EIOPA calls for ILS role in pandemic risk, but warns on correlations

Europe’s insurance and reinsurance sector watchdog, the European Insurance and Occupational Pensions Authority (EIOPA), has highlighted the potential role of the capital markets and insurance-linked securities (ILS) in risk transfer and reinsurance facilities to support pandemic insurance provision.

The Covid-19 pandemic has raised the issue of insurance coverage against such outbreaks and epidemics, with risks often lacking coverage, or coverage poorly defined and so work is ongoing around the globe to establish risk pooling facilities and backstops that can assist the insurance industry in providing a product that meets the needs of businesses and consumers when the next pandemic strikes.

EIOPA has published a new paper looking at how shared resilience solutions for pandemic risk can be developed, with the support of industry, private markets and the government as well.

The organisation calls for “skin in the game” from all parties, public and private, to ensure alignment and capacity is available for the size of the pandemic threat that Covid-19 has now made clear.

“Private insurance solutions alone will not be sufficient to protect society against the financial consequences of future pandemics. Solutions will require both public and private sector involvement,” EIOPA explains.

Highlighting the importance of four key elements, risk assessment, risk prevention and adaptation measures, appropriate product design, and lastly risk transfer.

It is risk transfer where the insurance-linked securities (ILS) market comes in, with the capital markets seen as one supportive source of reinsurance capacity to underpin any pandemic resilience solution.

EIOPA’s paper details a range of options for deploying pandemic insurance coverage, including ideas around parametric triggers and index-based protection.

It also details how the public and private sectors can work together to provide a better risk transfer and product delivery framework for pandemic risks, underpinned by reinsurance capacity sourced from all sides.

EIOPA consulted with the insurance and reinsurance industry on its paper and finds that the capital markets role could be critical in diversifying risk away from re/insurers.

As a positive, the paper states, “Alternative risk transfer mechanisms, modelled as insurance linked securities (e.g. nat cat bonds) can provide a layer of risk transfer and diversification in addition to (re)insurance solutions.”

But it also highlights the challenge with large systemic risks such as pandemics and how they can correlate with capital market movements, making ILS solutions sometimes less viable.

“Pandemic risks with a large business interruption component may prove to be correlated with traditional financial markets. The experience of natural catastrophes bonds may therefore not apply in creating a pandemic risk solution. The use of special-purpose vehicles through which reinsurers cede premiums associated with a book of business to investors may suffer the same challenges as any investment when the economy slows down and diversification effects disappear. Industry loss warranties, based on industry loss experience instead of insurer-specific losses, may allow for diversifying risks across sectors. However, insurance linked securities (ILS) are complex and expensive to structure, more so than conventional insurance,” the paper from EIOPA says.

A role for the capital markets in providing reinsurance capacity to underpin pandemic risk facilities seems assured, with parametric triggers likely the most suitable solution to ensure any payout is as closely tied to experience (rather than financial losses) as possible.

While correlation is certainly a consideration, many believe the capital markets would have a significant appetite for pandemic risk if ILS or catastrophe bond like instruments were structured in the right way.

As we explained last week, the CEO of Hannover Re said that investors could support up to $2 billion of capacity to back pandemic catastrophe bonds.

Gabriel Bernardino, Chairman of EIOPA, commented, “It is of the utmost importance not only to have a debate about how our society can better react to future disruptive events such as Covid19 but also to come up with a way forward. While it is clear that insurance cannot cover the full costs of pandemics, insurers and reinsurers should be part of the solution and not part of the problem. Furthermore, I strongly believe that shared resilience solutions can play an important role in mitigating economic fragmentation throughout the European Union and should be part of the recovery efforts towards a European Union that protects its businesses and its citizens.”

Other proposals are undergoing scrutiny in the United States, including the legislative proposal for a Pandemic Risk Insurance Act (PRIA) reinsurance backstop, the industry association-supported Business Continuity Protection Program (BCPP) and the most recent addition of Chubb’s proposal that includes parametric pandemic insurance coverage for small to mid-sized businesses.

All of these are likely to require capacity from multiple sources, private and public, insurance or reinsurance industry and capital markets, to become fully viable risk sharing and backstop solutions.