Bridging the capital efficiency gap


There’s vast potential for the re/insurance sector to help firms, governments and countries de-risk their balance sheets, says Andy Marcell, CEO of Aon’s Reinsurance Solutions business.

According to Aon’s Impact Forecasting team, there were an estimated 156 natural disaster events globally during the first half of 2018. Not one of these events was classified as a ‘mega catastrophe’ – an event that causes economic damage beyond $10bn – yet there were at least 15 separate billion-dollar events, all of which were weather-related, except for one earthquake event.

The cost of these events to the global economy was estimated at $45bn, with insured losses estimated at $21bn. While these figures were considerably less than their medium and longer-term averages, it is immediately clear that there is a huge disparity between the risks countries face, and the insurance put in place to cover those risks.

One might expect that this insurance protection gap would be confined to the less mature insurance markets, yet even in the US and EMEA, the gap can be significant, especially in individual lines and perils, such as flood. The charts below provide a quick overview of the prevalence of the gap between economic and insured losses for weather disasters in different regions across the globe.

Given the prevailing disparity between economic and insured losses, Aon continues to work with its clients and carriers to address the insurance protection gap, or, as the firm now terms it, the capital efficiency gap (see sidebox).

This article attempts to highlight some of the ways in which we, as an industry, can assist in reducing this gap by de-risking cities and countries.

Creating sustainable solutions

It will perhaps come as no surprise that Aon deploys a large amount of resource to the identification of ways in which the insurance protection gap/ capital efficiency gap can be reduced, at a company, governmental, country, and inter-country level.

In terms of the latter, an excellent example of a multicountry risk reduction strategy was introduced to the market in  2018, in the form of a catastrophe bond structured on behalf of the World Bank.

Recent history reminds us of the terrible destruction natural disasters can bring, with earthquake events such as those in Puerto Rico, Mexico, Nepal and Chile causing widespread destruction and huge economic losses.

The World Bank was committed to helping its Pacific Alliance member countries to mitigate their exposures to earthquake risk, and approached Aon to structure an appropriate, sustainable solution.

The resultant transaction was the largest ever earthquake catastrophe bond, providing a total of $1.36bn of earthquake risk coverage to specific Pacific Alliance members – with Chile receiving $500m of protection, Colombia $400m, Mexico $260m and Peru $200m.

The transaction also represented the largest ever sovereign risk transfer – and the second largest catastrophe bond in the history of the insurance-linked securities market. But aside from the historic size of the deal, the ground-breaking aspect of the bond was the fact that four countries united in a single issuance.

The bond was issued across five tranches of notes, with a parametric trigger based on US Geological Survey data, and with coverage provided on a three-year basis for the Chile, Colombia and Peru notes, and on a two-year basis for the Mexico notes.

Proceeds were not held in a trust to collateralise the reinsurance agreement; rather, they were reinvested into the local countries that the World Bank was supporting – Chile, Colombia, Mexico, and Peru – into sustainable projects and programmes.

In this way, by utilising the balance sheet of the World Bank to transfer the earthquake risk, investors were directly funding sustainable development projects, highlighting their prevailing emphasis on social responsibility.

If we as an industry can structure more transactions of this type, it’s possible that distribution could be moved into green funds, which would be highly significant from a social impact perspective.

De-risking balance sheets

It’s hard to believe that it is now more than a decade since the start of the global financial crisis, an event which has offered us innumerable lessons in risk – not just the prevalence of risk, but the interconnectedness of risk.

Following the crisis, many entities, either by free will or force, have reduced the level of risk they are willing to take, and for the re/insurance industry, as global risk experts, the past 10 years has been a time for us to highlight our expertise in risk management to companies that are now more receptive to risk solutions.

The danger now for re/insurers is that as economies begin to ‘normalise’, the benefits of risk transfer will be forgotten


Mind the capital efficiency gap

The capital efficiency gap effectively builds on the protection gap metric, taking a more nuanced approach that looks at the total cost of the risk in the context of natural catastrophes.

Whereas the protection gap is essentially the difference between insured losses and economic losses, the capital efficiency gap framework brings in costs associated with insurance premiums, administrative risk control costs and retained losses to provide an approach to addressing this critical problem facing society.

It is a more realistic approach since it considers public sector solutions as well as private sector solutions. So the protection gap metric might initially identify an issue, but the capital efficiency gap framework presents an economic analysis for different sources of capital, and the need for a more holistic approach to bridging the protection gap.


until the next big event. The good news is that, thanks to our efforts to date, we have seen an increase in the level of risk transfer across governmental and quasigovernmental entities, and the programmes that have been put in place are evidence of a longer term outlook in the continued mitigation of risk.

In this regard, and as might be expected, the entities at the centre of the US housing crisis have been keen to explore new approaches to risk mitigation. Freddie Mac and Fannie Mae are now regular cedants to the re/insurance market, and over the past five years Aon has been instrumental in helping them to utilise reinsurance as a mechanism for risk transfer, while continuing to grow carrier appetite for US housing risk.

Starting with a single reinsurer on a pilot transaction in 2013, by 2017 Aon Benfield had grown the sector to encompass over 40 re/insurer participants supporting the approximately $5bn of annual re/insurance limit for US mortgage credit risk. To date, Fannie Mae and Freddie Mac have completed over 60 reinsurance deals totalling $16bn of limit purchased and in excess of $3bn of lifetime expected premium for participants, at a forecast loss ratio of 10-20%.

Perhaps key to the success of this line of business has been the concomitant educational process in this relatively new line of business, as well as the ability for participating re/insurers to select tranches of mortgage risk that are aligned to their individual risk profile.

Making the reinsurance market comfortable with taking on these new risks has at times been challenging, but was essential to the process, given that the driver of the risk transfer was the high profile losses experienced during the financial crisis, which on the surface made the business appear risky. However, in this regard US mortgage risk has become highly scrutinised by regulators, and well modelled by actuaries and risk advisors, meaning that the quality of the underlying mortgages is now far superior to what it was pre-crisis.

As a result of this process, it has been rewarding for Aon to see that re/insurers are now prepared to invest in the requisite talent, tools and solutions to enter new areas of profitable growth business.

EXIM with the new

As is the case in many sectors, successful new solutions can open the door to new areas of growth. For Aon, showcasing the firm’s successes in the US mortgage credit risk transfer led to further opportunities to assist governments to facilitate the transfer of risk away from their own balance sheets, or those of their agencies.

In 2015, a congressional reauthorisation mandate permitted the Export-Import Bank of the United States (EXIM) to explore the merits of risk sharing with the private sector to reduce the bank’s and US taxpayers’ liability for potential future losses.

As we as an industry make greater inroads into such areas of business, entities will be able to more readily utilise re/insurance products to support their growth and make economic progress” Andy Marcell, Aon

As a result, EXIM sought to de-risk a portion of its balance sheet through a private market risk transfer programme, and selected Aon to design a solution. The firm’s leading relationships with global reinsurers, coupled with its previous working on de-risking governmental and quasi-governmental agencies, meant it had the resources and expertise to assist, resulting in the placement of $1bn in loss coverage for a significant portion of EXIM’s existing portfolio of large commercial aircraft financing transactions.

The solution was structured as a multiyear excess of loss programme on a known portfolio of risks, placed with 10 global reinsurers – led by XL Catlin, Liberty Specialty Markets, and Everest – and was funded by the fees generated by the original commercial aircraft transactions in order to not cost US taxpayers additional funds.

This historic programme was the largest public-private risk-sharing arrangement for a US government credit agency, and represented the maximum allowable coverage per transaction permitted under EXIM’s charter. It is a stepping stone to a more creative use of the private markets in global trade finance for EXIM, and assists in accomplishing its mission to support US exports and American jobs.

The programme is yet another example of how the re/insurance industry can assist public entities to de-risk their balance sheets and remove potential volatility, to the benefit of the government and taxpayers, while providing a diversifying growth opportunity for re/insurers.

More to follow?

These transactions represent just a tiny portion of the total opportunity for the re/insurance sector to assist firms, governments, and countries to de-risk their balance sheets, and in doing so reduce gaps in insurance protection and capital efficiency.

As we as an industry make greater inroads into such areas of business, entities will be able to more readily utilise re/insurance products to support their growth and make economic progress. It is worth stating that there has perhaps never been a better time to achieve this, given current market dynamics. To emphasise my point, I will leave you with an excerpt from Aon’s July Reinsurance Market Outlook study, which highlights the levels of capital available to support our aim of de-risking cities and countries: “Aon Benfield estimates that global reinsurer capital stood at $610bn at March 31, 2018, an increase of 1% relative to the end of 2017. Alternative capital rose by 7%, or $6bn, to $95bn, now representing 16% of the total.

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