In normal circumstances, underwriting risk in insurance is transferred to a primary insurer, who, beyond a certain limit, transfers it to a reinsurer. But there is another option that facilitates entering the capital market. The term used is known as ‘Insurance Securitisation’. The process calls for transferring the underwriting risk – the underlying cash flow into financial securities that can be traded.
This global volatility, triggered by climate change, inflation, societal schisms, and political risk of varied nature, requires that insurers/reinsurers evolve and recast themselves to meet the growing realities. There has been noticeable change in the nature of catastrophic risk. The severity and frequency of secondary or non-peak perils have been discomfiting in recent years. Losses from severe thunderstorms, flooding, and wildfires have been constantly rising. While the effects of peak perils like earthquakes or cyclones continue to torment human lives, the cumulative effects of non–peak perils now dominate the discussion. In the last five years, non-peak perils caused a loss of USD 175 billion (annual inflation-adjusted losses), of which only USD 84bn was insured. Severe convective storms are the highest contributor to this loss. A 1 °C increase in temperature leads to around 7% more water vapour absorption by the atmosphere. This leads to more weather-related natural catastrophes, according to a Munich Re report. As a result, the risk is becoming more frequent and severe as well.
As a consequence, traditional reinsurance capacity is becoming more elusive, expensive and unstable. The insurers have been increasingly looking for diversified sources of risk transfer. The investors have trained their focus on uncorrelated assets.
The available options and innovations like catastrophe Bonds (Cat Bonds) or Insurance-Linked Securities (ILS) initially emerged as alternative sources of reinsurance capacity. But they soon became an important pillar of broader enterprise risk management solutions.
Insurance-Linked Securities (ILS)
A wider category of financial instruments whose returns are linked to insurance or reinsurance risks. These are risk management tools that, through the process of securitisation, allow insurers/reinsurers to raise capital by transferring risks of catastrophic dimension to capital markets. Investors in these instruments are assured of attractive returns but may lose some or all of their principal if specified insurance events occur. Catastrophe Bonds (Cat Bonds) are an important component of ILS. Insurers or reinsurers transfer catastrophe risks—such as earthquakes, tropical hurricanes, floods, or hurricanes to capital market investors. Industry Loss Warrant (ILW) Sidecars are other examples of ILS.
Suppose an insurance company has issued thousands of policies covering homes against flood and inundation risk in Assam. It fears that a severe flood could generate claims of ₹10,000 crore. Reinsurers show reluctance to cover this enormous risk. The Insurer decides to issue a CatBond. For this, it will have to create a special purpose vehicle (SPV) which will issue the Cat Bond. Investors invest the above amount by subscribing to the bond. The principal amount is invested in highly valued securities or a fund. (In the US, it is invested in US Treasury securities. )
The Insurer pays a risk premium to the SPV. The SPV puts together the interest earned on the collateral and the premium received from the Insurer to pay investors an attractive coupon. It has to be remembered that a cat bond pays out only if a predefined trigger is met.
An Industry Loss Warranty (ILW)
another well-known type of ILS signifies loss payment at the industry level and not at an individual insurer level. i.e the payment depends on the total loss suffered by the insurance industry, rather than the actual loss of the buyer. An example with the following trigger would explain the concept. Event: Hurricane – Industry loss trigger: USD 20 billion ; Total Coverage purchased: USD 50 million. Suppose a hurricane occurs and the total insured industry loss is USD 12 billion- the ILW will not trigger the risk; if, however, the total industry loss exceeds 20 billion – the ILW pays the loss as per the contract reached.
India’s ILS market is still at a nascent stage and is yet to achieve the maturity seen in established jurisdictions such as Bermuda, Singapore, and the United States. To date, no Indian insurer has issued a publicly placed catastrophe bond. Nevertheless, India presents significant potential to develop an ILS market tailored to its unique risk landscape, including cyclones, floods, earthquakes, agricultural losses, and pandemic-related events.
The proposed GIFT IFSC framework offers a promising platform to position India as a regional hub for catastrophe risk securitisation. Achieving this objective, however, will require robust catastrophe modelling capabilities, transparent and credible trigger mechanisms, and a supportive regulatory framework that encourages innovation while ensuring investor confidence and market integrity. The ILS business involves the transfer of risks to the capital markets; as such, the process needs a distinct set of regulations.
Reference
https://www.munichre.com/en/risks/natural-disasters/losses-from-non-peak-perils-are-on-the-rise.html
Authored by:
Dr Abhijit K. Chattoraj – Chartered Insurer
