Use cat bonds for peak German disaster risks, with state taking the tail: Study

A study undertaken by reinsurance industry participants and consultants in Germany has proposed a three-layered approach to managing peak disaster risks, with the industry using catastrophe bonds to diversify risk into the capital markets, while the government would be expected to take the tail risks of really significant catastrophic events.

The research study undertaken by DEVK Re, E+S Rück and Zielke Research Consult, looks specifically at how to manage those really significant disaster events that would pressure governments and societies, as well as the insurance and reinsurance industry.

With a goal of increasing the availability of insurance coverage at the lowest-level, to benefit society, while protecting the re/insurers through use of capital markets risk transfer via cat bonds, then asking the government to step-in where losses go beyond those layers.

It’s a vision of a public-private partnership on risk, between the primary insurers and reinsurers, the capital market and the state.

“Customers would continue to take out their insurance with the primary insurer. However, the risk would not lie solely with this company or traditionally with the reinsurers, but would largely be borne by the capital market,” explained Dr. Carsten Zielke.

Insurers and reinsurers should sponsor catastrophe bonds to bring in more risk capacity to enable them to write more business, the study suggests.

But, for the rare occurrences, of really major catastrophic events, or an accumulation of events, there should be layers of protection above the catastrophe bonds that are financed by the state, to protect the continuity of the re/insurance market and ensure society can function.

It’s seen as something akin to a state guaranty for terrorism risk, which is already seen in some countries, but for natural disaster risk, while the government should also earn a share of premium as well, for taking on the extreme tail risk of events.

Those involved suggest that catastrophe bonds covering German peak disaster risks could prove attractive to investors.

But, of course we’ve seen over the years that the spread paid for assuming European catastrophe exposures have not always been sufficient to attract investors in.

The hope is, that by having the PPP arrangement in place, investors can be encouraged by the availability of tail risk cover, which should also help the insurance and reinsurance industry provide continuity, without such significant cycles, meaning the flow of catastrophe bonds should continue undeterred after losses.

PPP arrangements like this have been proposed all over the world, but we’ve yet to see them meaningfully embraced.

For policyholders, ideas like this are attractive as they suggest the government would not always be on the hook, so taxpayers less impacted, while re/insurance costs could be kept more stable even when disasters do occur.

Of course, those involved in the study could also set an example and look to the cat bond market for their own retrocession, to demonstrate the effectiveness of capital markets as catastrophe risk shock absorbers. The question is, would they pay the necessary price.

But, that leads us back to another recent article, where European governments have discussed catastrophe bonds and the potential for grants to help support their issuance, as a way to expand access to disaster and climate insurance in the region.

That, or something similar, could help to make it far more appealing for the re/insurers to sponsor cat bonds, while going some way to subsidising their costs, so they can pay the spreads that insurance-linked securities (ILS) investors need to earn, in order to deploy their capital to cat bonds in the European region.