Growing flood gap a “catalyst” for ILS: Franklin Templeton

Global investment firm Franklin Templeton has released a new report that examines the growing role of insurance-linked securities (ILS) in alleviating flood risk, particularly in the US where the financial burden on FEMA and the Treasury seems to be increasing every year.

Penned by Jonathan Malawer, Head of ILS, Commodities & Environmental Strategies at Franklin Templeton’s K2 Advisors business, the report notes that ILS and catastrophe bonds are gaining traction globally as potential solutions to the financial risk posed by flooding.

Specifically, Malawer notes that the appetite for alternative ways to transfer flood risk is growing in response to the increasing frequency and severity of flood events.

K2 Advisors attributes the heightened threat to rising global temperatures and sea levels, which may be contributing to cyclone-related inundation and storm surge, as well as inland riverine flooding.

“Going forward, we anticipate the increasing frequency of flood events, like Harvey in the United States, Hagibis in Japan, or Idai in Africa, will accelerate the development of the private flood market,” said Malawer.

“More efficient risk pooling and risk sharing mechanisms will help to alleviate financial flood risk exposure. Clearly there exists a meaningful gap between potential economic loss and insured loss, and this gap will likely widen with climate change and rising sea levels. This will be a catalyst for the ILS market, as consumers seek efficiently priced coverage for their risk exposures.”

With trillions of dollars in capital worldwide, Malawer asserts that there is clearly enough liquidity to meet the flood risk challenge, in terms of reinsurance capacity to support it, but the difficulty arises in how that capital base is accessed.

“Moving flood perils from government pools to private insurers will be a slow evolution,” he noted. “It will take time, particularly if existing coverage is subsidized.”

The transition, however, has already begun, with the US Homeowner Flood Insurance Affordability Act of 2014 representing one major landmark in the shift.

This Act enabled FEMA to enter its first transfer of NFIP risk through an ILS transaction in August 2018, when it transferred $500 million of flood risk to the capital markets by sponsoring issuance of an indemnity-triggered cat bond to secure reinsurance capacity.

And more recently, after witnessing the significant impact of Hurricane Sandy in 2012 on its subway system, the NYC Metropolitan Transportation Authority (MTA) issued a cat bond.

The MTA chose a parametric mechanism that triggers payments when storm surge reaches a particular water depth at select measurement stations around New York Bay, and which is designed to provide a cash influx of $100 million in the latest 2020 issuance.

“We’re seeing a growing market for these instruments in the United States and globally,” said Malawer. “As these events become more common and destructive with climate change and sea level rise, we expect the market to grow.”

The Franklin Templeton report also anticipates that the ILS market for flood risk will be boosted by new investors in the coming years, as environmental, social and governance (ESG) considerations are more widely adopted by the insurance, reinsurance and ILS industry.

But the private market still has a long way to go to improve the state of the flood market in the US.

For example, a recent study from flood risk analytics specialist KatRisk LLC and actuarial consultancy Milliman Inc. showed that 69% of metropolitan areas in the United States have 90% or more of their expected flood losses uninsured.

And as sea levels rise, total storm surge losses in these areas may increase 21% by 2050.

In terms of cost, flood losses to single-family residences could be upwards of $7 billion annually, with more than 87% of those costs uninsured by the NFIP.

If private flood insurance data were included, this estimate would only marginally decrease due to the small size of the residential private flood market relative to the NFIP.