ILS can play a broader role in narrowing the global protection gap: Moody’s

As the severity and frequency of natural catastrophe events continue to grow, addressing the protection gap remains an important focus, which has led Moody’s to call out that scaling the capital markets and tapping into the insurance-linked securities market can help narrow the gap as it continues to grow.

In a recent article published by Moody’s, the firm outlines that property and casualty (P&C) insurers and reinsurers cannot close the protection gap on their own, stating that they must charge enough premium to pay claims, stay within regulatory capital requirements, whilst also generating returns for shareholders.

These constraints ultimately limit how much catastrophe risk they can safely insure. At the same time, customers’ inability to afford coverage or the absence of coverage requirements also means that certain risks end up going uninsured.

“Catastrophes with the highest tail risk — rare but severe events that strike many policyholders at once — tend to have the widest protection gap. Severe earthquakes, for example, are rare but devastating. In many markets, earthquake insurance take-up rates remain relatively low because coverage is optional, costly, or perceived as unnecessary, contributing to some of the largest protection gaps across natural catastrophe perils. As a result, roughly 84% of US earthquake exposure is uninsured — among the highest protection gaps of any US peril, according to Moody’s data,” Moody’s explained.

Adding: “In contrast, wildfires are relatively frequent, but a severe wildfire usually costs far less than a severe earthquake. Consumers and businesses are more willing to buy coverage, and mortgage lenders typically require it, so the wildfire protection gap is much smaller.”

Importantly, Moody’s underscored that because insurers cannot fully absorb correlated tail risk, they turn to the reinsurance market to help support their capital. But, the firm also stressed that reinsurers face the same balancing act between holding sufficient capital and earning enough return on extreme catastrophe risks.

All of which leads Moody’s to turn attention towards ILS, and how the market can play a key role in helping narrow the gap.

“Capital markets investors can participate in both the returns and risks of catastrophe exposure through insurance-linked securities (ILS), which can help narrow the protection gap. Catastrophe bonds (cat bonds) and sidecars have grown quickly on strong investor demand, but are still a small share of capital markets,” Moody’s explained.

Alternative or third-party reinsurance capital, so that deployed through insurance-linked securities and related collateralized structures has risen steadily in recent years and even grew to a record $147 billion in the first-half of 2026, which clearly highlights how the broader ILS market continues to expand.

Artemis’ Q2 2026 catastrophe bond and related ILS market report shows that cat bond issuance in H1 2026 set a new record of almost $18 billion, as the outstanding market size at the end of June hit a new end-of-quarter high of $65.6 billion. All of which heavily suggests that investor appetite remains strong amid increased diversification within the asset class.

Moody’s added: “ILS can deliver attractive returns with little correlation to the economic cycle. ILS collateral is generally invested in low-risk and low-duration investments such as US T-bills. Cat bond spreads have generally outperformed US high-yield corporate bonds, particularly since 2022.”

“Because ILS losses are generally uncorrelated with financial markets, adding them to a portfolio provides diversification that could lift returns while reducing risk.”

Looking ahead, Moody’s said that it expects the ILS market’s expansion to continue as a broader range of institutional investors recognise its role as a diversifying source of return.

The firm also added that catastrophe risk features many of the characteristics that investors tend to seek within a fixed-income allocation, such as defined risk periods, attractive risk-adjusted returns, and limited correlation with traditional financial markets.

“Growth in ILS will be supported by advances in catastrophe modeling, greater transparency and standardization across transactions, and improved access to analytics that allow investors to evaluate catastrophe risk with increasing confidence and consistency. As market infrastructure matures and participation broadens, ILS has the potential to attract a larger share of global capital, helping create a more resilient and sustainable risk-transfer ecosystem,” Moody’s said.

Furthermore, Moody’s also highlighted how government owned insurers and public-private partnerships can also help narrow the protection gap.

“In the US, consumers in high-risk areas increasingly rely on state-backed insurers or residual “FAIR” plans, which usually cost more and cover less than the private market. Europe’s state-backed reinsurance mechanisms vary widely by country, and Asia-Pacific has few insurers of last resort,” Moody’s explained.

“Multilateral development banks and some governments have tapped the capital markets for parametric catastrophe protection – where the payout is tied to the event itself, such as a hurricane’s category at landfall or wind speed. Jamaica is a recent example. When Hurricane Melissa struck in October 2025, it caused an estimated $12.2 billion in damage, or about 54% of GDP. Jamaica’s pre-arranged disaster financing — including Caribbean Catastrophe Risk Insurance Facility coverage, a parametric cat bond, and contingent credit — provided swift liquidity. The Category 5 storm triggered a full payout of the country’s World Bank-backed $150 million cat bond. Though small next to total losses, that financing eased some immediate fiscal strain,” Moody’s continued.

To conclude, Moody’s notes that the global protection gap is especially pronounced in emerging markets, reflecting lower insurance penetration. Consequently, this means a larger share of losses remains uninsured, shifting the burden to governments and households, thereby generating heightened economic and fiscal strain relative to developed markets.

“The protection gap is often framed as an insurance problem, but ultimately it is a capital allocation challenge. The opportunity ahead is therefore not simply to transfer more risk, but to create larger, more resilient and more sustainable risk-transfer systems. By connecting global pools of capital, the ILS market can play a broader role in narrowing the protection gap in an increasingly uncertain world,” Moody’s concludes.