When an earthquake hit Chiapas province in Mexico last September, the president of the country said it was the strongest in a century. As scant a consolation this was to those affected by the quake, it did represent an unusual event in emerging markets: private bondholders saw their principal go towards the rebuilding effort.
The bond in question was a catastrophe bond, the most prominent instrument in the insurance-linked securities (ILS) asset class. Cat bonds offer investors a coupon if they put money aside in case of disaster. If a catastrophe meets certain conditions, the bonds trigger and money is released to help the issuer respond.
The developing world is in desperate need of protection from catastrophes.
Last year, 84% of economic losses were uninsured in both Asia and the Latin America and Caribbean region according to a report published earlier this year by Cass Business School. And the figure for Africa was 72%.
In developing countries, “where insurance penetration is typically low and governments and citizens have few financial reserves, losses from catastrophic disasters can devastate the economy, rolling back development gains for the country and exacerbating global inequality,” said the report.
When looking at disasters through the lens of uninsured losses — known by specialists as the protection gap — the importance of innovative solutions becomes obvious.
“There has been a lot of talking about the protection gap and a lot of thinking about it but to date the gap hasn’t decreased dramatically,” says Emma Karhan, who leads Aon’s recently-launched Public Private Enterprise specialty practice in London.
Karhan’s practice is trying to address the protection gap through bringing together public and private bodies, including the ILS market.
“There is definitely a role for ILS, it’s just a matter of where, how and when,” she says.
WHY THE FIT?
So, how do we go about defining the role for ILS? In particular, why would the developing world use cat bonds rather than traditional insurance?
There is certainly a space for ILS in the developing world due to how cat bonds can be structured.
Rather than using an indemnity format where payment reflects losses incurred, in the developing world it often makes sense for insurance to use a parametric structure. This is where the amount paid out is based on the physical attributes of a catastrophe such as wind speed or earthquake strength.
This is partly because the mechanisms for assessing loss are often patchier in the developing world. It also gives transparency to both sides in a market where trust may be lacking. National governments may not want to pass wealth out to foreign companies and may be suspicious about whether reinsurers will ultimately pay up.
“Parametric triggers are independently controlled and verified, which supports trust between national governments in developing countries and western corporations,” says Will Wilson, senior manager in insurance regulation and strategy at Deloitte in London.
The simplicity of the triggers also makes compensation speedier. This “supports liquidity in government budgets and enables them to quickly focus on responding to a disaster,” Wilson adds.
And for their part, ILS investors prefer this type of trigger to indemnity loss, because “they can stay at an arm’s length with a looser relationship but — crucially — more transparency,” according to Wilson.
Insurance firms can offer parametric coverage too. But the desirability of the parametric structure puts cat bonds — which cut out some of the middle-men in traditional insurance — firmly in the game.
Ironically, ILS will gain a more competitive edge once insurance firms themselves have a solid foothold in emerging markets. Risks providing diversification, such as those in developing countries, are attractive for reinsurers, which have leveraged balance sheets.
Reinsurers only need to allocate a small amount of capital to write those diversifying risks so currently they can provide cheap coverage in some parts of the world. But as a risk becomes more concentrating it becomes less attractive for reinsurers to write as it requires more capital.
This makes reinsurers less competitive when this happens and ILS can slowly start to offer a better price.
The Caribbean Catastrophe Risk Insurance Facility uses parametric triggers when it pools risk from different countries and offers insurance policies to governments.
CCRIF’s 2018/2019 risk transfer programme only included traditional reinsurance but in the past it has made use of the cat bond instrument. It told GlobalMarkets it sees numerous benefits from the parametric structure.
It said this is generally less expensive than equivalent indemnity insurance; payouts can be made very quickly as loss adjusters are not needed; governments have just one form to sign during the entire claims process; and the calculation of payments is “totally objective”.
Since its birth in 2007, the entity has made 36 payouts worth a total of $130.5m to 13 governments and all those payments were made within 14 days.
CCRIF does say that for all the benefits of avoiding the indemnity format there is a risk that payouts based on calculated losses do not match what happens on the ground.
And this has led to criticism. After flooding in Jamaica last year did not lead to a payout, the country’s politicians criticised CCRIF’s models.
“Often we are dealing with more highly politicised situations when we are working with emerging sovereigns,” says Stephen Moss, director of capital markets at catastrophe modelling firm Risk Management Solutions in London. “As a result, there’s an expectation that: ‘We’ve bought insurance, we will get paid.’”
But he thought frictions would ease as people become more familiar with the product they buy.
And ILS in the developing world could evolve to use more indemnity structures once trust has built up, following a path trodden in developed countries, according to Wilson.
For all Jamaica’s problems, CCRIF does provide benefits.
Entities in emerging markets face challenges when trying to offload risk on to the capital markets. They may lack the size for a transaction to be worthwhile and also the know-how. But this is where an intermediary such as the World Bank or CCRIF comes in.
These can play the role of “accumulating risks from many small entities and mashing them together to get the economies of scale and also provide an attractive amount of risk for the market,” says Moss.
CCRIF says that small islands and coastal states in the Caribbean would find it harder to insure themselves without an aggregator.
“The ability of these countries to effect financial risk transfer through affordable catastrophe insurance in traditional international insurance and reinsurance markets is limited by the high transaction costs that result from the limited volume of business they could bring to these markets,” it told GlobalMarkets.
Supranationals also have the expertise to produce a market-friendly product and can look beyond simple commercial goals.
“They can act or buy on behalf of the public and are often a simpler vehicle to work with than governments to help close these protection gaps,” says Karhan.
WHICH RISKS? WHICH COUNTRIES?
Southeast Asia and China are now tipped as locations where more risk could be transferred through catastrophe bonds.
In Southeast Asia there is growing risk, growing awareness of risk and better data and modelling, according to Moss.
The Monetary Authority of Singapore has been keen to develop the market. Its grant scheme offers to fund all of an issuer’s upfront costs to set up a catastrophe bond.
“Transactions happen in financial hubs where there is a confluence of banking, insurance and legal expertise,” says Wilson. “Singapore has demonstrated it is welcoming for new activity.”
Singapore as an active participant in regional forums can also spread awareness of ILS instruments.
“I don’t believe there’s an actual need to have a hub in Southeast Asia,” says Moss. “But what there is a need for is a strong regional advocate for these kind of tools being a viable cost effective and efficient way of transferring risk.”
China may also use ILS more; only one Chinese entity has issued a catastrophe bond so far. But administrations in Hainan, Hunan and Shanghai have all launched pilot programmes for catastrophe insurance this year or last.
According to Moss, reinsurers still offer cheap protection there due to the diversifying quality of Chinese risk. But this is likely to change.
“As China continues to grow that’s not going to continue to be the case,” he says. “We are going to end up in a scenario where China becomes the concentrating risk for the insurance market, and that’s really where the ILS market becomes incredibly powerful because it doesn’t need to be diversifying for it to be able to provide competitive prices.”
Regardless of where it spreads, how will the market cope once it starts taking losses from developing world perils?
Creditors generally hate losing their principal but when the earthquake bond was triggered in Mexico last year the ILS market was positive. The issue was settled quickly with no ambiguity hanging over participants.
“They don’t like paying out, but they like certainty,” says Moss.
It may also be true that the market liked the event because it demonstrated the value of coverage. In the same way that reinsurers can benefit from big catastrophes, the disaster could prompt other countries and firms to consider ILS.
And several months later Mexico came back to the market for earthquake protection along with Chile, Colombia and Peru, producing one of the largest catastrophe bonds ever.