Privatesector P U B L I C P O L I C Y F O R T H E Note No. 197 October 1999 Using Capital Markets to Develop Private Catastrophe Insurance John D. Pollner The global catastrophe insurance market exhibits inherent cyclical risks. Disaster-prone countries can improve their protection against catastrophic risk and premium volatility by using capital markets to boost the capacity of the private sector to absorb and spread the risks—both domestically and internationally. This Note proposes two mechanisms for more efficient management of catastrophic risk: pooled insurance coverage supported by liquidity and credit enhancement facilities, and hazard- indexed bonds to securitize risk. Support from multilateral development institutions can play a catalytic role in the development of these mechanisms while still preserving actuarially fair premiums. Some small countries may require multilateral support (a credit enhancement) to gain access to capital markets. Or perhaps all that is needed is for the government and local industry to recognize that the new mechanisms can both increase cover and stabilize premiums. Such an assessment requires scarce financial modeling skills—something multilaterals can help organize and finance. Catastrophic events are unique among insur- Also in the United States an options market based ance risks: while traditionally insurable risks on insured loss indexes has been set up at the occur with predictable frequency and relatively Chicago options exchange. These options allow low losses, catastrophes occur infrequently insurers to hedge some of their catastrophic risk but with high losses. Three mechanisms have in the capital market. In Japan, Europe, and the been developed in recent years to better man- United States markets for “cat bonds” offer age these risks by tapping capital markets. another alternative for transferring risks. In these In the United States public authorities in markets investors buy high-yield bonds that are earthquake-prone California and in hurricane- backed by premiums on the underlying insurance prone states such as Florida and Hawaii col- portfolio, but also contain provisions that trigger laborate with the private sector to address loss of interest and principal if a major catastro- insurers’ fears of large losses (and thus poten- phe occurs during the life of the bond. Investors tial market flight). These public-private efforts are attracted to these bonds because of their lack combine catastrophe coverage under special- of risk correlation with global financial markets. purpose pooled funds with outside capital (such as long-term loans and bonds that secu- Some of these risk management methods could ritize insurance risks), increasing the avail- be adapted for use in developing countries. ability of insurance. The pooling arrangement achieves efficiencies of scale while giving all High and volatile premiums parties the confidence that contractual obliga- tions will be met. This approach is also used in In catastrophe-prone developing countries the Europe. domestic insurance industry generally reinsures The World Bank Group ▪ Finance, Private Sector, and Infrastructur e Network Using Capital Markets to Develop Private Catastrophe Insurance BOX 1 PRICES FOR CATASTROPHE REINSURANCE Reinsurance prices are quoted as “rates on line.” Assume, for example, that a primary insurance company wishes to purchase reinsurance for catastrophic losses between US$15 million and US$25 million. If losses in a catastrophe are less than US$15 million, the company retains all the loss. This ceiling is referred to as the retention level. If the loss is more than US$15 million, the reinsurer pays Transferring risks abroad also means that because the excess up to the US$25 million—the excess-of-loss level. If the reinsurer the domestic insurers retain little of the underwrit- charges US$1.5 million for this US$10 million of coverage, the rate on line—the ing risk, they face low incentives to monitor com- price expressed as a percentage of the coverage—is 15 percent. pliance with structural codes or to promote Rates on line vary by type of risk. A primary insurance company doing busi- measures to mitigate losses or improve industry ness in an area at low risk of catastrophes will pay the lowest rates on line. Rates efficiency that in the long run might lower the cost also vary by retention level. The rate on line for US$10 million in coverage above a of insurance. When all but very low levels of risk retention level of US$15 million would be much higher than that for US$10 million are reinsured abroad, the reinsurance coverage is above a US$100 million retention level. The reason is that there is a higher proba- generally expensive because of the high likelihood bility that losses will exceed US$15 million than that they will exceed US$100 mil- that it will be triggered. Contracting reinsurance at lion. A typical average for rates on line is 13 percent. The rates for hurricane-prone countries are high relative to worldwide catastrophe rates. But retention levels for much higher levels of loss would lower the pre- small, disaster-prone countries are much lower on average than for U.S. insurers. miums because of the lower probability that losses would reach those levels. Thus a key cost issue is finding the right balance over time between retain- its local portfolio through international insur- ing risk locally and transferring it abroad. ance or reinsurance companies that can better bear the risk of catastrophic losses through Transferring catastrophic risks to the global diversification. While this reinsurance capital market transfers the risk abroad, it may not provide the kind of coverage that could ensure economic A simple numerical example shows how capital recovery and fiscal stability in the wake of a nat- markets can replace or supplement insurance ural catastrophe. Excessive risk transfer might and reduce costs. Assume that a primary insur- also imply low capital among local insurers. ance company calculates the probability of a loss of more than US$15 million but less than US$25 Insurance for natural disasters is generally avail- million at 10 percent. If the primary insurer pur- able for even small developing countries. But fol- chases reinsurance at this rate, it will break even lowing an unusual series of major losses, over time. Adding administrative and operating domestically or globally, insurance could costs, the reinsurer might charge a premium of become scarcer and pricier. Thus relying on rein- 12.5 percent (10 percent + 2.5 percent). surance from foreign companies affects the price of disaster insurance (box 1). Prices have been Alternatively, the primary insurer could issue a dropping since 1995. But they could rocket if a US$10 million bond to investors, then put the major catastrophe occurs and catastrophe rein- US$10 million in U.S. treasury notes paying, say, surance markets tighten. In 1990 the rate for 5 percent. The investors’ principal of US$10 mil- home insurance in parts of the Caribbean was lion would be put at risk as part of the contract. 0.4 percent. After Hurricane Andrew hit Florida If a catastrophe with losses exceeding US$25 mil- in 1992 prices more than tripled, reaching 1.3 lion occurs, the investors might lose all their prin- percent in 1994, then declined to 0.8 percent in cipal. For putting their principal at risk, the 1997. By contrast, Hurricane Mitch, which dev- investors would demand at least a 15 percent astated parts of the Caribbean and Central return—5 percent as risk-free interest and 10 per- America in 1998, had little effect on insurance cent for the “pure” risk of losing their principal prices because much of the property it damaged (akin to a default risk). Net of the investment in was uninsured. Thus the price of insurance treasury notes, the insurer’s total financing cost tripled for property owners in the Caribbean at would approach 10 percent, compared with the a time when there had been no change in their 12.5 percent with traditional reinsurance. underlying risk. Instead, the price fluctuations reflected changes in the supply of catastrophe In yet another option the insurer could arrange reinsurance following a disaster elsewhere. a standby credit of US$10 million with a 2 per- cent commitment charge and an interest rate of cover would also serve as a partial buffer 12 percent that kicks in if the loan is needed. If against fluctuations in international reinsur- a catastrophe occurs, and assuming a ten-year ance pricing, since the loan terms would repayment period for principal (yielding a com- remain unchanged. bined principal plus interest “insurance” cost of ▪ Once such arrangements prove financially 18 percent), the expected financing cost would viable, local financial markets or international be 3.6 percent (0.1 [18 percent] + 0.9 [2 percent]), commercial lenders could offer liquidity support much lower than with direct reinsurance. facilities. Development of these instruments would be catalyzed by the credit provided by These capital market schemes to replace or sup- multilateral development institutions. plement insurance have many possible varia- tions. These range from full risk transfer with no While this mechanism would finance rather than financing (where the full principal is at risk, just transfer risk, if structured with proper terms and as in reinsurance) to zero risk transfer with full appropriate levels of excess-of-loss coverage, it could financing (full repayment of principal). provide more cost-effective coverage and longer- term price stability than traditional reinsurance. Applying new insurance technologies Hazard-indexed catastrophe bonds Two compatible financial structures could be used to address the challenges of catastrophe Weather-indexed catastrophe bonds, based on insurance in disaster-prone countries, separately payouts linked to measurable weather events (as or as a joint mechanism. reflected in weather indexes or parametric mea- sures), have the advantage of being relatively easy Pooled coverage supported by liquidity and to implement once a reliable weather measure- credit enhancement facilities ment mechanism is identified. They bypass the traditional insurance “loss adjustment,” which A mechanism in which liquidity and credit en- requires site-by-site evaluation of losses before hancement facilities support insurance coverage indemnity is provided. The payout is simply based against catastrophic risks could function as follows: on the weather index reaching a certain range. ▪ The domestic insurance industry would trans- Payouts for the Tokyo Marine Insurance cat bond, fer catastrophic coverage (through premium for example, are based on specified Richter mea- cessions) to a central fund regulated by the gov- sures of earthquake intensity and damages within ernment and operated by the insurance indus- a specified radius around Tokyo. try. The risks covered would not be reflected on the balance sheets of local insurers but would The main risk with hazard-indexed instruments is instead be liabilities of the pooled fund. The basis risk—the risk that the basis for triggering the international insurance industry could then loss payment (such as a high windspeed, excessive reinsure catastrophic coverage under the fund rainfall, or earthquake intensity) is not directly up to a specified loss limit. linked to actual loss (such as damage to a specific ▪ Multilateral development institutions might house or building). A loss payment may be made provide contingent credit at the next highest (with the bondholder losing interest or principal) loss level, supporting the liquidity of the fund even though the insured experiences no loss. Or in the event of immediate large losses in the the insured may experience a loss but receive no initial years of operation. The credit would indemnity because the index is not triggered (as a eventually be repaid and secured through result of a lower-than-threshold windspeed). future premium collections by the fund. The extended repayment period would provide Most catastrophe bonds—such as those issued in optimal risk spreading over time. This layer of Europe and the United States—are triggered by Using Capital Markets to Develop Private Catastrophe Insurance reported losses and indemnification claims in the the catastrophe insurance pool, serving as one industry rather than weather indexes. But of the upper layers of coverage. Such risk trans- investor appetite for such bonds issued in devel- fer mechanisms—involving capital market oping countries might be low because of lack of investors under multiperiod contracts—can fur- direct knowledge of the local insurance industry. ther reduce the potential volatility of insurance Bonds based on easily verifiable weather indexes and reinsurance prices. They would also enable should be more attractive. Adding to their attrac- the government to insure public property at rea- tiveness are the opportunities they would offer sonable prices. And they would enable the local international investors for portfolio diversifica- insurance industry to extend coverage to such tion, since natural disasters have little or no cor- hard-to-insure sectors as small farmers, public relation with global financial market trends. infrastructure, and low-income communities. What would the financial structure of a scheme A catalytic role for development based on hazard-indexed bonds look like? institutions ▪ Catastrophe bonds could cover public infra- structure or provide financing to a private pooled Financial support from multilateral development fund, as described in the previous section. The institutions to create an insurance pool and bonds would pay higher-than-average yields but hazard-indexed bonds, separately or together, would also carry a risk of a significant drop in would meet several objectives. The support Viewpoint is an open the coupon rate or a loss of principal in the event would help reduce potential market failures due forum intended to of a catastrophe that leads to loss payments. to historical premium volatility that result in encourage ▪ A multilateral institution or affiliate could guar- lapses in coverage. It would also help overcome dissemination of and debate on ideas, antee the contractual payments of bond suboptimal coverage resulting from the scale dis- innovations, and best coupons and any principal due investors. In a economies in small countries’ insurance markets, practices for expanding fully private arrangement the bond payments and the lack of incentives for measures to miti- the private sector. The views published are would need to be fully secured by the premi- gate catastrophic losses. And because capital those of the authors and ums collected in the common fund. market–based arrangements could increase the should not be attributed ▪ The basis for triggering loss payments could insured asset base in developing economies to the World Bank or any of its affiliated organiza- be information from weather station tracking while promoting reliability in economic com- tions. Nor do any of the equipment with satellite links to global record- pensation following natural disasters, the sup- conclusions represent ing centers or from weather monitoring sys- port could encourage participation by the official policy of the World Bank or of its tems of the U.S. National Weather Service, international reinsurance industry. Executive Directors or which tracks high-altitude hurricane activity in the countries they the Pacific and Atlantic regions. Earthquake Such initiatives go hand in hand with the needed represent. risk could likewise be measured. restructuring of local insurance industries. Thus To order additional the involvement of multilateral institutions could copies please call Before hazard-indexed bonds are introduced, help strengthen the domestic insurance industry 202 458 1111 or contact Suzanne Smith, editor, historical data on hazard events and associated and improve hazard mitigation. Where regional Room F11K 208, losses would need to be compiled and analyzed rather than national arrangements are optimal, The World Bank, to ensure a sufficiently strong correlation multilateral institutions could facilitate inter- 1818 H Street, NW, Washington, D.C. 20433, between index-triggered payments and actual country policy dialogue. or Internet address losses. These data are essential for structuring ssmith7@worldbank.org. and pricing such insurance contracts. John D. Pollner (jpollner@worldbank.org), The series is also available on line Senior Financial Sector Specialist, Latin (www.worldbank.org/ A joint mechanism America and the Caribbean Region, Finance, html/fpd/notes/). Private Sector, and Infrastructure Department Printed on recycled While a hazard-indexed bond could be devel- paper. oped on its own, it could also be combined with