ILS & cat bonds can be a socially responsible investment: Mercer

by Artemis on December 22, 2015

Insurance-linked securities (ILS) and catastrophe bonds as an asset class can increasingly provide  sophisticated investors with a new type of responsible investment, creating another attractive angle to the investment case for ILS, according to Mercer.

ILS and catastrophe bonds as responsible investmentsILS and insurance or reinsurance linked investment instruments, such as catastrophe bonds, ILS funds and sidecars, tend to attract institutional investors based on their stable return profile over the longer-term, the diversification aspects and the low correlation between many insurance and reinsurance risks, particularly catastrophe and weather risks, with broader financial markets.

However, increasingly some investors are looking to the ILS market as a new socially and societal responsible investment category, as an asset class that provides essential disaster risk capital after major impactful regional catastrophe or weather events, enabling a greater ability to recover from disasters.

Here at Artemis we’ve long extolled the virtues of catastrophe bonds for disaster risk financing and to transfer the risks of catastrophe away from governments, cities and people, into the capital markets where the depth of capital exists to bear these exposures.

Global investment service provider and advisory Mercer discussed this trend recently, highlighting that as the ILS, catastrophe bond and insurance or reinsurance linked asset class develops, the frontiers of the market are becoming increasingly appropriate as responsible investments.

Mercer notes that even the core of the ILS market could be thought of as an investment that provides social benefit, giving the example of a Floridian primary insurance company sponsoring a catastrophe bond as part of its reinsurance protection.

Even in this case, where investors are providing capital to protect a for-profit insurance or reinsurance firm, the social angle exists. These sponsors require access to capital post event in order to maintain cashflow liquidity and to pay their claims. After the very largest catastrophes occur, the social benefits that a cat bond payout could eventually pass on to the insured customers in a region could be tangible.

The catastrophe bond market came into being as the traditional insurance and reinsurance market was felt to shallow and illiquid to provide the level of capital required after the very major peak catastrophes occurred. Hence the capital markets were targeted, securitisation adopted as a mechanism of risk transfer and the ILS market came into being.

The socially responsible undertones existed back then, as insurers and reinsurers realised the need to tap the capital markets to ensure claims paying ability after the very largest catastrophes. To a degree, that ethos perhaps got a little lost as the asset class grew, particularly so as the very soft reinsurance market emerged, making the capital markets seem less essential and more of a complement or diversification.

But now, as the ILS and cat bond market shifts its focus to issues such as the insurance protection gap, underinsurance and covering corporate risks which have previously lacked insurance, the social benefits are once again coming to the fore.

Mercer highlights some of the emerging market risk pooling initiatives, which provide much-needed disaster recovery capital and even encourage sovereigns to increase their resilience to risks, as examples of the ILS markets increasing responsible investments angle.

Sovereign risk pooling insurance providers, such as the African Risk Capacity (ARC), the Caribbean Catastrophe Risk Insurance Facility (CCRIF), PCRAFI in the Pacific are all examples of initiatives needing growing amounts of reinsurance capacity, some of which can be provided by ILS market investors.

In fact ARC has already seen involvement from some ILS markets on a collateralised reinsurance basis in its excess of loss reinsurance program and the CCRIF sponsored a catastrophe bond (World Bank – CCRIF 2014-1) with the help of the World Bank, enabling some ILS investor capital to begin to access these responsible and resilience focused insurance programs.

Additionally, Mercer highlight the MultiCat Mexico Ltd. series of catastrophes bonds, the latest of which of course is assumed destined to make a payout, as another example of ILS investments that fit the responsible investment strategy.

Mercer also believes that as microinsurance schemes around the world grow, providing much-needed access to insurance to some of the poorest communities, the need for reinsurance cover will increase and the ILS market and perhaps even catastrophe bonds can ultimately play a role there as well.

The other area Mercer highlights is the need for cover to be made available for risks that historically have been difficult to insure, or not insured at all, such as flood risks, municipal and other sovereign risks. By providing capital to back risk transfer for such insurance needs, the ILS investor community can become providers of much-needed risk capital to protect growing areas of society.

“Finding ways to transfer such risks is important to the fiscal sustainability of public entities, citizens and businesses,” Mercer notes. “It also represents an attractive business opportunity for the burgeoning ILS asset class.”

One area Mercer does not mention is the growing push to leverage the catastrophe bond structure alongside infrastructure projects, to create the resilience bond that has received so much coverage in recent weeks.

This could create a whole new dimension to the ILS asset class, giving investors access to a securitised investment opportunity that provides clear social benefits in terms of helping cities, governments and perhaps even companies to increase their resilience to natural disasters and severe weather events.

Then there is also the ARC initiative to create climate catastrophe bonds, the XCF or Extreme Climate Facility. This multi-year funding mechanism that aims to access private sources of capital and to diversify the sources of funding available for climate risk financing.

The XCF is expected to be structured as a catastrophe bond program, with clear trigger linkages to climate factors and so will provide the same portfolio benefits as other cat bonds and ILS investments, but with a clear responsible investment angle that could prove extremely attractive to large institutional investors.

Mercer believes that ILS investors could actually speed up the transformation of the asset class into more of a responsible investment opportunity.

Investors could “sit on the sidelines and wait for the market to develop organically,” Mercer offers, or they could take a more “activist position” by engaging directly with stakeholders on issues related to climate, disaster and weather risk, explaining their willingness to be risk capital providers and the opportunity that stakeholders have to take advantage of the ILS wave.

Mercer also highlights that by providing climate and weather risk capital to stakeholders investors may actually be helping themselves, as typically their portfolios contain significant risks due to the physical impacts of climate change and weather or disaster risk.

“For those investors committed to RI [responsible investments], the frontier of the ILS market could potentially be widened as a means of strengthening individual entities – and society at large – against shifting catastrophe and weather risks,” Mercer explains.

As ILS focuses in on responsible investing it could serve to both increase the appeal of the asset class for investors and also to broaden the appeal, introducing ILS investments to new investors and attracting investors specifically seeking responsible investment opportunities.

The insurance and reinsurance industry itself also has a lot to learn about promoting the benefits its core product range provide to society.

The transfer and financing of risk is key to a healthy future for society and our world as a whole. As a result the re/insurance industry and investors willing to back ILS products are needed to help society become more resilient and better able to recover from the risks it faces.

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