Sovereign Parametric Catastrophe Bonds as means to address the protection gap in emerging countries

Summary
  • Of the $232bn. of economic losses from natural disasters in 2019, only $71bn. was insured.
  • 35% level of catastrophe risk coverage in advanced countries downsizes to only 6% in emerging economies.
  • Out of existing disaster risk finance arrangements, the Sovereign Parametric Catastrophe Bonds seem to be the most viable instrument for the ECIS region.

As mentioned by AON in their Weather, Climate & Catastrophe Insight: 2019 Annual Report, last year brought $232 billion of economic losses from natural disasters, whereby only $71 billion was actually insured. It outlined that the world continues to face a fundamental issue of insurance gap, especially in emerging and developing countries, where losses for businesses and governments are only increasing following a decade-long rise in natural catastrophes linked to climate change.

Protection gaps exist in both emerging and developed markets. However, with Swiss Re estimating 35% level of catastrophe risk coverage in advanced economies versus 6% in emerging economies, the issue is far more important for the developing world, where the cost of disasters is not just measured in the deaths and injuries that they cause, but also in their long-lasting economic impact on survivors and countries. Natural disasters there do not just destroy homes, factories, shops, and fields; they can altogether annihilate years of economic growth, which is essential for the low and mid-income countries.

These governments need new ways to increase their access to finance to enable disaster response, recovery, and rebuilding. Ideally, such features should also help make financial systems more predictable and stable, so to be able to avoid or lessen inevitable shocks to the economy in case of devastating events.

Disaster relief aid, as the most obvious tool, is very reactive by its nature, pledged only during and after the event, and the amount generated is unpredictable. Pledges made can also be slow to materialize, with examples of payments taking months or even years.

The role of insurers in the emerging economies focuses mainly on the reconstruction of private assets, which reveal another important issue when (in many cases) critical infrastructure remains in direct state ownership, so exposed to the lack of insurable interest. For example, this is very much the case for Eastern European and CIS countries where insurance penetration of 0.5-1.5% is not allowing to count on the industry at the macro level.

In addition, there are other barriers to stimulate the growth of risk transfer in the developing countries when the state, instead of its retention, arranges a transfer of disaster expenses to third parties. Typically, there is no mature domestic insurance market to leverage and heavy (re-)insurance protectionism in some places. Nor are there sufficient government resources to fund sovereign backed insurance schemes.

When disaster strikes, immediate steps need to be taken to protect survivors and provide them with temporary shelter and emergency food and clothing. In the medium and long term, homes need to be rebuilt, places of employment and local infrastructure reconstructed. Ideally, this to be done in a manner that is resilient to future disasters. All this cost money. For this reason, issue of disaster risk finance, especially when it comes to post-event response, plays vital role for developing economies across the globe.

Mobilizing relief efforts quickly after a disaster can limit long-term economic losses but, unfortunately, many developing countries have limited access to finance for immediate response.

That is why, over the last decade, it made numerous international frameworks and political bodies, including the Paris Agreement, the Sendai Framework for Disaster Risk Reduction, and G20 as well as multilateral organizations like UNDP and International Financial Institutions to develop financing mechanisms to assist developing countries to cope with disasters.

Financial markets, governments, and the development community have introduced important innovations in disaster risk finance, giving rise to new or improved funding sources to respond and recover after disasters strike. Given the urgency and scale of the challenges developing countries face, pressures to scale up both categories of disaster risk finance are intense.

For post-disaster emergency financing, these innovations include development of national disaster funds, regional pooling schemes with the use of parametric solutions, contingent credit lines and solutions from Insurance-Linked Securities market, especially Parametric Catastrophe bonds, which, if well structured, can pay out almost automatically when disasters hit.

Through issuance of parametric sovereign catastrophe bonds, governments could access revenue streams that can finance timely shelter and support to victims and then set about rebuilding in a resilient manner.

Such instruments also allow a government to spread the cost of disaster response and prevention over several fiscal years, rather than creating a massive demand for funds in one particular year when the disaster occurs. In addition, as the money will flow from international financial markets, it will create a positive macroeconomic boost to the economy of the whole country and reduce dependence on foreign aid.

Use of the catastrophic bond mechanism also can help in effective solution for two important issues within emerging countries: addressing the “protection gap” on the macro level and dealing with low insurance penetration.

Given the successful track record of issuing and maintaining processes, as well as established mechanisms for triggering and pay-outs, this type of protection is now used with increasing frequency by single states and regional pooling schemes in different parts of the world.

Any developing government, which may consider disaster risk transfer in the form of parametric catastrophe bonds, will benefit from a number of objectives like guaranteed access to funds for recovery (up to agreed limits and in case of well-defined transparent trigger), budget planning certainty, no payback obligation and diversified source of funding to cope with the impact of natural catastrophes.

These are some reasons why the 2020 World Economic Forum (WEF) focused on responses to humanitarian risk by investigating areas where catastrophe bonds may prove valuable tools for risk sharing with private markets and investors raising catastrophe bonds and risk transfer to private or capital market investors as a key route towards sharing (transferring) risks.

Regional points for CEE, ECIS, and BRI transit countries

During only 2005-2014, the region of Eastern Europe and CIS alone suffered 314 disasters, resulting in more than 60,000 people killed, 11 million affected, and $25 billion worth of damage.

The region always had a big exposure to natural catastrophes whereby earthquakes in Almaty/Kazakhstan (1911), Ashgabat/Turkmenistan (1948), Tashkent/Uzbekistan (1966), Bucharest/Romania (1977), Vrancea/Romania (1986) and Spitak/Armenia (1988) almost destroyed respective places and 2014-2016 Balkans floods brought 5-15% damage to GDP of affected nations.

Unfortunately, with the world deadliest earthquake of 2019 near Tirana/Albania and 6+ magnitude events in NW China and East of Turkey – all happened just over last two months – strong reminders of constant exposure can be seen virtually in the live mode.

There is, in the region, a dearth of solutions available for Disaster Risk Finance in the short to medium terms due to some unique local historical, geopolitical, and economic factors. Challenges to be addressed include legislation, regulations, institutional capacity, culture, trust, and the size of the country/regional market to make it viable/attractive to the private sector.

One solution might be the creation of National Disaster funds. This, however, could be problematic due to existing tax, legislative, and regulatory frameworks. The time required for changes to this framework across the region is likely to be lengthy as a result of other national priorities.

Contingent Credit lines with international organizations, while attractive, can run into issues due to the low sovereign credit rating.

Sovereign Parametric Insurance schemes (potentially developing into regional pooling arrangements similar to CCRIF SPC, ARC or PCRIC) face the problem of extremely low insurance penetration (below 1.0-1.5% across ECIS countries, with only Kazakhstan and Turkey around 2%) and overall geopolitical and even religious fragmentation between the countries of the region. The time required to increase insurance penetration is simply too long.

In the meantime, if there is to be a solution that benefits everyone for the peak exposures, it will probably have to be organized by the government in the form of a Disaster Risk Transfer instrument, ideally combining best practices and lessons learned from other regions with a simple, clear and effective working mechanism.

So, out of potentially available instruments, the transfer of sovereign disaster risks for large events to capital markets in the form of Parametric Catastrophe Bonds seems to be pragmatic and possible to introduce quickly in the ECIS region.

Another three specific regional factors include Belt & Road Initiative, Investors’ perception, and recent success of new ILS domiciles, i.e. Singapore success story.

With different possible connotations around the world, Chinese Belt & Road Initiative is probably the largest infrastructural project in the modern history, which plays a vital role in its neighboring and transit countries.

Presuming investments of billions of dollars going into critical infrastructure, the initiative is seen by transit countries as an important opportunity to expand their international trade and give a boost to the own and regional economies.

However, with key transport corridors passing through countries of CIS and Western Balkans, the thread of devastating natural disasters takes on new dimensions. Especially with such corridors passing through the most earthquake-exposed territories of Eurasia, if not the world.

The issue of infrastructure protection in case of large disaster remains open, and post-disaster finance arrangements raise a big question mark. Especially in cases relating to the potential of contingent business interruption losses, whereby an earthquake in Central Asia, Turkey or Western Balkans may stop the whole corridor to operate for significant amount of time.

Other important factors in favor of potential sovereign cat bonds in the region are Singapore’s recent endeavors in ILS sphere thus boosting the concept for Asia and intra-class diversification for investment portfolios.

Recent Singapore’s success in becoming ILS center in Asia was proved by the issuances of several bonds in 2019, including noteworthy $225 mil. transaction for the government Philippines for earthquake and tropical cyclone exposures for 3 years.

The stable appetite for ILS as uncorrelated asset class that institutional investors experience is concentrated on North American exposures. There is, therefore, a potential for intra-class diversification, and any new territory, especially the one yet be explored, shall attract big interest from investors’ circle as these options bring significant diversification element into their existing allocations/ILS portfolios.

Also, generally speaking, the overall performance of the ILS as asset class over the COVID-19 market volatility showed its bespoke value for uncorrelation purposes whereby it acted as almost defensive assets with only insignificant outflow in catastrophe bonds but only as investors were looking to free some resources to use in other affected areas.

So, there are no doubts that having ILS in the portfolios and different strategies will allow any asset manager to have some pure liquid and uncorrelated allocation.

This article was first published 17th June 2020 on Seeking Alpha

Text by Kirill Savrassov is CEO of Phoenix CRetro, a Bermudian ILS specialists focused on ILS solutions for Central Europe, ECIS and BRI transit countries.

E-mail: k.savrassov@phoenix-re.co.uk