The Stormy Outlook For Insurance-linked Securities

 File 20170930 21594 1g23pfx.jpg?ixlib=rb 1.1

Water from Addicks Reservoir flows into Houston neighborhoods following hurricane Harvey in August. Allstate expects US$593 million in insurance losses for August due to the hurricane. (AP Photo/David J. Phillip, File)

The world has witnessed a shocking series of disastrous events in the past several weeks. Devastating hurricanes and Mexico’s 7.1 magnitude earthquake are just some of the latest catastrophes to captivate our collective attention.

Hurricanes, earthquakes and other extreme events aren’t always unexpected, especially given the wealth of knowledge available about Earth’s geophysical system. But the recent rapid succession of them is remarkable even to longtime observers of such events.

What do these recent events mean for the significant changes that have taken place in the insurance and reinsurance sectors to cope with the mounting exposure of private and public actors to disaster risk?

The latest series of disasters represents a serious test to what are known as insurance-linked securities (ILS). They’ve been adopted by insurers, reinsurers — the insurers of insurers — and public entities to limit their exposure to disaster risk and transfer it to financial markets.

The performance of these securities is significant as the U.S. federal government is in the process of integrating ILS into other disaster financing mechanisms within the United States — namely, the National Flood Insurance Program.

Hurricane Andrew and its aftermath

ILS, a relatively recent financial innovation that traces its origins to the mid-1990s, are largely a response by insurers, reinsurers and others being exposed to the increasingly costly impacts of disastrous events.

Effectively, ILS is a way to securitize disaster risk or transfer the exposure of these firms — and, more recently, governments — to the chance that they may have to pay claims in the aftermath of a hurricane, earthquake or other extreme event.

ILS, and their best known variant catastrophe bonds (cat bonds), act both as an insurance policy for those seeking to reduce some of their exposure to disaster risk and an as investment vehicle for those seeking to accept and gain access to that risk by buying into the bonds.

The securitization of storms began in the aftermath of 1992’s Hurricane Andrew and its enormous costs to the state of Florida.

insurance Rows of houses destroyed after Hurricane Andrew struck Florida in 1992. (AP Photo/Mark Foley, File)

Following the catastrophic damages and the bankruptcies of nine insurers, new financial architecture began to emerge to facilitate new, larger pools of capital being brought into the insurance and reinsurance sector.

This included the establishment of new reinsurance firms in the tax haven of Bermuda, a revolution in using statistical analysis to better model disaster exposure, as well as the creation of state-sponsored public insurers of last resort.

These public entities play an important role in the increasing integration of insurance and financial markets.

They create the underlying asset through the provision of insurance policies to those customers and property owners that private insurers do not want to insure and, later, via ILS and cat bonds, they transfer that risk to financial markets.

Bigger storms, bigger pools

ILS and cat bonds operate on this simple market-based logic: By providing insurers and others seeking to reduce their exposure to disaster risk with larger and more diverse sources of capital, they’ll be better equipped to handle extreme events when they occur.

Proponents of the securitization of storms also argue that by increasing competition between traditional reinsurance firms and new investors seeking to gain access to the market, homeowners and the public more broadly reap benefits by paying less for their insurance policies and enjoying a solvent and secure insurance sector.

These novel financial mechanisms also potentially benefit investors, providing a new source of diversification for their investment portfolio and an attractive yield, especially important in the low interest rate era of the past decade.

For all these reasons, there’s been significant growth of ILS as a source of both insurance and investment.

But larger questions remain unanswered, most importantly how they’ll perform in response to the latest spate of hurricanes and earthquakes.

From a political perspective, the market-based logics of ILS and the growing integration of insurance and finance remain underanalyzed and critiqued.

Crisis and opportunity

Harnessing financial markets to offset disaster risk and exposure for insurers may result in unforeseen or unanticipated results.

There’s currently a great deal of uncertainty about what impact Hurricanes Harvey, Irma, Maria, as well as the recent Mexican earthquakes, will have on ILS and cat bonds.

Regulators set up following the 2008 financial meltdown have warned that insurance-linked securities bear remarkable similarities to mortgage-backed securities (MBS), the financial instrument designed to transfer sub-prime mortgage risk to financial markets that sparked the crisis.

Rather than reducing disaster risk, ILS and cat bonds may actually amplify it by spreading exposure and impacts further than those immediately suffering the disaster’s effects.

While the size of the ILS market and the number of outstanding bonds remain small in comparison to mortgage-backed securities prior to 2008, regulators are concerned that investors may be buying into risk they do not fully understand. That’s a situation eerily close to the one that precipitated the 2008 crisis.

With mortgage-backed securities, sub-prime mortgages posed the risk. With ILS, it’s the exposure of insurers and others to the chance a disaster may strike a particular area during a particular period of time.

The latest series of storms and earthquakes represents a serious test to insurance-linked securities. How they perform will have important consequences for disaster risk management going forward, especially in the era of climate change and the increasing development of disaster-prone areas.The Conversation

About The Author

Korey Pasch, PhD Candidate in Political Science and International Relations, Queen's University, Ontario

This article is republished from The Conversation under a Creative Commons license. Read the original article.

The Conversation

YOU MAY ALSO LIKE

enafarzh-CNzh-TWdanltlfifrdeiwhihuiditjakomsnofaplptruesswsvthtrukurvi

follow InnerSelf on

facebook icontwitter iconyoutube iconinstagram iconpintrest iconrss icon

 Get The Latest By Email

Weekly Magazine Daily Inspiration

LATEST VIDEOS

The Great Climate Migration Has Begun
The Great Climate Migration Has Begun
by Super User
The climate crisis is forcing thousands around the world to flee as their homes become increasingly uninhabitable.
The Last Ice Age Tells Us Why We Need To Care About A 2℃ Change In Temperature
The Last Ice Age Tells Us Why We Need To Care About A 2℃ Change In Temperature
by Alan N Williams, et al
The latest report from the Intergovernmental Panel on Climate Change (IPCC) states that without a substantial decrease…
Earth Has Stayed Habitable For Billions Of Years – Exactly How Lucky Did We Get?
Earth Has Stayed Habitable For Billions Of Years – Exactly How Lucky Did We Get?
by Toby Tyrrell
It took evolution 3 or 4 billion years to produce Homo sapiens. If the climate had completely failed just once in that…
How Mapping The Weather 12,000 Years Ago Can Help Predict Future Climate Change
How Mapping The Weather 12,000 Years Ago Can Help Predict Future Climate Change
by Brice Rea
The end of the last ice age, around 12,000 years ago, was characterised by a final cold phase called the Younger Dryas.…
The Caspian Sea Is Set To Fall By 9 Metres Or More This Century
The Caspian Sea Is Set To Fall By 9 Metres Or More This Century
by Frank Wesselingh and Matteo Lattuada
Imagine you are on the coast, looking out to sea. In front of you lies 100 metres of barren sand that looks like a…
Venus Was Once More Earth-like, But Climate Change Made It Uninhabitable
Venus Was Once More Earth-like, But Climate Change Made It Uninhabitable
by Richard Ernst
We can learn a lot about climate change from Venus, our sister planet. Venus currently has a surface temperature of…
Five Climate Disbeliefs: A Crash Course In Climate Misinformation
The Five Climate Disbeliefs: A Crash Course In Climate Misinformation
by John Cook
This video is a crash course in climate misinformation, summarizing the key arguments used to cast doubt on the reality…
The Arctic Hasn't Been This Warm For 3 Million Years and That Means Big Changes For The Planet
The Arctic Hasn't Been This Warm For 3 Million Years and That Means Big Changes For The Planet
by Julie Brigham-Grette and Steve Petsch
Every year, sea ice cover in the Arctic Ocean shrinks to a low point in mid-September. This year it measures just 1.44…

LATEST ARTICLES

3 wildfire lessons for forest towns as Dixie Fire destroys historic Greenville, California
3 wildfire lessons for forest towns as Dixie Fire destroys historic Greenville, California
by Bart Johnson, Professor of Landscape Architecture, University of Oregon
A wildfire burning in hot, dry mountain forest swept through the Gold Rush town of Greenville, California, on Aug. 4,…
China Can Meet Energy and Climate Goals Capping Coal Power
China Can Meet Energy and Climate Goals Capping Coal Power
by Alvin Lin
At the Leader’s Climate Summit in April, Xi Jinping pledged that China will “strictly control coal-fired power…
A plane drops red fire retardant on to a forest fire as firefighters parked along a road look up into the orange sky
Model predicts 10-year burst of wildfire, then gradual decline
by Hannah Hickey-U. Washington
A look at the long-term future of wildfires predicts an initial roughly decade-long burst of wildfire activity,…
Blue water surrounded by dead white grass
Map tracks 30 years of extreme snowmelt across US
by Mikayla Mace-Arizona
A new map of extreme snowmelt events over the last 30 years clarifies the processes that drive rapid melting.
White sea ice in blue water with the sun setting reflected in the water
Earth’s frozen areas are shrinking 33K square miles a year
by Texas A&M University
The Earth’s cryosphere is shrinking by 33,000 square miles (87,000 square kilometers) per year.
A row of male and female speakers at microphones
234 scientists read 14,000+ research papers to write the upcoming IPCC climate report
by Stephanie Spera, Assistant Professor of Geography and the Environment, University of Richmond
This week, hundreds of scientists from around the world are finalizing a report that assesses the state of the global…
A brown weasel with a white belly leans on a rock and looks over its shoulder
Once common weasels are doing a vanishing act
by Laura Oleniacz - NC State
Three species of weasels, once common in North America, are likely in decline, including a species that’s considered…
Flood risk will rise as climate heat intensifies
by Tim Radford
A warmer world will be a wetter one. Ever more people will face a higher flood risk as rivers rise and city streets…

 Get The Latest By Email

Weekly Magazine Daily Inspiration

New Attitudes - New Possibilities

InnerSelf.comClimateImpactNews.com | InnerPower.net
MightyNatural.com | WholisticPolitics.com | InnerSelf Market
Copyright ©1985 - 2021 InnerSelf Publications. All Rights Reserved.