access to pure insurance risk is not trivial. Careful structuring and appropriate risk management allows for isolating genuine
insurance risk from counterparty credit risk. However,
the complete elimination of credit risk seems difficult to
achieve. 35

III. The workings of ILS

1. Transforming insurance exposure into
securities

actions along the transformation chain are technically

either (re)insurance or banking/capital markets instruments subject to separate sets of legal rules as captured
visually in graph 1. This holds true for the legal qualification of ILS as such, even if many ILS transactions
are subject to English and US/New York law. Nevertheless, many regulatory aspects come into play at an international level as well. In fact, there are many non-US,
non-UK protection buyers active in the field of ILS and
the vast majority of entities issuing ILS have been oper37
ating in off-shore domiciles.

Essentially, ILS is about transforming insurance exposure into securities created and issued for capital
market investors in order for them to participate in the
performance of the underlying insurance exposure.
From a strictly legal perspective, however, (re)insurance
markets and capital markets remain two worlds apart. 36
Even though they converge in practice as ILS structures
combine the economic substance of both worlds, at an
instrument level, the actual components of ILS trans-

Graph 1: Generic ILS transformation chain and legal framework 37.

35

Dirren (FN28), 135, discussing the function of special purpose

vehicles in the context of addressing credit risk in an ILS context.
36 Nevertheless, many integrated regulatory bodies have emerged.
Still, different law applies to (re)insurance and capital markets,
ultimately reflecting the fundamental differences between these
disciplines. See also Oliver Banz, Rechtsprobleme der Allfinanz, Diss. Zrich 1999 (=SSBR 20), 195ff.

37

This overview is very generic. It should be noted that investors

may acquire ILS directly without any fund involvement and that
funds or investors themselves may be willing and allowed to enter
into a derivative transaction directly without involving an SPV.

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2. Risk Transfer

2.2 (Re)Insurance vs. derivative

2.1 Basic considerations

The economic substance of a risk transfer arrangement

is best described by a process of effective transfer of risk
i.e. shifting of exposure from one party to another by
means of swapping a fixed premium (fixed leg) against
uncertain stochastic event-linked payments (floating
leg).41 As the term indicates, the techniques employed to
risk transfer arrangements share such risk shifting as a
common economic trait. Their legal characteristics may,
however, differ substantially. A brief review of the most
important differences shall focus on English and US/
New York law as the predominant legal basis for risk
transfer arrangement documentation in an ILS context.

The actual risk transfer takes the form of a risk transfer

agreement entered into between a protection buyer and
a protection seller. The protection buyer may be a (re)
insurer, (investment) bank, a corporation or a pension
fund seeking protection in the context of risk and capital management. The risk transfer agreement as such is
designed either as a (re)insurance contract or as a derivative. 38
The form and nature of the risk transfer agreement
usually has an impact on the regulatory treatment of
the parties involved, too. It may or may not introduce
particular requirements on the protection seller side on
considerations evolving around the proper functioning
of markets and protection of individual market participants and potentially calls for proper authorisation. 39
While a derivative arrangement is not necessarily regulated and may be concluded between the protection
buyer and any investor directly, risk transfer arrangements in (re)insurance format may only be entered into
by a carrier which has secured a competent authoritys
consent to conduct (re)insurance business.40 As a consequence, an appropriately licensed special purpose transformer vehicle is frequently used in order to allow non(re)insurance capital market investors to participate in
the economics of (re)insurance trades. Yet, as outlined
in greater detail further below (II.3), there are a number
of other considerations driving the use of transformers.

38

It may, however, also be structured as a loan arrangement providing funds to the protection buyer upfront and making the repayment of which, again as a means of transferring risk, contingent
upon certain parameters.
39 Dieter Zobl/Stefan Kramer, Schweizerisches Kapitalmarktrecht, Zrich 2004, N 24ff.
40 This is certainly true from a Swiss law perspective: derivatives
which, as in the usual case of ILS, are specifically created for an
individual counterparty are not subject to regulation, Article 4
of the Swiss Ordinance on Stock Exchanges and Securities Trading, see Brer (FN 7), N 1002. Further, loan arrangements are
only subject to banking regulation if they are entered into in
the context of a combination of active and passive banking business, Banz (FN36), 40; Brer (FN7), N 945ff.; Zobl/Kramer
(FN 39), N 161, 593. Most notably, the issuance of bonds is explicitly defined as an exemption and does not constitute passive
banking business in case the requirements of Article 1156 of the
Swiss Code of Obligations (CO) are met, Article 3a III lit. b of
the Swiss Ordinance on Banks and Savings Banks (Swiss Banking
Ordinance). For a discussion of insurance regulation parameters
see Banz (FN36), 11ff.; Brer (FN7), N 1094ff. It is also worth
noting that, generally, insurers are restricted to insurance business and activities directly arising from insurance business, see
Brer (FN7), N 1124; Clive OConnell, Legal Risks Mitigating Document Risk Some Hard Lessons Learned, in: Lane (ed.),
Alternative Risk Strategies, London 2002, 588.

When it comes to (re)insurance, the overriding theme

of the prevailing Anglo-Saxon legal regimes is the notion of protection against a fortuity and the respective
protection buyers insurable interest.42 More precisely,
an insurance contract is considered to be an arrangement under which a protection buyer, typically against
the payment of a fixed sum of money, secures a benefit,
the actual receipt of which is contingent upon the occurrence of a fortuitous event being either uncertain as
to its actual happening or its timing, and which usually
takes the form of a floating sum of money offered by
a protection seller in consideration of such fixed payment, intended to meet some loss or other detriment
the protection buyer suffers on the happening of such
event.43 Clearly, the latter is seen as the insurable interest.44 Historically, the concept of insurable interest has
served to divorce insurance business from pure (unenforceable) wagering agreements.45 As, under the terms
of insurance business, loss is critical to the protection
buyer, the protection sellers obligation to pay is contingent upon a proof of loss requiring the protection buyer
to demonstrate that it actually suffered a loss which

41

42

43
44

45

Brer (FN 7), N 21; Dieter Farny, Versicherungsbetriebs

lehre, 4. A., Karlsruhe 2006, 8ff. There are a number of other arrangements which also constitute risk transfer such as indemnity
agreements or specific contractual provisions allocating risks between parties. This type of risk transfer arrangements will not be
discussed in this contribution. See also Erik Banks, Alternative
Risk Transfer, Chichester 2004, 22.
Banz (FN36), 30ff.; Andrea S. Kramer, Critical Distinctions
between Weather Derivatives and Insurance, in: Culp (ed.), Structured Finance and Insurance, Hoboken 2006, 643; OConnell
(FN 40), 588; Maria Ross/Charlotte Davies, Credit Derivatives and Insurance A World Apart?, in: Johnson (ed.), Lloyds
ARTWork No. 5, London 2002, 3.
Kramer (FN42), 643; OConnell (FN40), 588 f.; Ross/Davies
(FN42), 3
OConnell (FN 40), 589. The principle of indemnity i.e. the
limit ation of the floating payment to the actual loss the protection
buyer suffers, applies to the insurance regulation of US states,
but not necessarily to English law, Kramer (FN42), 643, Banz
(FN36), 32 and fn 165.
OConnell (FN 40), 589 f. For a discussion of the Swiss law
equivalent drawing a distinction between wagering contracts,
Article 513 II CO, and enforceable business arrangements see
Brer (FN7), N 195 f. and passim, also referring to BGE 120 II
44 f.

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calls for indemnity.46 On a reinsurance level, the proof

of loss considerations are frequently dealt with on the
basis of the follow the fortunes-clause which essentially
determines that the reinsurance agreement follows in all
respects the fortunes of the insurance contract and that
loss payments effected by the direct insurer are binding
upon the reinsurer.47
Under English law a consequence which follows from a
contract being classified as insurance is the requirement
of the parties involved to observe the duties attached
to the doctrine of utmost good faith.48 While ordinary
commercial contracts are clearly subject to good faith,
they do not require the parties to reveal all aspects they
are aware of related to the proposed arrangement.49
Insurance, however, imposes on the parties involved
a duty to fully disclose all material facts they know or
should know. 50 Failure of a protection buyer to comply
with such duties entitles the protection seller to avoid
performance, the contract becoming void ab initio. 51
The result of such avoidance from inception is naturally
a return of premium and refusal or return of claims payments, respectively. 52 The overriding importance of the
utmost good faith doctrine and the remedies available
in case of non-disclosure may explain why (re)insurance
documentation has long been relatively light as opposed
to capital markets documentation. Nevertheless, (re)
insurance agreements increasingly incorporate explicit
warranties as provisions of fundamental importance
which require the protection buyer to operate in accordance with specific terms and the breach of which
discharges the protection seller from the performance of
its obligations ex nunc. 53
As an instrument primarily designed to transfer risk,
a derivative exhibits a similar purpose, yet still differs
from a (re)insurance contract: most notably, a derivative contract does not represent an insurable interest. 54
Accordingly, payments under a derivative are not dependent on demonstration of an actual loss. 55 Instead,
derivatives are linked to determined references typically captured by an index. 56 This feature is of particular
relevance to the characteristics and use of a derivative:
As insurable interest and proof of loss are irrelevant to
a derivative contract, derivatives may not just be used
as a risk management tool for hedging purposes, but
may also serve to generate speculative profits irrespec-

tive of any exposure relating to an event triggering the

payment of a specified contract amount. 57 Similarly,
even when used as a hedge, the actual loss exposure
and claims experience of a protection buyer may not be
perfectly matched by the protection offered by the derivative given the fact that these instruments are indexbased rather than indemnity-based arrangements compensating actual loss experience. 58 Such disparity which
may yield profits but can also leave incurred losses uncovered is commonly referred to as basis risk. 59
Risk transfer without constituting insurance business,
i.e. the absence of a requirement to proof a loss as a potentially time-consuming procedure, also tends to support swift execution of payments. Again, unlike insurance claims settlements, payments under derivatives are
driven by movements of the underlying index. Therefore, there is less need, if any, for a protection seller
to conduct a comprehensive review in order to scrutinize the claim and verify both validity and amount of
a claims settlement. 60 Likewise, non-indemnity covers
generally alleviate moral hazard and adverse selection
concerns of protection sellers and hence the underwriting process places emphasis on in-depth technical analysis of the parameters driving the trigger mechanism
rather than protection buyer-specific disclosure. 61
2.3 Documentation

As far as documentation is concerned, standard (re)insurance contract elements have emerged over time and
are being widely used. The respective wordings are
typically adjusted to fit the actual setting and jurisdiction in which the contracts are intended to operate. On
a direct insurance level, compulsory regulation driven
by consumer protection considerations 62 may apply and
hence needs to be observed. Thus, even though some
(re)insurance components can arguably be seen as fairly
standard, there is no universally used type of (re)insurance agreement.
Conversely, documentation of risk transfer transactions in over the counter (OTC) derivative format predominantly relies on documentation developed and
maintained by the International Swaps and Derivatives
Association (ISDA) with a view to identify and reduce

57
46
47

48
49

50
51

52
53

54
55

56

Kramer (FN42), 643; OConnell (FN40), 591.

Banz (FN36), 74 f.; OConnell (FN40), 601 f.
OConnell (FN40), 593; Ross/Davies (FN42), 4.
Ross/Davies (FN42), 4.
OConnell (FN40), 593; Ross/Davies (FN42), 4.
OConnell (FN40), 593; Ross/Davies (FN42), 4.
OConnell (FN40), 593; Ross/Davies (FN42), 4.
OConnell (FN40), 594.
Banks (FN41), 20
Kramer (FN42), 644; Ross/Davies (FN42), 4.
Banks (FN41), 20.

58
59

60
61

62

Banks (FN41), 149; Kramer (FN42), 644.

Banks (FN41), 20.
Banks (FN41), 20. See also Sara Borden/Asani Sarkar, Securitizing Property Catastrophic Risk, in: Current Issues in Economics and Finance, Vol. 2 No. 9, New York 1996.
OConnell (FN40), 601 f.
Jeworrek/Schfer/Holliger (FN 11), 27. For a discussion
of triggers see Swiss Re, sigma7/2006. (Re)Insurance addresses
moral hazard and adverse selection concerns also by means of retentions of the protection buyer designed to ensure that interests
of both parties to a risk transfer agreement are, at least partially,
aligned.
Banz (FN36).

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risks associated with derivatives business. 63 Beyond

risk management, the contract standardization is aimed
at reducing time and effort required when conducting derivative business. 64 More precisely, OTC derivative transactions are usually documented by a number
of interdependent agreements, reflecting particular
document architecture: serving as a basic agreement,
the ISDA Master Agreement provides the framework
around which the documentation is built. 65 Contentwise, the ISDA Master Agreement lays down the overall
terms of the contractual relationship between the parties to a derivative-based risk transfer arrangement. 66
The parties formally enter into the standard Master
Agreement as a pre-defined generic boiler plate document as prepared by ISDA rather than by one party.
Further, the Schedule to the Master Agreement is structured to tailor the underlying contractual basis according to the partys needs and preferences and contains
elections, additions, deletions and amendments to the
Master Agreement and, as such, specifies optional provisions. 67 Lastly, the economic terms and parameters of
any specific trade are incorporated by means of executing a separate Confirmation on a transaction by transaction basis. 68 As a matter of design, these Confirmations form part of and are governed by the terms of the
Master Agreement as further defined by the Schedule. 69
A key feature of the ISDA contract design is the actual
linking of multiple transactions: the documentation is
designed to consider all transactions entered into based
on and referring to a specific set of Master Agreement
and Schedule as forming one single agreement. 70 Technically, the contract structure permits netting of payments under all transactions as conceptually collapsed
into one agreement, both on an ongoing basis in a going
concern context and in the case of (early) termination

63

64

65

66
67

68

69
70

www.isda.org
Dieter Zobl/Thomas Werlen, 1992 ISDA-Master Agreement,
Zrich 1995, 11, 61. Time

and effort required to negotiate a Master Agreement may still be significant, though. However, once
both Master and Schedule are established, multiple transactions
can be based on such documentation, increasing efficiency over
time. In the ILS field in particular, a number of market participants do not seem to have achieved minimum efficient scale when
it comes to leveraging ISDA-based contractual relationships.
Paul E. Vrama/Craig R. Enochs/Fundi A. Mwamba, How to
Use the ISDA Master Agreement, Houston 2002, 7; Zobl/Werlen (FN64), 65.
Zobl/Werlen (FN64), 65.
Kramer (FN 42), 647; Vrama/Enochs/Mwamba (FN 65), 7;
Zobl/Werlen (FN 64), 65. Such customisation includes the
choice of law among US, English and Japanese law.
Tom Husler, Die vertraglichen Grundlagen im Bereich des
Handels mit derivativen Finanzinstrumenten, Diss. Basel
1996 (=SSBR 42), 175; Kramer (FN 42), 647; Vrama/Enochs/
Mwamba (FN65), 7; Zobl/Werlen (FN64), 65.
Vrama/Enochs/Mwamba (FN 65), 6; Zobl/Werlen (FN 64),
65 f.
Zobl/Werlen (FN64), 66ff.

2010

events, potentially enhancing credit risk management

quality considerably. 71

509

Similarly, parties to ISDA arrangements more often

than not require execution of bilateral security and
credit support documentation as conceived by the specific ISDA architecture in order to explicitly define
credit risk terms applying to transactions governed by
ISDA agreements. 72 Formally, the parties may agree on
a type of Credit Support Annex as an annex to the ISDA
Master Agreement and Schedule, respectively, or on a
Credit Support Deed as a stand-alone security arrangement, each complemented by a final Paragraph providing evidence for further elections or modifications the
parties deem relevant. 73 The parties may also rely on
third party Credit Support Providers to grant security.

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Christoph Brer A Primer on Insurance-Linked Securities

Ultimately, the ISDA framework provides for a reasonably robust basis to risk transfer business. However, a
caveat seems in order: the overall derivative business,
established standard documentation and workings have
not been tailored and are thus not necessarily best suited to capture and document insurance risk-based derivative transactions. As a response to these impediments,
ISDA initiated the production of insurance-specific
standard documentation and has recently introduced a
bespoke US wind event cat swap Confirmation template
supporting standardization of events referencing this
type of natural peril. 74 Still, there remains potential for
improvement and, as for any ISDA arrangement, credit
risk parameters require careful consideration. 75
Meanwhile, as far as the distinction between (re)insurance and derivative business is concerned, parties to
an ISDA-based transaction transferring insurance risk
continue to use specific language in Confirmations
making clear that the transaction documented by such
Confirmation is not intended to be and does not constitute (re)insurance as it would not be dependent upon
either party being exposed to a risk or suffering a loss
related to the underlying risk. Strictly though, legal
assessment continues to rely mainly on a transactions
substance rather than on the terminology used by the
parties. 76

71
72

73

74

75

76

Kramer (FN 42), 647; Vrama/Enochs/Mwamba (FN 65), 7;

Zobl/Werlen (FN64), 67.
Kramer (FN42), 647; Vrama/Enochs/Mwamba (FN65), 11.
Vrama/Enochs/Mwamba (FN 65), 12. For some economic and
legal considerations about credit and counterparty risks under
ISDA Master Agreements and the use of Credit Support Annex
to mitigate such risks see Maroan Maizar/Michael Jacquet/
Till Spillmann, Credit and counterparty risk: Why trade under
an ISDA with a CSA? GesKR 1/2010, 63ff.
ISDA media release May 19, 2009, www.isda.org/media.
A key issue is sufficiently insulating eligible collateral from counterparty credit risk as, depending on the arrangement chosen, a
collateral agreement may, for the benefit of the counterparty, not
just create a security interest in the collateral but allow for ownership in the collateral to pass and even permit rehypotecation.
Article 18 I CO; Ross/Davies (FN42), 3.

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Risk transfer in connection with ILS generally remains

bespoke per definition. Nevertheless, continued standardisation of documentation will facilitate the development of ILS.

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3. Transformer
3.1 Function

A transformer essentially is a special purpose vehicle

(SPV) which facilitates the generation and maintenance
of ILS. Clearly, the term transformer to date used
rather colloquially than technically refers to the entitys function as a platform which both assumes and
hedges risk by sequentially applying (re)insurance and
capital market instruments, or vice versa, to the risk
transfer legs. 77 In doing so, a transformer in fact operates as a facility which bridges (re)insurance and capital
markets.
In effect, transformer arrangements are usually designed such that the transformer does not retain insurance risk economically. From a functional perspective, investors ultimately serve as protection sellers.
Formally, however, a transformer may well retain risk
and investors participate in insurance risk transactions by holding equity of a transformer representing
a residual claim. Similarly, debt instruments issued by
a transformer exhibits an equity-like profile in that the
investors repayment claim is routinely subordinated
to claims of the protection buyer and other parties involved. 78
In addition to operating as a link between (re)insurance
and capital markets facilitating the transformation of
insurance risk into securities, a transformer company
performs a number of other functions reflecting features usually associated with a transformer set up:
Bankruptcy remoteness79 of an SPV is of paramount
importance. The desire to structure a transformer in a

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Christoph Brer A Primer on Insurance-Linked Securities

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Thus, a transformer appears as a subset of the SPV universe and is

characterised by its function in an ILS context. It is worth noting
that, as opposed to the more conventional SPV approach under
which an SPV regularly issues equity, debt and/or hybrids to finance and hedge the risks assumed, a transformer may create ILS
by entering into any combination of (re)insurance and capital
market instruments. While the majority of transformers indeed
issue equity, debt and/or hybrids to offset risk transfer business
written on a (re)insurance or derivative basis, they may also cover
an underlying (re)insurance agreement with an ISDA-based cat
swap or, conversely, take out insurance to lay-off risk exposure
assumed via derivative. See also Appleby, Guide to the 2009 Bermuda Insurance Market, 30, and passim.
78 See also Article 2 of the Directive 2005/68/EC of the European
Parliament and of the Council of 16 November 2005 on reinsurance and amending Council Directives 73/239/EEC, 92/49/EEC
as well as Directives 98/78/EC and 2002/83/EC (the European
Reinsurance Directive).
79 Markus J. Kroll/Johannes A. Brgi/Ulrich C. Sauter, Securitisation in der Schweiz, in: IFF Forum fr Steuerrecht Nr. 4,

bankruptcy remote way is twofold. First, a protection

buyer, as a key consideration attached to many ILS solutions, relies on an SPV as a platform which holds funds
readily accessible in case of a loss, considerably reducing credit risk concerns. 80 Second, investors expect to
commit their funds to genuine insurance exposure only.
Accordingly, the structure shall be insulated from any
bankruptcy threats other than stemming from a loss
occurrence. Technically, the primary approach applied
is to create not only formally the issuer for a narrowly defined special purpose and to confine the entitys
business to entering and performing a risk transfer arrangement and a corresponding hedging agreement
such as by issuing debt, as well as related activities, but
also to create trust structures holding shares of a thinly
capitalized SPV. 81 Alternatively, in the absence of trust
legislation, shareholder agreements and specific contractual provisions allow for achieving similar results.
Techniques most widely used are subordination and
limited recourse language as well as the pactum de non
petendo in order to limit the involved parties right to
initiate voluntary bankruptcy proceedings during an
ILS structures life-span. 82 Ultimately however, one
may bear in mind that structures are to be considered
bankruptcy remote rather than bankruptcy proof. 83
A further aspect that can hardly be divorced from the
concept of bankruptcy remoteness is the limited or nonrecourse feature. For repayment purposes, investors can
only look at the issuing SPV and are not entitled to claim
funds from the protection buyer. 84 The corresponding
accounting treatment flows not only from the separation of the protection buyer and the transformer as just
described but also from the decision making processes
around the conduct of the SPV which are independent 85
from and not controlled by the protection seller. As a
rule, ILS SPVs are not consolidated with the protection buyer. 86 This off-balance sheet treatment allows for
a risk transfer effect, actually laying off exposure to a
third party.
Furthermore, a transformer provides for a stable basis
for the inward risk transfer arrangement while, depending on the nature of the outward leg, investors may exit

80

81

82
83

84

85

86

St. Gallen 2002, 260.

Key in this context is the notion of full funding. See CEIOPS
Consultation Paper No. 36, Draft CEIOPS advice for Level 2
Implementing Measures on Solvency II: Special Purpose Vehicles, March 26, 2009.
Banks (FN41), 120; Kroll/Brgi/Sauter (FN79), 260.
Kroll/Brgi/Sauter (FN79), 260 f.
Suzanne Fleiner, Asset-Backed Securitization: Analysis of
the Special Purpose Entity Structure under the Legal Systems of
Switzerland and the United States, Diss. Zrich 2007, 60, in the
context of asset backed securities structures.
Analogous Hans Peter Br, Asset Securitisation, 3. A., Bern
2000, 103; Fleiner (FN83), 20 f.; Kroll/Brgi/Sauter (FN79),
260.
Banks (FN41), 120.
Analogous Br (FN84), 91; Fleiner (FN83), 21.

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In case inward risk transfer business proposed to be

conducted by an SPV falls within the definition of insurance business as described by applicable legislation,
proper authorisation has to be secured prior to commencing business. 88 The SPV, in fact, maintains the required business license ultimate investors may not hold.
Therefore, a distinction between insurance business and
non-insurance business can generally be drawn for most
transformer activities. 89
Finally, transformers are, as a matter of basic principle,
designed to operate as cost effectively as possible. This
includes speed and relative ease of incorporation, solid
yet not too stringent regulation, the level of ordinary administration cost and tax.90 Historically, most transformers have been operated in off-shore jurisdictions such as
Bermuda and Cayman Islands.91 Yet, the appeal of offshore domiciles must not be mistaken as being limited
to the benefits of a low or no corporate, stamp duty and
withholding tax environment, respectively. Off-shore locations have been offering a flexible environment capable
of accommodating innovative structures. In a similar fa
shion, they have also developed and maintained clusters
of critical auxiliary services such as legal and accounting
advice or administration and auditing services.92
Authorities largely perceive regulation of transformers
to be critical to the robustness of the risk transfer component of ILS structures as substitutes of paid-in capital
and, likewise, to their impact on the protection buyers
solvency.93 Accordingly, lawmakers, regulatory bodies,
international associations and committees will continue
to be introducing specific transformer legislation and
respective guidance. In this context, the notion of full
funding of transformers will play a key role. Similarly,
one may expect a heightened focus to lie on the issue
of recognising off-shore legislation as equivalent 94 to

87
88

89

90
91

92
93
94

Such term transformation works similar to the one achieved in

the conventional banking/lending area.
Appleby (FN 77), 35 f.; Monica Mchler-Erne, Insurance
Regulation of Securitization Evolving Towards More Qualitative
Methodologies, in: Toplek (ed.), Convergence of Capital and Insurance Markets, St. Gallen 2009, 261.
Appleby (FN77), 35.
Whrmann/Brer (FN6), 191 for a discussion of location considerations related to captives as another type of SPV.
Banks (FN 41), 121. Nevertheless, transformers have also been
tested on-shore in jurisdictions such as Ireland or France. See also
the Foot Report which suggests off-shore locations consider introducing tax regimes similar to on-shore locations, a proposal
which is fundamentally driven by the immense financing needs of
on-shore countries and the UK in particular.
Whrmann/Brer (FN6), 191.
Mchler-Erne (FN88), 260ff., discussing the approaches taken
by Bermuda, the EU, Germany and the UK.
Eva Maria Kuhn, Risk Transfer Pathways for Insurers and the
New European Regulation, in: Toplek (ed.), Convergence of Capi
tal and Insurance Markets, St. Gallen 2009, 360 f.

on-shore regulation such as Solvency II and the partial

creation of a level playing field.

511

3.2 Segregated cell concept

Nimble off-shore locations have introduced a concept

which further enhances the efficiency of the SPV model:
the segregated cell company.95 This concept is a type
of legal corporate structure that is a single legal entity
consisting of a core and an unlimited number of cells,
whereby the cells are statutorily segregated from each
other.96 In essence, segregated cells cater for separate
account facilities which may serve as a substitute for
a legal entity without the need of creating a corporate
body. Thus, a cell within a legal entity rather than a
stand-alone vehicle may be established per transaction,
helping to control cost and drive operational efficiency.
This makes segregated accounts a valuable instrument,
primarily in connection with privately negotiated ILS
transactions.97
Strictly, cells are not self-dependent as third parties
are required to deal with the segregated cell company
as such which enters into an agreement on behalf and
for the benefit of an explicitly named cell.98 The main
legal characteristic of the segregated cell concept is the
ring-fencing of the cells assets and liabilities and, consequently, the protection of cells assets from the liabilities of other cells by statute.99 This legal division between the cells restricts creditors recourse to cell assets
other than the assets of a specific cell with which they
entered into a contractual relationship and, under certain circumstances, to the assets of the core.100 In effect,
the segregated cell concept provides for a facility similar
in result to stand-alone entities and yet eliminates the
need to create separate corporate entities or complex arrangements addressing solvency and perfection issues
in relation to charges.101 Still, infrastructure and, to a
large extent, administrative processes can be shared on a
common corporate basis.
Admittedly though, the nucleus of limited liability is
by no means novel. Also, the creation and segregation
of sub-units within a legal entity is not entirely unique.
Both off-shore and on-shore jurisdictions have introduced mutual fund legislation permitting the legal divi-

95

96
97

98

99

100
101

Terminology differs from location to location. For example, Bermuda refers to segregated account company as outlined in the
Segregated Account Companies (SAC) Act while Guernsey terms
their equivalent structure protected cell company (PCC) as defined by the Companies (Guernsey) Law.
Whrmann/Brer (FN6) 194.
Ramseier/Grieger/Woo (FN18), 123 f.
Whrmann/Brer (FN6), 194.
Appleby (FN77), 29; Whrmann/Brer (FN6), 194.
Whrmann/Brer (FN6), 194.
Appleby (FN77), 30.

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their position by means of trading. That way, actual

term transformation may be achieved. 87

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GesKR 4

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512

sion of sub funds within umbrella structures.102 Indeed,

the concept of segregated units within a single corporate shell continues to spread, especially in a securitisation and mutual fund context. Clearly, limited liability
demands appropriate diligence of creditors. It is paramount to consider carefully the parameters attached to
a proposed transaction. This involves a review of not
only the form and amount of capital involved, but also
the substance of the assets most frequently held as collateral.
4. Collateral
Collateral arrangements address financial distress concerns as a means to preserve the amount and quality
of funds committed to a structure. Again, bankruptcy
remote status is vital to ILS structures in that they are
designed to safeguard the proceeds from investors to secure both the protection buyers contingent claim and
the repayment of the notional amount of funds to investors to the extent that no priority loss payments have
been made under the structure. As such, collateral arrangements are also designed to offer investors uncorrelated insurance exposure. The collateral component also
reinforces the dual nature of ILS pay-offs which may
be de-composed into a risk transfer premium and an
investment return effectively thrown-off by the funds
posted by investors, generated in one way or another.
There is a myriad of options to secure claims attached
to ILS. First and foremost, the proceeds raised are deposited in a collateral account and invested in assets of
substantially stable value.
Widely used collateral concepts include total return
swaps (TRS) and repurchase agreements (Repos) which
are not only designed to preserve the value of the collateral irrespective of the timing of its liquidation but
also to create a LIBOR-based investment component.
In essence, a TRS is a bilateral financial transaction
where the parties exchange a floating rate determined
by the value of an individual or a number of specific reference asset(s), comprising cash flows as well as capital
appreciation and depreciation, for a fixed rate such as
LIBOR.103 Under a Repo, the repo counterparty sells
eligible securities to the transformer against cash and simultaneously agrees to repurchase the same amount and
type of securities at a later stage.104 The timing of the repurchase is reconciled with the occurrence of payments
under the ILS structure. Such, the arrangement is aimed
at ensuring the availability of the notional amount in

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Christoph Brer A Primer on Insurance-Linked Securities

2010

As an example for respective on-shore legislation see Article 92ff.

of the Swiss Collective Investment Schemes Act (CISA).
103 Emmanuel Durousseau Case Study: Cat Bond Transaction by
SCOR (Atlas), in: Barrieu/Albertini (eds.), The Handbook of Insurance-Linked Securities, Chichester, 2009, 160.
104 Zobl/Kramer (FN39), N 1244.

cash when required, effectively matching cash-flows.

TRS are usually based on ISDA documentation whereas Repos are typically executed in the form of a Global Master Repo Agreement (GMRA).105 The value of a
TRS or Repo is a function of the counterpartys financial strength and ability to perform its obligations as the
instrument is only fit for purpose as long as the counterparty maintains high credit quality. Accordingly, respective documentation is drafted to include additional
security features such as rating triggers, counterparty
substitution mechanisms, frequent valuation of collateral assets, collateral account top up features or additional securities such as parental guarantees.106 In order to add a supplementary layer of security, some ILS
structures also apply tri-party Repos, which include a
third party such as a clearing house to act as an intermediary in between the two parties.
While it is true that many investors seek investments
structured as LIBOR-plus instruments, linking ILS
pay-offs to LIBOR is by no means a necessity given the
fact that ILS are, quite rightly, primarily viewed as a diversification play rather than as chasing absolute return
levels. It seems preferable to prevent ILS structures from
credit risk contamination introduced via structures involving extra third parties beyond the issuer(s) of securities held as collateral. The most stringent approach is
two-pronged i.e. adhering to a conservative preference
with investments in highly secure and liquid short-term
instruments issued by (still) solid governments or quasigovernmental agencies, collectively and commonly referred to as risk-free securities, combined with permitting the protection buyer access to these funds in case
of a triggering loss. Frequently, a custody account is the
platform used as a home for collateral assets. This type
of custodial arrangement facilitates the control of bank
credit risk as the legal ownership of funds typically remains with the transformer rather than transfers to the
financial institution. Also, the banks creditors do not
have recourse to the assets held in custody except to the
extent that the custodian itself has a claim against such
assets.107 The contingent access of the protection buyer
to these funds is structured by way of creating a security interest over the assets held in the account in favor of
the protection buyer. Alternatively, a bank may, against
a fee, issue a letter of credit to the benefit of the protection buyer, backed by the assets allocated to the custody
account. From an investors perspective, the downside
105

The GMRA is maintained jointly by the International Capital

Market Association (ICMA) and the Securities Industry and Financial Markets Association (SIFMA). See also Zobl/Kramer
(FN39), N 1251.
106 Unfortunately, some of these features have only been routinely
included in ILS collateral documentation post Lehman. See also
Lane (FN12), 9ff.
107 Article 16 and 37 lit. d Swiss Banking Act; Urs Emch/Hugo
Renz/Reto Arpagaus, Das Schweizerische Bankgeschft, 6. A.,
Zrich 2004, N 2295.

of this concept is the haircut the financial institution issuing the letter of credit routinely applies as a function
of the type of assets supporting the security arrangement. When determining the value of such assets, they
subtract a certain percentage from the assets notional
or market value which, as a result, leads to overcollateralization in most instances and adversely impacts on the
efficiency and return prospects of a transaction.
Trusts are still another popular collateral instrument. A
trust is a tri-partite arrangement and can be established
by the transformer as a grantor pursuant to a trust deed
to be signed by the protection buyer as beneficiary and
a third party administrator as trustee. Since an important number of ILS are sponsored by US-based carriers
taking out cover for US perils on an indemnity basis,
parties to ILS structures are often concerned with New
York Regulation 114 trusts. Such reinsurance trusts are
created through a reinsurance trust agreement among
the reinsuring transformer (grantor), the reinsured
(beneficiary) and a bank (trustee).108 In order to qualify
as a collateral arrangement permitting the reinsured to
enjoy solvency relief credit under New York regulation,
the trust must not only be clean, unconditional and investing in certain types of securities, but also allow the
beneficiary to withdraw the assets held in trust at any
time.109 This introduces an element of sponsor credit
risk and may again leave investors at unease when contemplating the purchase of securities with underlying
risks ceded by a US-based carrier in reinsurance format.
Finally, a key consideration attached to collateral arrangements is loss tail development and settlement management. Clearly, investors are keen to see funds posted
as security to be released as quickly as possible in order
to allow them to deploy funds otherwise and to keep
opportunity cost as low as possible. Protection buyers,
in contrast, would like to preserve their access to collateral as long as exposures exist and claims may develop
or arise. Collateral release circumstances are, however,
often not clear cut given the potential uncertainty following the expiry date of risk transfer arrangements
and require careful structuring and wording.
5. Issuance and placement of securities
5.1 Basic considerations

In connection with the issuance and placement of securities, a distinction has to be drawn between two types
of ILS:

Privately negotiated transactions are largely arranged

and structured by or on behalf of specific investors.
These investors, as a rule, consciously commit themselves to relatively illiquid yet exclusive and flexible
arrangements as potential diversifiers and return enhancers, and do not have any intention to exit a position during the ordinary course of business. Therefore,
securities need not necessarily cater for ready marketability and may only be transferred in a strictly private
setting.
A fair share of ILS is nevertheless designed as tradable securities with a view to support a liquid secondary market and to foster an ever broader investor base.
Evidently, features supporting fungibility are fundamentally important to securities issued in the context of
such transactions. The comments below shall shed light
on this latter type of ILS in liquid format.
5.2 Primary market

Parties involved with a primary offering typically opt

for a firm underwriting approach whereby, further to a
book building process based on an engagement letter,
an intermediary or a number of intermediaries forming
a syndicate underwrite the issuance and, in turn, resell
the securities to investors.110 Even though the intermediaries are frequently referred to as initial purchasers,
they do not necessarily buy the securities in a technical
sense. Under the underwriting agreement, they rather
commit to subscribe securities to be originally created,
pay up the notional amount plus a premium, if any, and
manage the subsequent placement process.111 Obviously, the intermediaries offer their services against a fee.112
The placement process is primarily concerned with raising an appropriate amount of funds from investors and,
as such, proper disclosure and investor information is
crucial. Accordingly, a primary focus lies on compliance with applicable securities laws. ILS offerings are
customarily structured as private placements in order
to avoid the complexity and expense inherent in public
placements which require the publication of an issuing
prospectus and, in case the important US investor base
shall be approached, the need to comply with SEC registration requirements under the Securities Act.113 As a
consequence, the placement is restricted to individually
contacting a limited number of prospective investors
instead of conducting general solicitation.114 Placement
activities with a US nexus rely on the exemption provid-

110
111
108

Malcom Wattman/Matthew Feig/James Langston/James

Frazier, Legal Issues, in: Barrieu/Albertini (eds.), The Handbook of Insurance-Linked Securities, Chichester, 2009, 114.
109 Wattman/Feig/Langston/Frazier (FN108), 114.

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112
113
114

Emch/Renz/Arpagaus (FN 107), N 1905; Zobl/Kramer

(FN39), N 1078, 1094.
Emch/Renz/Arpagaus (FN 107), N 1918 ff. Zobl/Kramer
(FN39), N 1092.
Zobl/Kramer (FN39), N 1081.
Wattman/Feig/Langston/Frazier (FN108), 101 f.
Wattman/Feig/Langston/Frazier (FN 108), 102; Zobl/Kra
mer (FN39), N 1065ff.

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ed by Rule 144A which generally restricts the resale of

securities to qualified institutional buyers (QIBs).115 As
ILS placement circumstances are heavily influenced by
US law, offering circulars distributed are, not surprisingly, worded in a fairly US-centric way.

Meanwhile, most private investors are left with the only

possibility to invest in ILS investment funds. It seems
fair to state that the ILS transformation process needs
to be taken a step further to create a financial instrument i.e. mutual fund shares private investors are capable of investing in.

5.3 Secondary market

ILS funds have been predominantly established offshore. From an on-shore regulation point of view, parties are thus primarily required to deal with distribution
issues.123 While, again, the majority of ILS fund shares
continue to be distributed on a private basis, some ILS
funds target a broader investor audience. Recently, the
industry has also seen some on-shore ILS fund launches. Relevant issues with regard to accessing ILS include
buy-side restrictions in a more general sense involving
the investment restrictions framework applicable to certain institutional investors such as (re)insurance companies or investment eligibility criteria in a discretionary
asset management mandate context124. Interestingly
enough, only risk-transfer related aspects of ILS have
received considerable regulatory attention. Regulators
have hardly issued specific rules or guidance related to
investing in ILS and, where applicable, the recognition
of ILS as admissible assets of institutions subject to particular regulation.125

Transformers as issuers of liquid ILS usually intend to

apply for the securities to be admitted to the exchange
of their domicile. These listings, however, are not primarily sought to facilitate trading. In fact, they address
formal buy-side restrictions prospective investors may
be facing related to securities which are not listed on a
regulated market.
Actual trading activity takes place in a private setting,
yet is technically supported by clearing institutions.
Legally, transactions are straight contracts of purchase.
Nevertheless, secondary market trading habitually involves a broker/dealer which executes orders on behalf
of investors.116 Again, based on the 144A exemption,
ILS in the secondary market are transferred among
QIBs only as a rule.117
The secondary market also performs an important
function for valuation purposes. Executed transactions
and quotes issued by broker/dealers allow for mark-tomarket valuation while private transactions are marked
to model and/or valued based on reportings provided by
the protection buyer and potentially involve third party
valuation agents.118

IV. Access to ILS

For institutional investors there are essentially two
ways to invest in ILS: they may purchase ILS in the
market directly.119 Due to the complexity and relative
newness of this asset class, only very few large investors
have been going down this route yet.120 They still tend
to engage external specialist investment advisors instead
of building significant in-house capabilities and also set
up specific investment vehicles for this purpose.121 As
a second alternative, institutional investors may opt for
purchasing shares of a dedicated specialist ILS fund.122

115

116
117
118
119

120
121

122

Rule 144A defines a QIB as, amongst other things, an institution

owning more than USD 100m in securities issued by unaffiliated
entities, Wattman/Feig/Langston/Frazier (FN 108), 102 and
fn 7.
See for a general description of the broker function Zobl/Kra
mer (FN39), N 1213ff.
Wattman/Feig/Langston/Frazier (FN108), 102.
See also Ramseier/Grieger/Woo (FN18), 123 f.
Ramseier/Grieger/Woo (FN18), 119.
Ramseier/Grieger/Woo (FN18), 119.
See also Dirren (FN28), 142 f.
Dirren (FN28), 142; Ramseier/Grieger/Woo (FN18), 119.

In general, regulators are expected to recognize the diversification benefits ILS offer as an alternative investment at a portfolio level. An aspect worth observing in
a fund context though is the management of liquidity. It
is paramount to prevent ILS investment funds from a liquidity mis-match caused by incompatibility of liquidity terms offered by the fund and the liquidity profile
of the underlying ILS investments.126 When evaluating
funds, potential investors will scrutinise these issues
during the course of the usual due diligence process,
much like other ordinary fund selection criteria.127

V. Conclusion
The convergence of (re)insurance and capital markets
has led to the creation of ILS. As instruments increasing the efficiency of risk and capital management and,
at the same time, providing diversification benefits, ILS

123

124

125
126
127

See for example definition and regulatory requirements for funds

established abroad Article 119ff. of the CISA, linking the authorisation requirement to public distribution.
For a discussion of regulatory aspects of discretionary mandates
offered by banks and the Swiss Bankers Associations portfolio
management guidelines see Christoph Winzeler, Vermgensverwaltung durch Banken, SZW 2006, 420ff.
An example of rare explicit ILS investment regulation is BVV 2
which allows pension fund investments in ILS.
Ramseier/Grieger/Woo (FN18), 120.
Ramseier/Grieger/Woo (FN18), 129.

offer attractive opportunities to protection buyers and

investors alike.
Structuring and executing ILS, however, present many
challenges and require the involvement of appropriate resources given the complex and multidisciplinary
nature of transactions and products. Professionals involved in ILS will continue to combine (re)insurance
and capital markets components and it is expected
that, in the very near future, developments will evolve
around the design of risk transfer agreements, collateral
and the regulation of transformers. In this context, the
parties will be keen on balancing tailor-made elements
and standardisation aimed at supporting the growth of
ILS. Clearly, the continued development of ILS requires
a high level of technical skills and creativity in order
to capture opportunities, but also to manage downside
risk properly.

GesKR 4

2010

515

Aufstze

Christoph Brer A Primer on Insurance-Linked Securities