On catastrophe bonds for Chinese earthquakes

There has been some discussion of the potential for catastrophe bonds in China for transferring earthquake risks to the capital markets ever since the 6th Annual European Insurance-Linked Securities Conference, held by rating agency Standard & Poor’s in London last week. We attended the event but have only now had time to write down our thoughts on this topic to add to the discussion about whether parametric earthquake cat bonds will come to China anytime soon.

As we’ve written many times, China is experiencing rapid development, growth and expansion and as a result insurance penetration is sure to rise rapidly alongside growth. This will create a massive market for property insurance, meaning that there will be a need for considerable reinsurance capacity to support the nascent insurance industry and also considerable retrocession capacity to allow reinsurers to offload the risk they cannot afford to hold onto. Couple this with a country that has significant exposure to natural hazards in the forms of earthquakes, typhoons, floods, hail and snowfall and you can see that there is certainly a need for innovative mechanisms to assist with the transfer of risk.

Given the scale of the modernisation, development and construction, coupled with the huge population within China it is fair to assume that the amount of insured exposures in the country could one day eclipse the U.S. making it the largest insurance market in the world (that is some way off however, approximately 2050 according to the panelists at the event). This means that the reinsurance capacity required to adequately cover the exposures could be far more than the global reinsurance market capacity could support. Naturally this suggests that the capital markets could have an opportunity to step in and provide capacity for reinsurance and retrocession cover within China and given that the risks and exposures will be relatively high the premiums offered for taking on natural catastrophe risk in China are likely to be very attractive to capital market investors.

So, the discussion at the S&P event in London was on the topic of Modelling Catastrophe Risk in Non-traditional Markets. The panel was asked to look at Chinese earthquake risk specifically, discuss the methods their risk models for that peril employed and look at where the exposures were highest. Panelists from all three of the major risk modelling firms, EQECAT, AIR Worldwide and RMS, were in attendance.

The general consensus was that we are now at a stage of development with risk models and the availability of earthquake data in China that it is feasible for someone to bring a parametric catastrophe bond to market to offload China quake risk to the capital markets. While issuance of a China earthquake cat bond is now feasible the question is who would issue that, as insurance penetration is still very low, domestic re/insurers are unlikely to be the first and foreign reinsurers are still building capacity in the country.

The panel suggested that a sovereign bond was likely the first way that a catastrophe bond market could develop in China. Currently the Chinese government would be on the hook for reconstruction costs and disaster recovery should a major quake strike one of their many large cities. By issuing a parametric trigger cat bond the Chinese government could finance this risk via the capital markets, something that could be very attractive given the discussions of a potential hard-landing in the Chinese economy right now.

In the future, as insurance penetration rises, earthquake insurance cover becomes more common (it is optional in China right now) and foreign reinsurer activity increases in China, the likelihood is that we will see some participation from the capital markets in risk transfer of Chinese natural catastrophe risk. It could be some way off though, as there are concerns over issues such as data quality, transparency from the organisations controlling earthquake data in the country (although the USGS is an option for a parametric quake cat bond) and construction standards. A major quake in a large Chinese city could cause upwards of $50 billion in economic losses at any time and at that size of risk once insurance penetration catches up the capital markets becomes a natural fit for the risk.

Interestingly, Nikolaus von Bomhard, chief executive of Munich Re, is quoted in the Financial Times here as calling on China to create a public-private partnership to help protect the population and their businesses against earthquake risks in the country. Mr. von Bomhard told the FT that China currently only has about 5% earthquake insurance penetration on commercial property policies, a very low figure. Swiss Re had estimated recently that a major Chinese quake could cost $157 billion but only a very small amount of that would actually be insured. von Bomhard said that the awareness of catastrophe exposures needs to be increased in Asia and that Munich Re think that a public-private partnership to cover earthquake risk was required. As an example the Sichuan quake in 2008 which caused around $85 billion in economic losses only resulted in $300m of insured losses due to low insurance penetration.

A national earthquake insurance pool proposal was approved in China back in 2003 but no progress has as yet been made on turning the idea into a reality, according to the Asia Development Bank. The FT article uses examples such as the Earthquake Commission in New Zealand as a good example of a scheme which covers the majority of any earthquake losses.

A public-private Chinese earthquake pool could even be financed through the use of parametric triggers or indices and then financed by capital market investors, to enable the government to offload the risk as well. Alternatively an insurance pool could be established and then the government could enter into a MultiCat type catastrophe bond with the support of the World Bank and a major reinsurer.

There are solutions available for Chinese earthquake risk and the data and modelling is certainly ready to support some kind of parametric earthquake cover. Whether that gets transferred to the capital markets is as yet uncertain and another question would be around how high the coupon to investors might need to be in order to get them to commit capital to such instruments. Given the projections which suggest that the Chinese insurance market will become the world’s second largest by 2020 and could become the world’s largest by 2050, it seems inevitable that catastrophe bonds and the capital markets will find a role to play in transferring natural catastrophe risk.

Here are a few other articles we’ve written discussing the potential for catastrophe bonds in China in recent years:

– Asia’s growth economies face highest financial risk from natural disasters

– Catastrophe bonds in China, some discussion on their feasibility

– Urgent need for more natural catastrophe coverage in China

– New RMS China Typhoon Model could help facilitate insurance-linked securities

– China now considering issuance of catastrophe bonds

– Shanghai plans insurance exchange, to include securitization of risks

– China in need of a catastrophe pool; a good fit for catastrophe bonds?

Read our other article from Standard & Poor’s 6th Annual European Insurance-Linked Securities Conference – A capital market for longevity risk is not far away