The Intelligent Quarterly from the publishers of The Insurance Insider

Autumn 2017

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Built-in resistance

Lucy Jones

The destiny of South America's shanty towns may soon be aligned with insurance-linked securities (ILS) investors in an ambitious transaction that aims to improve their chances of withstanding natural catastrophes.

The project is the brainchild of US-based non-governmental organisation Build Change, which designs disaster-resistant homes and schools in emerging nations in partnership with catastrophe risk modeller RMS.

Their vision is to retrofit dozens of neighbourhoods in about six cities to make them attractive to ILS capital.

Alongside the World Bank's $425mn pandemic insurance facility and the proposed UK foreign aid catastrophe bond, the project is one of several where ILS investor appetite for new risk is being channelled into emerging world development.

Risk transfer is now seen by the UN as a "fundamental arrow in [its] quiver" to address disaster risk, as Robert Glasser, the UN Secretary-General's special representative for disaster risk reduction, said at the Global Platform for Disaster Risk Reduction in Mexico in June.

It was also a mantra of the previous UN Secretary General Ban Ki-moon that insurance was central to reducing the exposure of the poorest people to climate catastrophes. In 2015, the G7 promised climate risk insurance for 400 million of the world's most vulnerable people within five years.

In so-called "informal neighbourhoods", such as those seen in some Latin American countries, buildings are frequently built spontaneously, without any design practice or legal procedures, using poor-quality construction materials.

As families grow, upper storeys are added on top of buildings, making these homes highly susceptible to flood and earthquake.

Over the past decade, working in 12 countries, Build Change has made over 50,000 such buildings safer and trained 30,000 people to do the same. Sometimes structures are rebuilt, but often they are reinforced.

Retrofitting is already underway in Bogota in Colombia, but discussions on similar schemes are also taking place with authorities in the second largest Colombian city, Medellín, as well as Quito in Ecuador, San Juan in Puerto Rico, Santiago in Chile and Mexico City.

A forum of interested parties was held recently, at which the World Bank and Swiss Re became part of the conversation about disaster-resistant homes.

Parametric pay-off
Once these neighbourhoods have been made insurable through retrofitting, the plan is to structure a parametric ILS transaction protecting the dwellers against hurricane and flood.

The aim is to construct a multicity transaction from the outset, with local governments paying the premiums and the risk being farmed out to the capital markets.

One issue that the buyers of cover often raise about parametric ILS transactions is whether the trigger - which is aligned with physical characteristics of an event such as shake strength or wind force - will provide protection that meets their actual losses.

But anxiety about basis risk "should never be a showstopper", says RMS managing director Daniel Stander.

"It's well understood that the bond is not in place to recover all of a municipality's losses, so a perfect match between loss experience and payout isn't really the goal," Stander says.

It is important to quantify the sources of basis risk and design a transaction which meets a city's appetite for it.

"City officials are looking for an injection of cash or services immediately post-event. If used effectively, this liquidity can accelerate emergency response, expedite recovery and prevent a disaster becoming a humanitarian crisis."

Such a transaction could be at least two years off, and the various political wills need to be aligned, but the result would be a naturally diversified portfolio that could be bundled up into a single public or private deal.

"Resilience bonds", as these types of transactions have been dubbed, are currently being scrutinised by Swiss Re's Global Partnerships division, which was established in 2011 to help national and municipal governments strengthen their ability to face disaster.

The idea is to find ways of monetising avoided losses, says Ivo Menzinger, a leader of Europe, the Middle East and Africa at Swiss Re's Global Partnerships.

If risk is reduced, the expected loss is lower, which means the insurance premium reduces over time.

"The key question is whether the saving in the future can be leveraged today to partially finance risk reduction measures," says Menzinger.

Data challenges
Build Change's director of education, Michael Collins, says another barrier to deploying a risk financing deal for a retrofit has been the lack of data available, but that is now changing.

The organisation presently collects more data on structure characteristics in informal neighbourhoods than companies issuing commercial policies in the US.

"We're researching whether this previously unavailable information can be used to generate a more granular overview of risk," he said.

In some emerging countries large amounts of data are available, in part due to the systems put in place by international development agencies over the past few decades, which can be used to develop models for insurance solutions.

Both sides need to agree on the view of risk provided by a model that is going to be used as the basis for a risk transfer, says Claire Souch, director of AWHA Consulting, which advises on catastrophe risk modelling and management.

"We've learnt that working with local experts in the country is crucial," she adds.

In countries where data has not been collected, substitutes are becoming available.

The UK's Met Office is pioneering a process called reanalysis where modern data assimilation techniques are applied to historical periods.

Using reanalysis, the atmosphere around the globe over several decades can be recreated on an hourly basis to provide reliable information about the state of a climate in any given region.

In the past 18 months, says Souch, there has been a coming together of development agencies and the private market which could benefit countries that cannot afford to pay for commercial models.

ILS affordability
Cost is usually a chief concern of governments, which generally consider a risk transfer transaction as a cost item on their budget sheet rather than an investment.

"Country X can say 'That's great, but we can't afford that'," says Bill Marcoux, a partner at law firm DLA Piper.

"They have competing demands on their budgets. For example, they are trying to build hospitals, schools and roads, and trying to feed kids. They know they have exposure but can't spend the money on it."

This financial constraint has led to discussions on providing assistance with premiums at the outset to get countries involved, he says.

Another challenge is the absence of legislation in some countries that would allow the use of a cat bond.

The question of who a payment is made to and whether it can be misspent has also arisen, although the World Bank and UN, through trial and error, have experience of deploying funds that can be passed on to the insurance industry.

Insurance education
Rowan Douglas of the Insurance Development Forum says the relationship between the insurance industry and developing world was once characterised by "mutual bewilderment".

While this is changing, it takes a significant shift in thinking to convince governments and organisations of the benefits of a risk transfer transaction.

As it may take a long time to establish risk transfer deals, they typically require bipartisan political support.

In addition, governments may have the resources to pay for cover but then have little to show for it if there is no claim, which is no vote winner.

This year, Jamaican MPs questioned the rationale of the country belonging to the Caribbean Catastrophe Risk Insurance Facility after failing to receive a payout since signing up for the scheme in 2007.

Moreover, using insurance to manage risk could also be a major shift for the charitable sector as well.

The Global Partnership for Education (GPE), a Washington, DC-based organisation which aims to strengthen education systems in developing countries, is researching whether risk transfer can replace grants to get schools up and running again when disasters strike.

"Integrating insurance approaches into our work will be a challenge because it moves beyond GPE's traditional focus of grant-making and delivering technical assistance," says CEO Alice Albright.

"But it also promises to bring big benefits. It could lower the amount of money we need to keep on hand against uncertain future disasters and it forces us to account for and manage the risks we face," she adds.

Quantifying the pay-off
Research shows that the rewards of investing in insurance cover for the developing world can be substantial, justifying the shift away from post-disaster donations.

According to research by RMS, commissioned by the UK Department for International Development, insurance schemes could nearly quadruple the amount of disaster relief going to low and low-to-middle income countries within the next 10 years.

It found that insurance plans could provide payouts that would meet 11 percent of average annual losses in such countries, up from the 3 percent insurance cover that exists presently.

Current cover provides about $0.9bn of the $29.1bn average annual disaster loss across low and low-to-middle income nations, with a further 8 percent, or $2.2bn on average, covered by humanitarian aid.

According to Sophie Evans, programme director of capital, science and policy practice at Willis Towers Watson, it is also possible to incentivise appropriate behaviour to manage risk - for example, by giving credit to a region that has made an adequate disaster response and risk reduction plan. "ILS... can be structured to deliver value beyond the financial mechanism itself," she says.

There has been no shortage of investor interest in the recent flurry of development-related cat bonds.

For example, amid investor demand, the World Bank's pandemic cat bond expanded from an initial $100mn to a final $320mn, with specialist ILS funds making up the largest group of investors.

And there are opportunities to place these products in institutional or high net worth portfolios given the diversification benefits, low correlation and, of course, social and environmental impact, says United Nations Development Programme (UNDP) special adviser Jan Kellett.

The UNDP is currently scoping out ILS financing to equip municipalities in the Western Balkans to reduce the risks associated with flash floods, earthquakes and droughts.

"We envision these products to be particularly well suited to those investors looking to intentionally create positive impacts in addition to financial returns, so are confident in the wide-reaching applicability," he says.

But while the risk and the capital are both there in abundance there is an ongoing failure to pair them up.

The Centre for Global Disaster Protection established by the UK government in July and the Insurance Development Forum both hope to act as matchmakers.

The protection gap space is undoubtedly getting more interest and offers a huge opportunity to the ILS sector, but reaping rewards is likely to be challenging.

As Marcoux says: "No one would say this is low-hanging fruit."


This article was published as part of issue Autumn 2017

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