Reinsurance opportunity in sovereign catastrophe risk financing: S&P

by Artemis on August 27, 2014

Ratings agency Standard & Poor’s highlights the opportunity for insurance, reinsurance and the insurance-linked securities (ILS) market to work with governments to provide and support sovereign catastrophe and disaster risk financing tools.

The provision of financial tools to help governments manage or transfer their exposure to catastrophe and disaster risks is a key mechanism for achieving greater disaster resilience. Standard & Poor’s latest report suggests that reinsurers have a huge opportunity to support the building of governments resilience to the financial shocks caused by large natural catastrophe events.

Extreme catastrophe or disaster events can often derail the growth of an economy as well as create ripple effects which can impact the global economy, supply chains and heighten sovereign risk. Developing a market for products to protect governments from catastrophe risks will, according to S&P; “Help reinsurers reinforce their relevance to new clients and new risks should lead to a stronger insurance market and increased insurance penetration.”

This is a topic we at Artemis have been writing about since the website first launched, suggesting that provision of contingent catastrophe risk financing is a real opportunity for the reinsurance, ILS and catastrophe bond communities. Protecting fiscal budgets from the impacts associated with weather and natural disasters would provide a mush needed buffer to help local insurance markets sustain themselves and grow. In our view you can broaden this opportunity much more widely than just governments; to include banks, corporates and other entities operating in emerging regions who currently lack catastrophe risk financing.

S&P notes that growing middle class wealth in many of the world’s emerging economies outpaces insurance penetration growth, widening the gap between economic and insured losses and ultimately putting an additional burden on governments and other lenders into countries.

The higher the level of uninsured losses is, the higher the chances that an economy could be derailed, resulting in disruption to the local economy, budgets having to be reshuffled to support disaster recovery and often leading to more hardship for the population.

By building resilience and having disaster risk transfer and financing in place, governments can protect their economic stability, speed recovery and aid reconstruction, with sources of contingent capital from insurance, reinsurance or the capital markets.

S&P believes that reinsurers can play a key role in this effort, as can the ILS investment community. Capital is required to support risk transfer products and many of these needed risk transfer products would not be covering typical insurable interest. Rather protection and risk transfer for fiscal or budgetary interests are required, something that the ILS market has a real opportunity to play a key role in.

S&P research shows the potential opportunity in stark light. It’s research shows that the top 20 most vulnerable nations are emerging markets and that insurance penetration (measured by premium as percentage of GDP) is just 0.9% in these countries, compared to a global average of 2.1%.

S&P’s report shows some telling figures, such as the fact that some modelled catastrophe events could erode huge percentages of the affected countries GDP. Also telling are figures on insurance penetration, where some catastrophe losses in recent history see as little as 3% of the costs covered by insurance (eg. the Kobe earthquake).

Insurance penetration is rising and emerging economies are often rising the fastest. However, when you look at the types of insurance and the levels of cover available the gap remains and is often not being narrowed as rapidly as exposure and development is increasing. This leaves a widening gap which the reinsurance and ILS market should aim to support closing.

The macroeconomic instability which can result from major catastrophe events in emerging economies of the world can go so far as to also affect the developed economies, due to the interconnecting nature of finance, supply chains and economics. Therefore it is in the interests of the mature economies to ensure that emerging economies are protected and resilient to natural catastrophes and weather extremes.

S&P says that the reinsurance market can help these catastrophe-exposed economies to better understand their exposure, reduce their liability and increase their economic stability as a result. Reinsurers can offer support in modelling catastrophe exposures, educating stakeholders as to the importance of resilience, creating bespoke risk transfer solutions and acting as intermediaries for the capital markets, to paid up buyers and sellers. We would suggest that some capital markets ILS players are already capable of disintermediating the reinsurers here to a degree and some ILS managers we speak with are already actively exploring these types of opportunity.

The key is putting these types of catastrophe risk transfer and financing facilities in place before disaster strikes. The injections of capital possible from parametric insurance, reinsurance and catastrophe bonds, as well as other contingent forms of catastrophe or disaster risk financing, can make measurable differences to the way economies recover from major loss events.

S&P suggests that if reinsurers take the lead in developing these forms of catastrophe and disaster risk transfer and financing, they could find they reinforce the industry’s relevance in new regions, open up new markets and position themselves for future growth in emerging and rapidly growing economies.

S&P notes correctly that there is a mindset change required to encourage adoption of contingent risk financing, such as insurance, reinsurance and catastrophe bonds. These tools can be considered a tax rather than a benefit if they do not pay out, or are not triggered by sufficiently large disasters.

This is not just an education process. It may also require the development of standards regarding disaster risk disclosure, something the United Nations is keen to have adopted. If governments, corporates, banks and lenders were mandated to disclose their exposure to natural catastrophes and extreme weather, the logical next step would be a need for insurance, reinsurance and risk transfer products to protect their balance sheets against these risks.

So encouraging a long-term view to disaster risk protection is also essential, helping governments and other potential cedents to see the benefits of purchasing contingent financing for catastrophe exposures. Designing risk transfer products carefully to take into account economic, cultural and developmental differences is also key, the ethnographers and design thinkers of the world may soon find themselves required in the re/insurance market to aid expansion into new markets in a sustainable and sympathetic way. You cannot shoe-horn your product set into new markets, as many re/insurers have been trying in recent years, with no understanding or empathy for the local, cultural and financial market differences.

S&P notes the importance of demonstrating the robustness of risk models, in order to enter new markets. These models will likely be used to demonstrate the benefits of any insurance or reinsurance product, so ensuring that they are understood and appreciated will be key.

Selection of triggers will also be important, with parametric triggers likely to play a key role in expansion of the re/insurance and ILS market into emerging economies. However, if the triggers are not well-designed and losses occur which products do not pay out as a result of the negative backlash from government and population could create reputational damage. Education and an understanding of the scenarios under which a product will pay out, as well as attention to detail in trigger design, will be key.

S&P concludes; “There is a strong case to be made for the benefits of government-backed risk protection solutions. The successful development of this market could be key to entrenching the relevance of insurance in high-growth markets.”

This all boils down to perhaps the best opportunity the insurance, reinsurance and ILS market has had in years. More catastrophe risk transfer and financing is required as these emerging economies grow. And there is increasing pressure for governments, corporates, banks and other entities to protect themselves, their shareholders and benefactors from catastrophe and weather risks.

At the same time as this is occurring, the insurance and reinsurance markets are seeking new opportunities and the insurance-linked securities (ILS) market is seeking growth and diversification. This means that the capital required to back these risk transfer tools will likely be available.

S&P notes that the recent growth of the alternative reinsurance capital and ILS market suggests that it may be easier to find capital to back these emerging market solutions. The ILS market is hungry for access to new risk, with capital on the sidelines ready to support new initiatives and existing investors seeking diversification opportunities which will enable them to grow.

The development of these emerging economy insurance markets may require the provision of contingent catastrophe risk financing first, providing a capital buffer to the economy and GDP which then fosters sustainable insurance market development. Providing protection at the GDP and fiscal level, via sovereign disaster risk transfer, could actually result in more rapid development of local insurance markets, given the additional buffer provided.

S&P closes by saying, that taking on a role of developing awareness and acceptance of insurance-backed solutions for states’ catastrophe exposure will benefit reinsurance companies in the long-run. It will provide diversification of risk exposure, educate and develop new insurance markets which can become a source of growth for years to come and ultimately reinforce the relevance of the reinsurance industry to new potential clients.

That sounds like an opportunity the reinsurance industry would be foolish to ignore, given the currently challenging market. However these opportunities need to be approached with sustainability in mind. Boldly attempting to create premiums in emerging or developing regions, with no thought for the development of that economy or its local insurance market, is increasingly being proven not to work.

You can access the full report from S&P via its website (login may be required).

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