Insurance-Linked Securities (ILS): How to Construct a Performance Index

Abstract

Increasingly, insurance-linked securities (ILS) are being seen as a source of alternative beta. Modern asset pricing theory suggests a general framework in which risk premia can be systematically modeled. From an investor’s point of view, this framework suggests a natural question: Besides being described, analyzed, and modeled, can the ILS risk premium be systematically captured and replicated—analogous to the well-known equity risk premium or the more recently discussed alternative beta risk premia? The authors offer a methodology for the construction of a performance index designed to cost-efficiently capture ILS alternative beta. They discuss some implications of the availability of ILS performance indices for both passive and active management of ILS exposures.