Natural disasters a risk to sovereign ratings, risk transfer required: S&P

by Artemis on September 11, 2015

Rare but extreme natural disasters and catastrophes can cause sovereign ratings downgrades, with the biggest impacts seen from earthquake and tropical storm simulations, making sovereign risk transfer and catastrophe insurance key, according to S&P.

“Our simulations indicate the impact that rare but severe natural disasters–those that can be expected once every 250 years–can bring to bear on sovereign ratings. The biggest ratings impact is likely to come from earthquakes, followed by tropical storms,” Standard & Poor’s analyst Moritz Kraemer explained.

“Geographically, ratings of sovereigns in Latin America and the Caribbean appear to be most at risk, followed by Asia, taking into account higher geologic and climatic hazards than in the rest of the world,” Kraemer continued.

This has been evidenced in recent weeks by the devastating floods that hit Dominica after tropical storm Erika brushed the island. The economic loss is expected to amount to around half of GDP, a level where the island nations sovereign rating could get called into question.

Demonstrating the importance of insurance and catastrophe risk transfer, in cases such as this, the CCRIF SPC has made a payout to the Government of Dominica, under a parametric excess rainfall policy. However, most sovereigns do not have significant catastrophe insurance protection and the levels of cover purchased are often not enough to prevent ratings coming into question.

“The ratings of low-income developing sovereigns are particularly vulnerable to severe natural catastrophes,” Kraemer added, “followed by emerging and the less threatened advanced economies. It is therefore no coincidence that sovereigns with lower ratings tend to be more vulnerable to natural catastrophes than higher-rated sovereigns.”

In a study, Standard & Poor’s used data on catastrophe event damages provided by Swiss Re to construct a simplified sovereign rating tool. S&P simulated the impact over a five-year period of a one-in-250-year occurrence of four perils (earthquakes, tropical storms, winter storms, and floods) on key macroeconomic variables: GDP growth, the balance of payments, as well as on general government debt and deficits.

The rating agency said that it sees particularly large potential direct economic damage and related pressure on creditworthiness for sovereigns on or close to the edges of Earth’s geological plates, for example, around the Pacific Rim (for example Chile, Costa Rica, Ecuador, Japan, Panama, Peru, Philippines, Taiwan), in the Caribbean (Costa Rica, Dominican Republic, Panama), and on the North Anatolian fault (Turkey).

In Japan S&P explains that a 1-in-250-year event could cause a significant economic downturn and a decline in the sovereign rating by at least two notches, an event which could cause severe economic and financial repercussions across the rest of the world.

“We believe that in the immediate aftermath, the earthquake would result in a disruption of trade flows, block supply channels, with a simultaneous sell-off of foreign assets held by the Japanese residents and partial repatriation of Japanese financial assets held abroad, possibly causing an economic lowdown in the rest of the world and turmoil in global financial markets,” the rating agency explains.

The subject of sovereign catastrophe insurance is raised as one way to mitigate the threat that these major catastrophic events pose to nations.

“We believe that one way to mitigate the economic and ratings implications of natural disasters is catastrophe insurance,” S&P says.

The existence of a robust catastrophe insurance or risk transfer program can have a significant impact on the rating effect of a major catastrophe event, the rating agency explains, lessening the impact and helping the country to recover more readily.

“In the case of the five biggest earthquakes covered in the study, the rating impact would be a downgrade of about one notch if 50% of the damage were reinsured, compared with almost two notches for no insurance coverage at all,” S&P continued.

Also adding; “These findings are particularly relevant for emerging and developing sovereigns. They are typically the most vulnerable to natural disasters in terms of direct and indirect economic losses and, as a result, creditworthiness. It is also in those economies where insurance coverage is typically low.”

For other risks, S&P says that sovereign ratings would come under pressure if a one-in-250-year tropical storm hits, although generally less so than in the case of an earthquake which is the largest single natural disaster threat to a sovereign rating.

Flooding is not expected to result in a sovereign rating threat, however S&P says the economic impact is far from negligible. Among the sovereigns S&P reported on, severe floods would cause the most economic damage in Hungary and Thailand, weakening their macroeconomic metrics and creditworthiness.

European sovereigns face the threat of windstorms and are frequently hit by winter storms, but winter storms are unlikely to lead to downward pressure on sovereign creditworthiness partly thanks to the much higher insurance penetration in the region most exposed to windstorm.

The threat to sovereigns is expected to increase though, as climatic trends looks set to result in more severe storms and more frequent impacts, according to S&P. While these trends are unproven, with the increasing urbanisation of coastal areas, and populations moving to regions exposed to severe storms, surges and other perils, the chance of greater economic impact and a sovereign rating effect is rising all the time.

“Looking ahead, climatic perils could intensify in line with past trends as climate change gathers pace. Specifically we view it as possible that storms and floods will become more frequent and more severe as the average global temperature rises and weather patterns shift,” Kraemer said.

“Before long, this could lead to an upward revision of the damage caused by one-in-250-year catastrophes, and thereby also result in a stronger hit to ratings than suggested in this report,” he added. “We expect that climate change-induced intensification of the frequency and severity of natural
disasters would hurt the ratings on poorer sovereigns the most, adding to global ratings inequality.”

Of course it’s not just sovereigns that are at risk. So are cities, town and of course the world’s companies and corporations.

With the exposure so severe and the potential economic impacts so great, it is important that sovereigns, governments and corporations take action by securing risk financing and risk transfer, as well as making efforts to increase resilience, in order to become better prepared and able to recover when the worst happens.

The 1-in-100 year initiative being pushed by the United Nations, UNISDR and others, is perhaps a valuable platform to work on enhancing resilience to natural disasters and catastrophe events.

The initiative seeks to encourage corporations to report their 1-in-100 year exposure to catastrophes and weather events, with the desired outcome being that they are encouraged to take responsibility for their exposures.

Currently these exposures are not often quantified, leaving the impacts uncertain and the potential for an event to cause a major economic loss and perhaps close down the corporation or company greater.

By taking responsibility, buying insurance or risk transfer protection up to a certain level of return period, corporations, sovereigns and cities could recover more quickly, better protect populations and employees and increase resilience as a result.

The insurance capacity required to facilitate these efforts is significant and therefore the capital market investors in insurance-linked securities (ILS) and the catastrophe bond market would be required to assist.

In fact the catastrophe bond is already becoming an accepted sovereign disaster risk transfer tool, something which we foresee increasing in use as more countries seek to secure a source of efficient and rapidly paying post-event risk finance.

Two examples came to late just in the last week, with Mexico’s government revealing its intention to renew the MultiCat catastrophe bond in October, and the Philippines government said that it is targeting a $100m to $300m cat bond with the assistance of the World Bank.

These are great examples of sovereigns putting in place disaster risk transfer and sources of ILS capital that can respond quickly when the worst catastrophes strike, better enabling the recovery of each country.

S&P’s report looks at how sovereigns would respond to disaster both with and without insurance and finds that a “50% insurance coverage ratio would lessen the hit to growth by about 40% over 2016-2020 compared with a scenario without any insurance coverage.”

“We believe that the insurance industry’s reimbursement of insured losses accelerates the restoration of the damaged assets, especially productive capacity and infrastructure, which in turn reduces indirect economic losses in the period following the disaster. In absence of insurance coverage, the cost of reconstruction falls fully on property owners and their capacity to shoulder the reconstruction. As a result, the economy with higher insurance coverage recovers more quickly and suffers from lower cumulative GDP damage than in the absence of insurance coverage.”

“The benefits of insurance coverage can also be observed in a potentially lower adverse impact on public finances, with a 50% insurance coverage scenario resulting in weaker deterioration of government accounts, although not to the same extent as for growth trajectory. This is partly because following such an event, we expect the government to increase spending on public investment regardless of the share of insured losses in total losses. Insurance tends to cover private property rather than public infrastructure, therefore limiting the benefits to developments of public finance indicators.”

“The importance of catastrophe insurance is also significant for external indicators. That’s because assuming that the bulk of the ultimate risk is shouldered by internationally operating reinsurance companies, insurance payout-related capital inflows help offset a deteriorating current account balance and help finance capital stock restoration without the need for high external borrowing. Therefore, the higher the insurance coverage, the earlier economic recovery will ensue and the milder the impact on fiscal and, especially, external indicators.”

The report demonstrates the importance of insurance, risk transfer and the capital markets playing a key role in building the world’s resilience to disasters.

This key topic, which is expected to be discussed in detail at this years Monte Carlo Reinsurance Rendez-vous needs action. The insurance, reinsurance and ILS space, which are in search of new opportunities for deploying capacity, would be well-served by taking up this issue and seeking to create solutions to assist in this goal.

Read all of our Monte Carlo Rendez-vous 2015 coverage here.

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