Cat bonds & ILS an important part of the protection gap solution: S&P

The disparity between overall economic and insured losses post-natural catastrophe, as seen recently in both developed and emerging parts of the world, highlights the potential for greater participation and risk transfer from the insurance-linked securities (ILS) space, suggests Standard & Poor’s (S&P).

In a recent report, analysts at ratings agency S&P have underlined the potential for ILS structures and capacity to assist with closing the global protection gap.

As shown by the recent impact of hurricane Harvey in the U.S., hurricane Matthew in Haiti in 2016, and typhoon Haiyan which struck the Philippines in 2013, there’s a serious lack of insurance penetration for some of the world’s perils and in some of the most susceptible regions.

As a result, the protection gap (disparity between economic and insured losses post-event) is increasing in many parts of the world, ultimately leaving governments with the burden of refinancing and rebuilding efforts.

As an example, S&P reports that Matthew’s impact on Haiti resulted in an economic loss of $2.7 billion, with just $25 million (which includes a payment from the CCRIF SPC) being insured. Similarly, typhoon Haiyan caused economic damages of more than $13 billion, with just a small portion of this being covered by insurance.

While the actual economic and insured loss remains uncertain for hurricane Harvey, reports suggest that the economic loss could be more than $100 billion, with insurance covering around $25 billion, which, while an improvement on the ratio seen in Haiti and the Philippines, shows how the protection gap is a global issue.

Furthermore, reinsurance broker Aon Benfield put 2016 global catastrophe losses at roughly $210 billion, of which only 26%, or $54 billion was covered by some form of insurance protection.

“This difference is not limited to less-developed and developing countries,” says S&P.

Adding; “Cat bonds alone will not be able to close the protection gap, but they can be an important part of the solution to cover extreme events.”

Much of the catastrophe bond market is focused on U.S. wind risks, but in recent times organisations such as the CCRIF SPC (Caribbean Catastrophe Risk Insurance Facility) and the World Bank, for example, have issued catastrophe bonds to supplement their catastrophe risk transfer needs.

The use of a parametric trigger structure has enabled poorer, vulnerable parts of the world to obtain coverage for the impacts of cyclones and other extreme weather events in parts of the Caribbean, and more recently for the impacts of pandemic outbreaks, as seen with the World Bank’s Pandemic Emergency Financing Facility (PEF).

And while catastrophe bonds alone won’t be able to close the global protection gap, it’s an element of the expanding ILS space that can be utilised to cover some of the world’s peak exposures, in both developed and emerging parts of the world.

“Clearly, there is much more that can be done. Although we do not anticipate insurance being provided on an indemnity basis, capital market investors have been willing to provide protection on a parametric basis. The low level of insurance penetration does not necessarily mean the data used in modelling the risk is less robust,” says S&P.

The rating agency continues to stress that it does not believe the modelling process is perfect, and that models from companies with a certain level of gravitas in the natural catastrophe arena, and that are considered independent from the purchaser, would appeal to capital markets investors.

One area S&P highlights as having potential for catastrophe bonds and the broader ILS space to have an influence is in the U.S. flood market. Which, as shown by hurricane Harvey, lacks insurance penetration in many vulnerable parts of the country, especially in some coastal areas.

S&P and others have highlighted the potential for ILS to help close the flood protection gap in the aftermath of Harvey, owing to the potentially massive economic loss and significantly lower insured loss, alongside the pressure the event has put on the already stressed National Flood Insurance program (NFIP).

Regarding flood risk, S&P says; “Although the models are generally relatively new, at one time, so were the U.S. hurricane and earthquake models. Given the current construct of the executive and legislative branches, this could be the appropriate time to update the cost of flood insurance to better reflect the risk, as well as for the NFIP to cede it so taxpayers bear less of the burden.

“Given the appropriate return, investors would likely be interested in taking on flood risk.”

Increasingly, private and public-sector entities are collaborating on risk transfer as countries and regions look to improve resilience and recovery efforts in the face of natural disasters. Reports suggest events are to become more frequent and more severe in light of the changing climate, and as the risk landscape evolves, it’s likely that the entire risk transfer industry will be needed to meet the challenge.

“Now is a fitting time to expand the “peril universe” to capital-markets investors. There is currently a large amount of capital looking to be invested in non-credit-linked, diversifying assets. Pricing is as low as it has ever been. The risks are not going away and real risk transfer is desirable and achievable with the help of cat bonds, alternative capital, and traditional reinsurance,” concludes S&P.