Would a Cat bond work for major flooding? ILS expert weighs in

Insurance-linked securities (ILS) such as Cat bonds aren’t ideal for raising capital to cover large-scale secondary peril events in Canada, such as the recent rainstorms that flooded Ontario, says an ILS expert.

But they can help the P&C insurance industry raise capital for a major earthquake in Canada.

Canadian Underwriter talked to ILS expert Chin Liu of Amundi U.S. last week about ILS securities and climate change. Liu was in Toronto for a series of meetings right around the time flooding from a severe storm in Ontario caused insured damage estimated to be around $1 billion.

“Generally speaking, most ILS investors would have very little risk appetite for secondary perils,” Liu observed, when asked if ILS might be used for the kind of large-scale flooding seen in Ontario this week. “I can see the challenges or pushback by investors if [a Cat bond] would only cover flood, tornado, hail or wildfire….

“I can say it loud and clear: investors want to make money. [They] don’t want to invest in something that has a higher probability of either losing money, or [for which] the industry has less modelling capability on the risks.”

Based in Boston, Liu is a managing director and director of ILS, fixed income solutions and responsible investment research at Amundi U.S. He talked to CU about the most likely opportunity for using ILS securities in Canada.

Earthquakes — a low-frequency, high-severity Cat peril — would more likely be of interest to global investors in ILS securities, Liu told CU.

By adding more capital, and therefore making earthquake coverage more affordable for Canadians, Liu thinks ILS securities could help shrink Canada’s earthquake coverage gap.

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Insurance Bureau of Canada studies have shown the take-up for earthquake coverage in B.C. is about 65%. In Quebec, another active seismic zone in Canada, only about 4% of homeowners have bought earthquake cover.

“If someone was to do a Cat bond, I think it would be very likely the bond would be well-received if it covers earthquake only,” Liu said. “With the capital coming in from the ILS market, that can potentially add more capacity to the space. That can potentially lower the premium or the price of earthquake insurance.

“And that can potentially motivate more people to buy earthquake insurance to really shrink the [coverage] gap.”

How Cat bonds work

ILS solutions turn to market investors to raise capital for insuring large-scale disasters. Catastrophe bonds are probably the best-known example of an ILS security, although they make up only one-third of the total global ILS market of around $103 billion, says Beat Holliger of Schroders.

How do Cat bonds work?

Insurers or reinsurers look to reduce or remove their risk of paying out on an insured event by creating Cat bonds for market investors to purchase.

For a typical contract period of between three and five years, ILS investors receive interest payments on the Cat bonds they purchase, paid out of the insurance risk premium plus a money-market return.

If no catastrophe happens within the specified period of the Cat bond, the investors walk away with their invested money, plus interest. But if a catastrophe with a pre-defined peril and pre-agreed insured loss amount happens, the investors do not receive their money back; instead, the insurers use the investors’ bond money to pay for insured damages caused by the peril covered by the ILS security.

Photo Credit: Cars are partially submerged in flood waters in the Don Valley following heavy rain in Toronto on July 16 2024. THE CANADIAN PRESS/Arlyn McAdorey