Insurance-linked securities have role to play in government and state insurance arrangements

by Artemis on August 31, 2011

The private insurance market and the capital markets can help state governments finance themselves for disasters and other large insurance type claims, says a report from reinsurer Swiss Re. The latest Sigma study from Swiss Re discusses ‘State involvement in insurance markets‘ and while it identifies the areas where the state or government has to back itself, due to lack of capacity in the private markets, the report identifies many areas where private insurers and the capital markets have roles to play.

Insurance-linked securities, catastrophe bonds in particular, have a definite role to play in helping states finance the risks of major natural catastrophes and increasingly other classes of risks. Catastrophe bonds are particularly suited to addressing low-frequency, medium-to-high loss events, as they show in the graph below.

Catastrophe bonds are suited to low frequency, mdeium to high loss events

Catastrophe bonds are suited to low-frequency, medium-to-high loss events

New financial technologies such as catastrophe bonds and parametric insurance policies are ideally suited to increasing the capacity available to states looking to offload some of the risks which fit in the bottom right quadrant of the graph below. With the size of the insurance and reinsurance markets growing all the time, insurance-linked securities allow that capacity to grow even further by passing insurance risks to the capital markets. They are perfectly suited for dealing with larger losses, and even if they can’t cover the whole loss they at least significantly lower the reliance on government or state financing.

Catastrophe bonds can cover a wide range of probabilities of losses according to Swiss Re’s report. Loss probabilities within cat bonds have ranged from 1 in 10 year events right down to 1 in 1000 year events. Generally though, cat bonds cover risks with probabilities of losses in the 1 in 50 to 1 in 200 year range.

The other benefit that the report from Swiss Re highlights is the speedier payout that a catastrophe bond or a parametric triggered insurance policy can offer a state government at times of disaster or crisis. The speedier payout can be vital to recovery after an event, so even if the capital markets or private insurance cannot cover the entire risk, having a portion of cover in a cat bond or such structure can be extremely beneficial.

You can download the full Sigma report from Swiss Re in PDF format here.

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