A new report released today says that by decreasing barriers in the emerging market of insurance-linked securities, insurance companies might be able to obtain the capital needed to cover more risks in disaster-prone areas of the country.
“Historically, insurance has been an essential part of stability and recovery for individuals, businesses and communities – encouraging recovery, economic growth and prosperity,” said Glenn Yago, director of capital studies at the Milken Institute. “We need to rethink how we approach catastrophic risk and private-public partnerships in this field so that communities have the resources necessary to recover quickly in the event of a disaster.”
Catastrophic losses from the Northridge earthquake, Hurricanes Andrew and Katrina, and widespread flooding in the early 1990s prompted many insurers to look for new market-based solutions to provide coverage in hazardous markets. As risks and costs continued to increase, however, insurance companies have had difficulty finding ways to cover these disaster-prone areas, according to Yago.
The report, “Financial Innovations for Catastrophe Risk: Cat Bonds and Beyond,” is based on a Milken Institute Financial Innovations Lab attended by representatives from the insurance, reinsurance, and bond ratings industries, along with practitioners in finance, law and government regulation. This Financial Innovations Lab and the report were supported by Allstate Insurance Co.
“Expanding the investor pool for insurance-linked securities will help diversify investor portfolios at attractive returns,” said Jeff Cooper, assistant vice president of Protection Finance for Allstate Insurance Co. “If we can do this and streamline the transactions for insurers, sovereign entities and other risk bearers, this market will have a tremendous positive impact on disaster recovery.”
Catastrophe bonds – also known as cat bonds – and other insurance-linked securities are alternative sources of capital for insurers, reinsurers, governments and companies that can provide both capacity and price stability. Governments and industry have started to look at these innovations. In 2005, the Mexican government became the first federal sponsor to issue a catastrophe bond, Cat Mex, for protection against major earthquake losses.
These new tools are gaining a foothold in the marketplace, according to the researchers. For example, the cat bond market grew from $2 billion in 2002 to $14 billion in September 2007. These bonds outperformed equally rated corporate bonds in the period from January 2005 through September 2007, returning 25.65 percent versus 17.51 percent. However, they face regulatory, industry-based and market barriers, such as high transaction fees and an insufficient supply of issuances, before they can make the necessary impact.
The report offers several solutions to ease these barriers:
• Decrease in fees and standardize transactions through a variety of measures that include eliminating the need to conduct transactions offshore by establishing special purpose vehicles (SPVs) onshore and by standardizing loss warranty documents, issuance structuring and documentation.
• Attract large institutional investors by increasing the amount of investment-grade cat bond issuances.
• Securitize a wider range of risk (currently the majority of bonds are for wind and earthquake risk) and geographic distribution (including fast-developing regions, such as India and China) to increase diversity in the market.
• Educate investors and, more important, asset allocators, to enhance legitimacy and further establish the bonds as an asset class.
• Improve risk management tools for investment professionals, develop appropriate benchmarks that address risks in other parts of the world, increase market transparency and accessibility of the asset class, and issue more collateralized debt obligations (CDOs) to target investor preference.
• Increase liquidity and transparency in the secondary market by issuing larger transactions.
• Increase participation by the rating agencies to achieve more than a single rating, currently the norm, to attract more traditional fixed-income investors.
This Financial Innovations Lab took place in New York in October 2007. It was called to address ways to expand and share insurance risk in the area of catastrophe coverage. Financial Innovations Labs are part of the Milken Institute’s continuing leadership in promoting financial innovations to help solve ongoing social, economic and environmental challenges. The full report is available at www.milkeninstitute.org.
Source: The Milken Institute
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