Even as countries across the globe grapple with climate change, alternate risk transfer mechanisms like parametric solutions are emerging as the best option. A parametric transaction uses the physical characteristics of a catastrophe event as the trigger. A catastrophe bond (CAT) is a high-yield debt instrument that is designed to raise money for companies in the insurance industry in the event of a natural disaster. A CAT bond allows the issuer to receive funding from the bond only if specific conditions, such as an earthquake or tornado, occur.
According to a PwC report, the insurance protection gap could reach $1.86tn by 2025 and Asia Pacific could account for nearly 50% of all uninsured risks.
Aon’s Weather, Climate and Catastrophe Insight has pegged economic losses in 2021 at $343bn, of which only $130bn were insured, leaving the global protection gap at 62%.
However, these figures do not tell the true story. The US contributed 71% of the total insured losses and it is an economic superpower that can support communities through government-backed disaster relief. Developing countries do not enjoy this luxury and the maximum impact of disasters is often borne by the most vulnerable communities themselves.
Hazard, exposure and vulnerability
While discussing natural disasters, it is important to focus on three areas – hazard, exposure and vulnerability. Hazard refers to the perils to which we are exposed. Exposure looks at things like population density in highly exposed areas and vulnerability looks at how well a country can cope with the occurrence of a disaster.
Tokyo is one of the most exposed cities with respect to earthquakes and it has also the highest GDP in the world. This combination significantly increases its vulnerability. However, Japan has some of the best early warning systems and strictest building codes to ensure that critical infrastructure can withstand severe events.Kirill Savrassov, chief executive Phoenix CRetro
California, a highly exposed state of the US is, however, underprepared for a large earthquake akin to the one that occurred in 1994. If the US, a country with one of the highest insurance penetrations, is underprepared for natural disasters, where would developing countries be?
The UN Office for Disaster Risk Reduction has said that a well-conceived emergency preparedness and response strategy not only saves lives and protects critical infrastructure, but also contributes to post-disaster recovery by lessening the impact of the disaster in the first place.
It is estimated that for every $1 spent on disaster preparedness it will save $4.40 in ex-post disaster relief measures carried out six months post-event.
The focus is now on how natural catastrophe risks can be transferred to financial markets for disaster relief in emerging markets. The parametric CAT bonds market has gained momentum in recent years.Urs Ramseier, Twelve Capital founder
As climate change leads to increasing numbers exposed to, and uninsured for, natural disasters, financial markets will have to play an important role to lower the protection gap.
Hybrid risk transfer mechanisms
Parametric catastrophe bonds are a hybrid insurance and capital market instrument that are being used by sovereign nations and risk pools to speed up the claims payment process and increase the transparency of risk transfer.
A parametric product works on an IF:THEN basis. If wind speeds or an earthquake magnitude surpass a certain threshold, then the purchaser will receive a pre-defined payout amount. Governments currently using these products include the Philippines, Mexico and Jamaica, and there is great potential for other countries or sovereign risk pools to use them too.
Catastrophe bonds are specialised instruments but the level of knowledge outside the community is still limited. In order to broaden their use, better education and awareness is required, both at a private and public level.
Once the beneficiaries are comfortable with the product, they can utilise innovative grant schemes to sponsor catastrophe bonds at very affordable rates. Hong Kong has set up a two-year ILS grant scheme which covers up to 100% or HK$12m ($1.53m) of the upfront issuance costs, making it an appealing place for those looking to transfer climate-related risk to the capital markets.
According to Global Insurance-Linked Securities Market Outlook, the ILS market ended another year on a high note as the annual new issuance record was broken once again. The higher volume of new issuance in the year also contributed to the growth of the market as a whole. The notional outstanding at the end of 2021 stood at USD 33.8 billion and for the second straight year, 2021 new issuance outpaced scheduled maturities. Since the end of 2012, the catastrophe bond market has achieved a Compound Annual Growth Rate (CAGR) of 9.4%.
Parametric insurance or parametric risk transfer is a type of insurance, reinsurance or risk transfer arrangement that does not indemnify the full loss for the protection buyer.
Catastrophe and green bonds in the private sector have become the most prominent innovations in the field of sustainable finance in the last 15 years. According Sovereign Climate Debt Instruments IMF`s Report, the issuance of these instruments could provide an additional source of stable financing with more favorable market access conditions, mitigate the stress of climate risks on public finances and facilitate the transition to greener low-carbon economies. Emerging market and developing economies stand to benefit the most from these financial innovations.
China and natural catastrophes
China is another region that is highly exposed to multiple perils. Rapid economic growth and increasing impact of climate change are increasing China’s vulnerability to natural catastrophic events.
China experiences several meteorological disasters every year. Around seven cyclones hit the east coast annually and as the country lies between critical tectonic plates, it also suffers frequent earthquakes. Although the damage and losses as a percentage of GDP are relatively low, the most vulnerable groups are often disproportionately affected.
China recently benefited from a parametric insurance payout after heavy rains impacted 16 cities in the Guangdong province. The programme began in 2016 and has now expanded to a cover of $350m for tropical cyclones and excess rainfall.Toby Pughe, Insurance-Linked Securities (ILS) Analyst Tenax Capital
According to the provincial emergency management department of Guangdong, the extreme weather has affected nearly 480,000 people, destroyed more than 1,700 houses and caused direct economic losses of CNY1.76bn ($260m).
Questions arise over whether China is prepared for more severe events. The floods in 1998 damaged 21.2m hectares of crops, 6.85m houses and took a toll of 4,150 lives. These caused economic losses of more than $35bn. In 2008 the 8.0 magnitude Wenchuan earthquake caused 70,000 deaths and economic losses of more than $159bn.
The speed of payments released via parametric instruments is critical in ensuring that vulnerable groups get back on their feet faster. The importance of building-back-better should also not be overlooked, since large-scale disasters also have an impact on the broader economy.
Pilot scheme in Henan province
Henan province in central China has also launched a pilot scheme for catastrophe insurance in the wake of the massive floods in July 2021 that cost the province economic losses in billions of yuan.
On 28 June 2022, Henan officials issued the ‘Guiding Opinions on Carrying out the Pilot Work of Catastrophe Insurance’ covering catastrophes such as rainstorms.
The first batch of cities selected for the trial scheme were the hardest hit by historic floods in summer of 2021 and are seen to have the highest risk of damage from rainstorms and floods. The coverage of the catastrophe insurance programme would be expanded to the whole province gradually.
The pilot disaster insurance scheme provides protection against rainstorms, floods, and the resulting geological disasters resulting in the deaths of individuals or missing persons and housing damage or collapses.
The scheme allows selection between two options: Indemnity or parametric insurance. In the latter case, insurance payouts will be made if the cumulative rainfall is at least 150mm over three consecutive days.
The Henan’s opinions also state that local governments are responsible for coordinating, establishing and improving the province’s catastrophe insurance working mechanism, and providing support in the promotion and implementation of catastrophe insurance, disaster prevention and mitigation to prevent and resolve economic losses caused by major natural disasters.
Local governments in typhoon-prone areas on the Chinese coast have taken on catastrophe insurance, but such insurance is largely still in its infancy in China, partly due to a lack of a central government push.
Countries exposed to natural disasters will never be able to eliminate the hazard element of risk and unless communities move away from disaster prone areas. They will also not be able to reduce their exposure. However, through innovative risk transfer instruments they can reduce their vulnerability to the catastrophic events by transferring their risk more efficiently to capital market investors.
A catastrophe bond is a debt instrument that allows the issuer to get funding from the capital market, if and only if catastrophic conditions, such as a hurricane, occur.
Climate change is expected to increase the likelihood and severity of these extreme weather events. Although the two instruments are of different nature, this paper analyzes them together given that both of them can contribute to the resilience to climate risks and have been recently issued at the sovereign level.
These innovative finance instruments allow policymakers to tap wider capital markets for the financing of Sustainable Development Goal–related projects (green bonds) and mitigate the stress on debt sustainability after natural disasters (catastrophe bonds). Thus the financial industry is becoming increasingly important in accelerating the transition to sustainability and carbon neutrality.
Despite new sponsors entering the field, the life and health ILS market remains relatively small with less than 5% of outstanding cat bonds today covering mortality or morbidity perils. Looking ahead, Capital Markets is optimistic that offering pandemic risks will be an area of growth for the ILS market driven by increased risk awareness.