ILS & Disaster Risk Finance (DRF)
ILS As DRF solution
The Europe and CIS (ECIS) region is affected regularly by natural hazards.
The historical record of large disasters goes back to ancient Greece, where an earthquake in Crete destroyed Alexandria.
Much more recently, in XX century earthquakes devastated Almaty (1911), Ashgabat (1948), Skopje (1963), Tashkent (1966), Bucharest (1977) and Spitak (1988). Floods, as well, has been an issue: from destruction of Pest in Hungary in 1838 to losses equating to 5-15% GDP of suffered countries during 2014-2016 Balkans floods.
In fact, close to 1/3 of the capitals of the ECIS countries have been at one time or another devastated by earthquakes or/and floods.
The impacts of these disasters are pervasive. They displace and kill people, destroy property, incapacitate industries, disrupt day-to-day life, and often affect the economic development of countries for years after the event.
Disaster Risk Finance solutions for the ECIS region
The protection gap, the difference between economic and insured losses, is a damning reflection on both the insurance market and those responsible for managing risk. Protection gaps exist in both developed and emerging markets, but where catastrophe risk coverage is around 35% in developed markets, it is just 6% in developing countries. According to AON, last year brought $268 billion of economic losses from natural disasters of which, just $97 billion was insured. Developing counties suffered a disproportionate share of uninsured losses, where damage sustained by businesses and governments are only increasing following a decade-long rise in natural catastrophes linked to climate change.
From natural disasters in 2020
Of them insured
And predominantly in developed economies
Or 64% is the Gap
Increasing to 94% for developing countries
The long-term impacts of natural disasters are not predetermined, and the overall effect depends on the vulnerability of a country’s infrastructure, their access to disaster risk financing, and resilience. With inadequate insurance programs and a lack of alternatives, vulnerable countries (and sometimes even regions) have to rely on handouts from multilateral agencies and global development aid. However, such aid is reactive by nature, and payments can be slow to materialize. According to critics, there are also question marks around who the true beneficiaries of development aid are. Disasters do not just destroy homes, factories, and agricultural land in the short-term; they can annihilate years of economic growth.
Traditional indemnity insurance has been used for hundreds of years and to great effect. However, some of its limitations have started to surface over the last decade. For example, subjectivity around policy wordings has led to disputes in the courts spanning months, if not years, delaying disaster recovery and impacting affected parties further. The validity of traditional insurance is not being questioned by any means, but its suitability on a macro level in developing countries is. For example, in former Soviet Union countries, insurance in its traditional form is not suitable because sovereigns are responsible for critical infrastructure (therefore lack insurable interest). This is also true for large global development projects like the Chinese Belt & Road Initiative.
When a natural disaster strikes, immediate steps need to be taken to protect survivors and provide them with temporary shelter, food, and water. Moreover, in the medium to long-term, homes, places of employment, and critical infrastructure such as schools and hospitals need to be rebuilt. In developed nations, government bodies such as FEMA in the USA typically act fast and provide these things. However, the same cannot be said for less developed markets. This is where Insurance-Linked Securities could make a significant contribution.
When Hurricane Maria struck the island of Puerto Rico in 2017, its people were without clean food and water for more than six months, 98% of buildings were either damaged or destroyed, and it took a further 11 months for power to fully restore on the island. If a parametric catastrophe bond program or similar ILS solution was in place, capital could have flowed back into the economy sooner, and a return to their baseline would have been faster. Traditional insurance products, of course, still have a role to play, but ILS are perfectly suited to those who require fast injections of capital. This correlates with the United Nations' argument that the speed of recovery really matters if a developing country is to minimize the long-term impacts of natural disasters on economic growth and productivity.
Furthermore, this type of disaster financing is far more efficient than traditional forms of insurance. Rather than waiting for loss adjusters and surveyors to assess the damage, ILS can provide immediate liquidity to governments that need it the most.
By introducing a transparent, fast paying insurance-linked security like a catastrophe bond, economic growth and productivity could return to or exceed the baseline faster than if traditional insurance was in place. These capital flows help to address humanitarian crises, the rebuilding of infrastructure, and the creation of jobs. By stipulating that the bond proceeds must be spent on redevelopment projects, governments can focus on building back better and replacing old and weak infrastructure with buildings that conform to updated code.
So far, government pools such as the Caribbean Catastrophe Risk Insurance Facility (CCRIF) and Africa Risk Capacity (ARC) have illustrated the benefits of pooling regional risk and leveraging ILS. A recent example is the CCRIFs payment of $10.7m to Nicaragua after Tropical Cyclone Eta. Although this may seem a small amount in dollar terms, payment was made within 14 days. These fast injections of capital can often be the difference between life and death.
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.
Multinational agencies like the World Bank and the United Nations Development Programme (UNDP) are doing an excellent job promoting products such as parametric insurance and instruments that transfer risk to the capital markets. However, their involvement alone is not enough. We believe that industry participants, associations, and, more importantly, academia need to join forces in a dedicated effort to educate local market participants, opinion leaders, and government officials to help them make better decisions.
Moreover, convergence between insurance and the broader capital markets is relatively straightforward in terms of legislation and local frameworks. If a country has already utilized the capital markets through sovereign bond issuance, it can do the same for disaster risk financing without any additional constraints.
Several articles and video extrapolating on the topic of parametric sovereign catastrophe bonds as disaster risk finance instruments for the region of ECIS