Why ILS needs regional as well as line diversity – Clive O’Connell for Insurance Day

Geography can play an important part in providing diversity to ILS investors as well as providing protection against disaster where no protection currently exists

The storms of 2017 proved wrong the cynics who had doubted the resilience of insurance-linked securities (ILS). Investors did not flee at the first sight of a loss. Instead, and to the contrary, since the hurricanes, investment has not merely been replenished but has increased substantially. ILS has shown it can support insurers and reinsurers through crises. ILS, conceived after Hurricane Andrew in 1992 and developed after Hurricane Katrina in 2005, has come of age.

That said, ILS will and must continue to develop. The additional funds that have been received for investment must be invested and the historic concentration of funds in Gulf of Mexico risks cannot be sustained. Investors need more diversity of risk.

One means by which this is being tackled is by expanding the classes of business covered by ILS and products are being developed in cyber, marine and other areas. Class is not, however, the only diversifier available. Geography can play an important part, not just in providing diversity to investors but also in providing protection against disaster where no protection exists at present.

Protection gap

Most parts of the world are threatened by natural disasters. Many of these areas are in the developing world where insurance penetration is low. It is a general rule of economics that insurance develops behind the economy and this leaves developing countries exposed until such time as that gap is closed. Indeed, the gap that emerges as the economy grows places those countries in peril. A catastrophe could end their economic advancement.

Insurance solutions are not immediately available. It is not realistic to believe that insurance penetration can grow from 1% to 50% or so overnight. While micro insurance projects and other attempts to develop an insurance infrastructure are important, at least in the interim another solution is required.

This solution necessarily comes from the top down. It does not just apply to developing nations. Even the most advanced countries have a coverage gap. Hurricane Sandy in 2012 hit the most affluent and economically advanced area of the world and yet only 50% of the economic loss was insured.

When natural disasters hit, governments, whether local or national, are faced with a number of priorities. First, there is the need to provide shelter and food to those immediately affected. Second, emergency restoration of facilities is required followed by rebuilding of the affected area, ideally in a manner to make it resilient to future disasters.

Without protection, a government, with possible foreign aid, can manage the first priority but restoration of infrastructural services and rebuilding, let alone rebuilding on a resilient basis, will not occur. Without restoration and rebuilding, the developing economy in the region will collapse.

In contrast, the insurance claims payments and government funds that poured into the affected region after Sandy, helped to reboot the economy of a region that had been in the doldrums since the downturn of 2008. In other words, coverage can provide not only restoration of an economy but can accelerate it.

Without insurance penetration the only way to achieve this is for governments or quasi-governmental organisations to obtain the cover. As governments or their proxies do not own or have an insurable interest in much of the property that will have to be restored, insurance cannot be used. Another form of cover is required and the one most suited to the task is cat bonds.

Catastrophe bonds

One huge advantage of cat bonds over insurance is they will pay immediately on the occurrence of the trigger event. They do not require adjustment. Thus, money for emergency accommodation and food can be swiftly available. Rebuilding to resilient standards can commence immediately and the economy can be reactivated.

Of course, this could be achieved by governments using their own reserves. That, however, requires the establishment of such reserves and ear marking of funds in case of disaster. It may also leave a country vulnerable to multiple events. Cat bonds, on the other hand, allow the government to spread the economic burden over a number of fiscal years.

Where no insurable interest exists, indemnity triggers cannot work. Industry loss index triggers are also inappropriate as none exist. The only trigger that can be used is a parametric one. This has the advantage of allowing immediate determination of whether a loss is payable.

Disadvantages can stem from a lack of historic data, which can make risk modelling difficult. Although, with seismic and weather science and satellite imaging, a growing volume of reliable data does exist. These techniques can also assist in developing triggers that are wholly objective.

One issue that must be addressed is the role of government in disaster management and a potential “moral hazard”. If a government operates the sluice gates, it can influence what is flooded. Likewise, the utilisation of firefighting resources can be engineered to maximise recovery unless adequate safeguards are imposed.

The use of cat bonds as a protection to governments is growing and must continue to grow as it will help the world, particularly the developing world, become resilient to disaster and less reliant on overseas aid. At the same time, governmental ILS presents a new and diverse investment class to the growing body of capital that see ILS as a mature and attractive class.

Article originally published by Insurance Day and the full article can be read here.