The recent COP26 climate summit brought up the theme of how insurance could help build resilience in the face of rising climate volatility. As cities around the world face more regular and extreme weather events, governments will come under increasing pressure as they are forced to bear the costs of damaged infrastructure.
But within the ILS market, the concept of structures that could help meet some of these needs is not new. A framework for a “resilience bond” was first launched in 2015, which proposed a variation on conventional catastrophe bonds to incentivise investment in infrastructure spending by offering premium rebates.
This could involve cities upgrading their costal protection systems or reinforcing houses to protect against damage caused by storms and floods, for example: benefitting insurers as well by reducing risk.
The aim was to “link insurance and resilience projects to monetize avoided losses,” according to a 2017 report by the RE:bound program (a partnership between RE:focus partners, Risk Management Solutions (RMS), Swiss Re and The Rockefeller Foundation).
The idea had gained traction amongst some high-profile advocates. Samantha Medlock, senior counsel on the United States House Select Committee on the Climate Crisis, told the BBC that “resilience bonds are, in my view, the next exciting and innovative frontier in infrastructure and resilience finance,” while Rowan Douglas, head of Willis Towers Watson’s Climate and Resilience Hub boldly called the concept a “financial and scientific revolution” which “will save billions of dollars and thousands, if not millions of lives, around the world.”
Yet despite this concept falling in line with the current zeitgeist, resilience bonds have failed to take off in the past five years, raising the question of what needs to be learned to meet goals of building in resilience.
The concept has failed to gain significant traction partly due to the difficulties in modelling such a product, and defining what exactly it means, market participants told Trading Risk.
Payback challenges
Andy Palmer, head of ILS structuring for the EMEA APAC regions at Swiss Re Capital Markets, told Trading Risk that the concept is “a very nice idea in theory, and where we've seen that it can have good application is on a local scale but it’s unlikely to be widely adopted.”
This is for three reasons. Firstly, because infrastructure developments are unlikely to be significant enough to bring down premiums, especially if the insurance covers a large area.
“If you have a bond, let's say, which covers the United States, what resilience project is going to reduce the risk if you're looking at the entire of the United States?” said Palmer.
Secondly, the time-lag between starting an infrastructure project and completing it is likely to exceed the time frame of most cat bonds and insurance products. For instance, the Thames Barrier in London took eight years to build, far exceeding the usual 3 to 5 year lifespan of a cat bond.
What resilience project is going to reduce the risk if you're looking at the entire of the United States?
“If you have a three-year cat bond, there’s no way you're getting the benefit of something which is taking 20-30 years to be built, because it won't be in place by that time”, Palmer continued.
Additionally, the costs of a large-scale infrastructure project are likely to exceed the savings a cedant could expect from a resilience bond rebate.
“In most cases your investment in protection is so much bigger than any premium reduction you can ever think of that it just doesn't work in particularly large infrastructure investments, such as building a dam,” said Ivo Menzinger, Swiss Re's EMEA managing director for public sector business.
However, he noted that where there are more permanent relationships between insurers and cedants, risk reduction projects are possible.
“In Switzerland, we have monopoly insurers in some cantons. And interestingly, they are really engaged in in risk reduction projects, like fire risk reduction and sometimes even natural catastrophe risk. So where you have this long-term relationship between the insurer and the insured, it makes sense that the insurer can invest in risk reduction.”
While monetising avoided losses in an insurance sense may be difficult, risk reduction projects as investments in themselves could be more viable - if outside the ILS world. “If you say the definition of a resilience bond has nothing to do with monetizing avoided losses, but the definition of a resilience bond is that the proceeds are used to actually reduce risk, that in itself, I think is going to develop into an interesting asset class comparable to for instance, green bonds”, said Menzinger.
Redefining goals
Other types of standard cat bonds or ILS deals can be used for similar goals, where they are sponsored by entities that would use a payout for reinvestment rather than meeting insurance claims.
It may “take some time to realise that this is an efficient way to support society”, according to Palmer, as they fall “outside of what has been created and recognized in the sustainable bond space”. With regular green bonds the proceeds are used specifically for a project, he explained whereas risk transfer bonds “aren't particularly being used for anything other than to collateralize the coverage, to be there in case there is an event.”
Jo Syroka, a senior underwriter & director of new markets at Fermat Capital Management noted that there are several catastrophe bonds that support “important resilience building and development efforts of governments,” pointing to the bonds issued on behalf of countries by the World Bank as well as sovereign catastrophe risk pools for the Caribbean (CCRIF-SPC), Africa (ARC), and the Pacific (PCRIC).
Yet the advantage to this approach, when coupled with fast-response parametric triggers, is that governments can swiftly access pay-outs, essential for tackling economic and humanitarian hardship after a disaster, instead of waiting for payments which take longer to procure, such as aid.
So, although some of the promises of resilience bonds met insurmountable barriers, the growing awareness of the need to prepare for and mitigate climate change has spurred viable alternatives.
“Building programs that can effectively utilize and leverage insurance in this way takes time—there is no short-cut to that,” said Syroka, “but I do believe such initiatives will become an increasing source of recurring risk transfer to the ILS market.”