Q&A with François Divet, Head of ILS

This is the first of two Q&As with François Divet, Head of ILS, where he’ll tell us about the basics of this unique alternative asset class, as well as what investors should keep in mind when selecting an ILS manager.

What are Insurance-Linked Securities, and how do catastrophe bonds generate returns?

Insurance-Linked Securities are floating-rate instruments where the underlying risk is not credit risk, but insurance risk — mainly natural catastrophes. Also known as catastrophe bonds (cat bonds) these instruments effectively provide protection to an insurer or reinsurer against a predefined event, such as a US hurricane or a Californian earthquake.

In return, we receive a coupon composed of two elements. First, there is a fixed spread — the premium paid by the sponsor for transferring that risk. Second, there is a floating-rate component generated by the collateral, which is held in a fully funded special purpose vehicle.

If no qualifying event occurs, we earn that coupon and receive our principal back at maturity. If a major event breaches the agreed thresholds, we may lose part or even all of the principal. So the return is fundamentally driven by insurance premia, not by corporate credit risk.

How do cat bonds differ from traditional fixed income?

Although cat bonds are technically fixed-income instruments, the risk driver is completely different. We are not exposed to economic cycles, corporate earnings or sovereign fiscal dynamics. We are exposed to physical catastrophe risk.

The duration is usually around three years at issuance and shorter at portfolio level. But the real differentiator is correlation. Historically, ILS have exhibited very low correlation to equities and traditional credit markets. That diversification benefit is one of the main reasons investors allocate to the asset class.

What risks are investors actually taking — and what causes permanent loss versus mark-to-market volatility?

The risk we are taking is event risk. If a sufficiently severe insured event occurs, we can suffer a permanent capital loss on that instrument. However, not all drawdowns are permanent. Mark-to-market declines can also result from shifts in supply and demand in the secondary market, or from an increased perceived probability of loss while an event is developing. In those cases, prices may fall temporarily even if the bond ultimately redeems at par.

So there is a clear distinction between realised loss — triggered by an actual event — and temporary volatility driven by market dynamics.

Why do insurers issue cat bonds rather than rely solely on traditional reinsurance?

Insurers use both traditional reinsurance and capital markets solutions. ILS is both a complement and, in some ways, a competitor to the traditional reinsurance market. One key advantage of cat bonds is that there is no counterparty credit risk. The collateral is fully funded and segregated in an SPV. In contrast, with traditional reinsurance you are exposed to the creditworthiness of the reinsurer.

Another important difference is maturity. Cat bonds typically provide three years of protection, whereas traditional contracts are often renewed annually. That allows insurers to lock in pricing for longer. In some cases, using capital markets can also strengthen an insurer’s negotiating position with traditional reinsurers.

How does diversification in ILS work, and why can’t it eliminate tail risk?

If you invest in a single cat bond, you can lose 100% of your investment. So diversification is absolutely essential.

We diversify across perils and regions — for example US hurricane, US earthquake, European windstorm or Japanese earthquake. We diversify geographically at a lower regional level. For example, within the US hurricanes, exposure to Texas is not the same as exposure to Florida. We also diversify structurally, across senior and junior layers and different trigger types.

That said, we cannot eliminate tail risk entirely. Many bonds are exposed to peak perils such as US hurricane and US earthquake. If a truly extreme event occurs in those regions, multiple bonds in a portfolio may be affected simultaneously. Diversification reduces drawdowns, but it does not remove systemic catastrophe risk.

How is ILS different from mortgage-backed securities, and could it trigger a crisis?

I think it is fundamentally different. First, the underlying risk is physical catastrophe risk, not credit and interest-rate risk. Second, cat bonds are fully collateralised — there is no embedded leverage. Third, insurers cannot cherry-pick policies to offload. They transfer defined books of risk on an all-or-nothing basis.

In the mortgage market prior to 2008, counterparty and leverage were key problems. In ILS, those structural weaknesses simply are not present. In addition, the asset class has low correlation with broader financial markets. For those reasons, I do not see the same systemic risk dynamics.

How do you decide which perils and regions to emphasise?

We operate within clear portfolio guidelines. We target a specific expected loss at fund level — typically around 2–2.5% — and we apply hard limits by peril and geography.

US hurricane remains the largest risk in the market, followed by US earthquake. But we manage exposure carefully to control downside risk. We are not trying to trade the market actively; once we are comfortable with a bond, we typically hold it to maturity unless conditions change materially or when the bond is no longer at risk due to the seasonality of the underlying perils covered.

What distinguishes a strong ILS manager over a full cycle?

I think the best way to assess a manager is over multiple cycles — including heavy loss years such as 2017 or 2022, as well as benign years.

A strong manager maintains discipline, limits drawdowns during severe events and avoids reaching for yield late in the cycle. Diversification may reduce returns slightly in quiet years, but it protects capital when large events occur. That consistency is critical.