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Catastrophe risk: a wake up call for insurers

Alamy Cat Floods Germany 575x375 20Jul21

The recent floods in Europe should be sounding alarm bells for the insurance industry. With events like these on the rise thanks to global warming, insurers facing compounding losses should look to catastrophe bonds as an alternative to costly reinsurance.

Parts of northwestern Europe were hit by devastating flooding early last week, with Belgium, the Netherlands and northwest Germany the worst affected. As of Tuesday afternoon, at least 205 people were known to have died and 200,000 houses were without power.

Although the financial scale of the losses is not yet known, the German Insurance Association (GDV) expects Germany to face its biggest losses since 2013, when floods in the southeast of the country caused almost €9bn of damage.

Fitch says the latest floods could add up to five percentage points to non-life insurance groups’ combined ratios, a measure of underwriting profitability. While reinsurers and recent good results will cover most of the losses, this may not always be the case in the future.

Climate change-driven events such as these are becoming more common in Europe. Even before last week, severe weather between June 17 and June 30 had caused an estimated $4.5bn of insured losses in the region, according to Aon, surpassing the $4.3bn record set in 2013.

And these previously once in a decade events are going to become more frequent. According to the European Union’s PESETA IV study into climate change in Europe, annual flood damages in Europe could grow sixfold by 2100 if the global temperature rises by 3°C.

As a result, insurers may have to start looking elsewhere to shore up against potential losses.

Part of the answer could lie in catastrophe bonds, which effectively allow insurers to hedge their exposures to large and predictable losses.

Cat bond buyers receive regular interest payments in exchange for accepting the risk that they could lose their principal if pre-defined triggers are breached — a certain volume of claims, for example, or a certain severity of weather.

Although cat bonds are an established product elsewhere in the world, there is a gap in the European market.

Data from insurance linked security (ILS) investor Plenum suggests that only 9% of the cat bond market is exposed to European windstorms, with only one bond, issued by Generali, covering “material storm risk in Germany”.

According to Aon, $11bn of property cat bonds were issued in 2020, a small amount compared with the $89bn of annual global insured losses noted by Swiss Re. And there is plenty of room for growth, given that many go without insurance across the globe. In Europe, between 2010 and 2019, 69% of the average annual natural catastrophe losses were not insured, again according to Swiss Re.

The stats for flooding are even starker. Between 1980 and 2019, floods were responsible for 40% of loss-related natural catastrophes globally, causing almost $1.1tr of damage, according to data from Munich Re. Of this, only 12% was insured.

Of course, if there is to be a bigger cat bond market, the instrument needs to appeal both sides of the bargain.

A cat bond is a principal at risk product, meaning that investors are liable to lose everything in the event of a pay-out. With the likelihood of pay-out events set to increase, why would investors buy them?

They might draw solace from the observation that cat bond returns show little sensitivity to broader market disruption, compared with other securities. During the height of the coronavirus sell-off last March, the Eurekahedge ILS Advisers Index, which tracks the performance of 28 ILS funds, dropped just 0.7%, compared with the 12.5% fall in the S&P 500.

And investors are well rewarded for the risk they take on. Earlier this month, the World Bank issued a $185m short three year cat bond to provide storm protection for Jamaica. It pays a coupon of 4.45% over Sofr.

However, there are still hurdles to be overcome by prospective issuers, with the negative rate environment in the eurozone making it expensive for them to use short dated collateral in the form of money market funds.

Some have found their way around this by pledging other assets. A green cat bond that Generali sold last month will use paper issued by the European Bank for Reconstruction and Development.

The EBRD is, for now, the only European supranational to support the cat bond market. For the Generali deal, it issued a bespoke note matching the cat bond’s maturity and triggers.

Perhaps policymakers elsewhere should take a leaf out of the EBRD’s book to unblock the system and allow more of this kind of capital markets transaction in Europe.

Swiss Re expects reinsurance rates to harden into 2022 because of reduced risk appetite following two successive years of above average losses.

While the higher coupons and collateral requirements of cat bonds may seem expensive, insurers faced with increased reinsurance costs in the face of more frequent pay-outs might be happy to stomach to the costs.