European Central Bank calls for greater use of catastrophe bonds

The European Central Bank (ECB) alongside a macro-prudential oversight body it operates, the European Systemic Risk Board (ESRB), has called for greater use of catastrophe bonds to address the insurance protection gap and mitigate catastrophe risks from climate change in the European Union.

The transfer of catastrophe risks and physical climate change risk drivers to the capital markets is seen as a prudent step to both support the broadening of the insurance and reinsurance market’s capacity to respond to climate change, and move risk away from public and private balance-sheets.

Insurance coverage and adaptation measures are both seen as critical levers for the European Union nations, as they respond to growing climate risk exposures and the impacts of severe weather and natural disasters across the region.

With only around a quarter of climate-related catastrophe losses currently covered by insurance and reinsurance in the EU, the ECB and ESRB are exploring and recommending ways that more of that loss burden can be captured and covered.

The feeling is that the loss burden has been growing and is likely to continue to, with climate change a factor in this, so putting in place the mechanisms to transfer more risk and support the insurance industry expanding its coverage of them, is seen as critical.

“This insurance protection gap could widen in the medium to long term as a result of climate change, partly because repricing of insurance contracts in response to increasingly frequent and intense events may lead to such insurance becoming unaffordable. This would further increase the burden on governments, in terms of both macroeconomic risks and the fiscal spending needed to cover uninsured losses, and may also pose financial stability risks,” the ECB and ESRB explain.

One of the main objectives is to ensure insurance can pay out promptly when climate catastrophe events occur, with parametric triggers seen as a valuable tool for certain layers of risk and certain types of protection buyers.

It’s important that any mechanisms used are complementary to traditional insurance and additive to the re/insurance market’s mission to cover more risk, while stakeholders must have skin in the game, with the ultimate goal of lowering the economic cost to the public sector from these disasters and reducing the potential for a taxpayer burden.

Private insurance and reinsurance are seen as “the first line of defence to cover losses from climate-related natural disasters.”

But, by adopting a laddered approach to risk transfer, more support from the financial markets can be introduced as well, the ECB and ESRB believe.

The financial markets can be used to transfer risks using catastrophe bonds, supporting the reinsurance of climate-related catastrophe risks, the pair state.

At the bottom of the ladder sits insurance and insurance pools, above which are the reinsurance markets and also the capital markets using instruments such as catastrophe bonds, the ECB and ESRB work suggests.

Above these private market risk transfer layers, sit public-private-partnerships and other public mechanisms for alternative risk transfer, while at the top sits an EU wide excess layer, which could also feature catastrophe bonds as a way to transfer more of the risk before government or EU-wide support is required.

At all layers, design of insurance, reinsurance and risk transfer instruments needs to also encourage adaptation, so that it reduces climate vulnerability over time, the ECB and ESRB also state.

Catastrophe bonds and other forms of risk transfer to the financial and capital markets, have additional benefits to their risk transfer alone, such as diversifying the sources of risk capital available to protect and augmenting the ability of traditional re/insurance markets to absorb more risk at the most appropriate return-periods.

In addition, cat bonds are seen as a way to combine impact underwriting with impact investing, the ECB and ESRB said.

Cost is seen as an issue though, with cat bonds seen as expensive for European risks.

Although, as has been seen with some recent European catastrophe bond issues, this cost-gap to traditional reinsurance is decreasing, given the current hard market environment.

There is also a role for catastrophe bonds in providing risk transfer support more directly to public initiatives, such as PPP’s or governments, as well as to an EU wide excess layer of risk transfer, the ECB and ESRB suggest.

For the largest disasters, the ECB and ESRB recommend that an EU-wide public scheme for natural disaster insurance could be an option to complement national schemes.

Here, aggregated funding could help to pay premiums needed for laying off the excess to the financial markets, with catastrophe bonds again a relevant risk transfer tool.

It’s the latest call for greater use of capital market tools for risk transfer in Europe and there is a clear ground-swell of opinion that leveraging insurance-linked securities (ILS) such as catastrophe bonds can support the re/insurance market to do more, while also providing options for transferring the largest risks of more infrequent events off the public balance-sheet.