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As China grapples with the twin issues of increasing natural hazards and low insurance penetration, the economic progress it achieves tends to be annihilated. Catastrophe bonds can be a viable solution to this problem. Asia Insurance Review spoke with two insurance-linked securities experts to discuss the feasibility of CAT bonds as a risk transfer mechanism in China.
China has always been exposed to natural disasters. Typhoons, earthquakes, tsunamis, floods, landslides and wildfires have occurred throughout Chinese history. Some of these events have been the most destructive, particularly in terms of fatalities.
In recent years the impact of these perils has grown and some of them are becoming even more frequent and severe. Exposure to risk in China is changing.
China has a massive protection gap
Yet, China has the largest insurance gap across the globe ($76.4 bn or 0.6% of GDP) according to 2018 edition of Lloyd’s report on global underinsurance ‘A world at risk: closing the insurance gap’.
The report states that in China between 2004 and 2017, around 98% of losses resulting from natural catastrophes were not covered by any type of insurance.
McCarthy Denning head of insurance and reinsurance Clive O’Connell and Finetiq Hong Kong managing director Michael Skrbic spoke with Asia Insurance Review about how catastrophe bonds can be a viable alternate mechanism for risk transfer in China.
Mr O’Connell said, “Increase in population and the concentration of that population through urbanisation, means that one event can affect more people than before. Also, the economic development of the country results in greater financial progress and hence it causes greater financial loss in the event of a catastrophic event. In addition, climate change makes storms, floods and wildfires more frequent and of greater severity.”
Protection gap drives the demand for capital solutions
Traditionally insurance helps mitigate the economic impact of natural disasters. The development of an ‘insured’ economy, however, typically lags behind economic development. Thus developing economies are often more exposed to the economic risk of natural disasters than more mature economies.
Mr Skrbic said, “China’s massive Nat CAT protection gap will drive the demand for capital solutions that can support natural disaster resilience. China is also absorbing a significant level of international risks through its belt and road initiative infrastructure projects.”
He said, “Managing the large risk aggregations is a high priority for government authorities. Any slow-down in economy (China’s) is unlikely to change this dynamic as the existing catastrophe protection gap is already so wide and the exposures continue to grow.”
“In areas of the world where the gap between insured and non-insured risk is great, a natural disaster can end economic development and devastate the economy. The disaster wipes out investments and leaves the population impoverished,” said O’Connell.
In 2012, superstorm Sandy struck the north east of the United States, one of the most economically developed areas of the globe and caused significant destruction. Even in that mature economic region, only 50% of the economic losses were insured.
Natural disasters at times help kick start growth
“It needs to be highlighted that the insurance proceeds that flooded into the Sandy-struck area to pay for the rebuilding and repair were sufficient to kick-start the regional economy that had been moribund since the global economic downturn of 2008. In other words, when protected by insurance, a natural disaster can operate not to frustrate economic growth but to catalyse and kick-start it,” said O’Connell.
O’Connell said, “Governments alone cannot adequately prevent or provide protection from these catastrophic events. The private sector has necessarily to chip in to complement governments’ efforts to manage catastrophic risks by creating a better ecosystem so that people take greater precautions to reduce climate change risks.”
Catastrophe bonds can overcome deficiencies of traditional insurance
There are, however, other, non-insurance products like catastrophe bonds that can assist in avoiding these aspects of insurance and also overcome one further deficiency in insurance.
Insurance policies require the insured to prove loss. In cases of commercial insurance, this will require the insurer to send a team of loss adjusters to the area to assess the value of what has been destroyed and damaged and the likely cost of repair. Checks will be made to ensure that the policy terms have been met and any covered business interruption loss may take a year or so to calculate.
There will therefore be a considerable delay in the payment of the claim when, often, what is needed is an immediate payment to start the process of rebuilding and to keep the workforce employed. However, this is not how insurance operates.
“A product now frequently used by insurance companies and their reinsurers to provide solvency protection in the event of major natural disasters is catastrophe (CAT) bond,” said O’Connell.
Protection under a CAT bond is provided by investors from the capital markets. A special purpose vehicle (SPV) or a cell in a protected cell company (PCC) is established and capitalised with the amount of money required as protection. A fee or premium is paid by the entity seeking protection.
Payments to covered entities are immediate in event of catastrophes
If a defined trigger event occurs during the period of cover, which is generally a year, the funds held by the SPV are paid immediately to the protected entity. If no event occurs, the funds are paid back to the investors together with the premium and any interest earned on the sum during the year.
O’Connell said, “The payments are automatic upon the occurrence of the trigger event and so money is received immediately after the disaster has occurred. There is no adjustment. There is no need for any direct physical damage. There is no need for insurable interest; an event occurs and the payment is made.
“The definition of the trigger is of vital importance to all parties. It is the basis for calculation of the premium and is essential so that one can determine when payment should be made. While some CAT bonds have used triggers based upon losses suffered by the protected insurers or based upon indexes of market wide losses to insurers more generally, such triggers have little use in areas where insurance is not widespread. Instead, parametric triggers based upon the scale of a natural disaster are used.”
Defining the parametric trigger is important
A parametric trigger would define a trigger event as, for example, an earthquake of above a precise magnitude occurring within a defined area. Similarly, a storm can be so defined based upon objective and empirical measurements. This means that as soon as a storm of earthquake occurs in the defined area and of the defined magnitude, a payment is made. Money will flow immediately to the devastated area and allow immediate steps to be taken to begin the task of renewal.
Mr Skrbic said, “Catastrophe bonds originating from China would provide diversification for insurance linked securities (ILS) investors who are currently exposed to North American concentration risk. China’s existing provincial level pilot schemes have focused on parametric index-based triggers, avoiding the potential lengthy settlement process associated with indemnity-based loss triggers.
“Quick access to relief funds is an understandable priority for governmental authorities in a disaster scenario. Parametric triggers are also attractive to ILS investors as they mitigate information asymmetries between the sponsor and the capital provider(s).”
Things are happening on the ground
In January this year Swiss Re provided reinsurance cover to a county-level index insurance cover for Mao County in Sichuan province of China. This is the first parametric product to drop-down to the county level of coverage in China. Mao County is one of the regions of China considered at highest risk of earthquakes.
Mr Skrbic said, “Senior officials of the Hong Kong Government (including the chief executive and the financial secretary) have recently announced regarding introduction of legislative changes to allow the issuance of ILS.
“Singapore issued its first CAT bonds in February this year, but Hong Kong has the advantage of being a special administrative region of China and part of the rapidly developing Greater Bay Area. Hong Kong is, therefore, well positioned to capture future insurance related opportunities emerging from mainland China,” he said.
“Hong Kong is promoting its position as a captive insurance centre. Captive insurance could provide solutions for a variety of mainland China entities, including municipalities and agricultural associations.”
Catastrophe bonds present a fresh way of looking at financial protection against disaster; a way to ensure that businesses and economies can continue to grow, develop and thrive.