ILS & capital markets can help cover $4.6tn GDP exposure gap

by Artemis on September 8, 2015

A recent, pioneering study has brought to light potential expected losses of $4.6 trillion in economic output for the world’s major cities from man-made and natural disasters over the next decade, signalling vast opportunities for the insurance, reinsurance and ILS space.

A huge $4.6 trillion of projected GDP is at risk from 18 man-made and natural disasters across 301 of the world’s major cities, according to a new study by Lloyd’s of London that utilised original research from the Cambridge Centre for Risk Studies (CCRS) at the University of Cambridge Judge Business School, resulting in the Lloyd’s City Risk Index.

The risk landscape is changing, as the economic power witnessed in the developed world, including Western Europe and North America, is starting to shift to parts of Asia, Latin America and Africa. And as these regions experience unprecedented growth in terms of population, asset values and coastal/city migration, the potential economic losses from catastrophes spikes also.

The main finding from the study is that out of a projected $373 trillion in GDP between 2015 and 2025 across the 301 selected cities, roughly $4.6 trillion (1.2%) is at risk from 18 catastrophes.

The 18 catastrophes are as follows; cyber-attack, drought, earthquake, flood, freeze, heatwave, pandemic, market crash, nuclear accident, oil price shock, plant epidemic, power outage, solar storm, sovereign default, terrorism, tsunami, volcano and windstorm.

According to experts from the CCRS and Lloyd’s Chief Executive Officer (CEO), Inga Beale, building cities’ and thus the broader world economy’s resilience to such events is key to reducing the figure, an area the insurance, reinsurance, insurance-linked securities (ILS) and wider risk transfer markets are certainly capable of contributing.

“Insurance is part of the solution. Lloyd’s research shows that a 1% rise in insurance penetration translates into a 13% reduction in uninsured losses,” said Lloyd’s CEO Inga Beale.

And, the more insurance that’s used typically results in a greater use of reinsurance and alternative risk transfer structures such as catastrophe bonds, derivative products, and other innovative solutions designed to enhance a region’s resilience and recovery capacity post-event.

Low insurance penetration levels in many parts of the emerging world likely contribute to the $4.6 trillion total. With more people than ever before now living in cities, including parts of the world which are highly vulnerable to flooding, hurricanes, windstorms and so on, the potential uninsured losses when a catastrophe strikes is constantly on the rise.

Given the massive sums of exposure involved, the traditional insurance and reinsurance markets alone are not deep enough to support the risk transfer needs required to even make a small dent in the potential losses.

The global capital markets are the only source of risk capacity large enough and with sufficient liquidity to put in place a disaster risk financing plan that could begin to mitigate these exposures. Tools such as catastrophe bonds are suitable products to help ensure some level of resilience is achieved.

“Governments and businesses, together with insurers, must work to ensure that the potential for losses is reduced and, as a result, contribute to a more resilient international community. Insurers must continue to innovate, ensuring their products are relevant and offer customers the protection they need in the rapidly changing risk landscape,” continues Beale.

To reduce the $4.6 trillion figure, thus building the resilience of major cities to impacts of manmade and natural disasters, the capacity, structures, expertise and modelling capabilities of the reinsurance, ILS and capital markets will surely be needed, not just that of primary players.

In fact, Artemis recently reported on the changing risk landscape in parts of Asia, and how reinsurance and ILS use will shift its focus alongside this change.

The abundance of alternative and traditional sources of reinsurance capital in the global markets doesn’t appear to be going anywhere fast. And while some industry experts and analysts bemoan its presence in the sector, others have stressed its vitality if the industry is going to breakthrough into emerging, large scale risks such as the ones discussed in the Lloyd’s City Risk Index.

And this point is again highlighted with the findings of the Lloyd’s and CCRS research, as building resilience of this magnitude, for a wide variety of economies that have different levels of exposure to an array of risks, will need the support of many public and private entities, including combinations of the both.

An example of such a risk financing vehicle or structure can be seen with catastrophe bonds and risk financing pools, which can utilise parametric triggers that inherently produce rapid payouts post-event, and in some cases, as seen with the African Risk Capacity, require member states to meet resilience targets in order to qualify for the policies it provides.

The need for capacity is clear, and the capital markets offers the deepest, most liquid source of it. Furthermore, combine this with the growing appetite of institutional investors accessing traditional and alternative sources of reinsurance risk, to diversify on products and geographies within their portfolios, and it’s evident that the support of the entire risk finance landscape is needed, available and willing to mitigate the $4.6 trillion sum.

Highlighting just how much of an impact building cities’ resilience could have, Professor Daniel Ralph, Academic Director of Cambridge Centre for Risk Studies, said; “Our simple methodology suggests that between 10 per cent and 25 per cent of GDP@Risk could be recovered, in principle, by improving resilience of all cities.”

“A framework to quantify the average damage caused by a Pandora’s box of all ills – a ‘universal’ set of catastrophes – can be used to calibrate the value of investing in resilience. This is what the GDP@Risk metric for 300 World Cities attempts to provide,” concluded Professor Daniel Ralph.

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