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V o lu m e Financial Innovations for Catastrophic Risk: Cat Bonds and Beyond Financial Innovations Lab Report Financial Innovations Lab Report April 2008 5 Financial Innovations Labs bring together researchers, policy makers, and business, financial, and professional practitioners for a series of meetings to create marketbased solutions to business and public policy challenges. Using real and simulated case studies, Lab participants consider and design alternative capital structures and then apply appropriate financial technologies. This Financial Innovations Lab Report was prepared by Glenn Yago and Patricia Reiter. Volume Financial Innovations for Catastrophic Risk: Cat Bonds and Beyond Financial Innovations Lab Report Financial Innovations Lab Report April 2008 5 Ac k nowl edg m en ts We are grateful to the participants of the Financial Innovations Lab for their contributions to the ideas and recommendations summarized in this report. We especially thank Allstate Insurance Company for its support in this important project. Eric Silvergold (Guggenheim Partners), Michael Millette (Goldman Sachs), John Brynjolfsson (PIMCO), Beat Holliger (Munich Re), Víctor Cárdenas (Ministry of Finance, Mexico), Erwann Michel-Kerjan (Wharton Risk Center), Eric Tell (Merrill Lynch), Barney Schauble (Nephila Capital), and Albert Selius (Swiss Re) generously provided time, expertise, and data for this report. In addition, we would like to thank Jeffrey Cooper and Joe Manzella (both from Allstate Insurance Company) for their guidance in designing the Lab and their review of the report. Our graphic facilitator, Deirdre Crowley (Crowley & Co.), provided support, illustrating and summarizing the key ideas from the Lab. Finally, we would like to thank our editor, Dinah McNichols, as well as our Milken Institute colleagues Karen Giles, Caitlin McLean, and Bryan Quinan, who helped organize the Lab. The Milken Institute is an independent economic think tank whose mission is to improve the lives and economic conditions of diverse populations in the United States and around the world by helping business and public policy leaders identify and implement innovative ideas for creating broad-based prosperity. We put research to work with the goal of revitalizing regions and finding new ways to generate capital for people with original ideas. We do this by focusing on human capital—the talent, knowledge, and experience of people and their value to organizations, economies, and society; financial capital—innovations that allocate financial resources efficiently, especially to those who ordinarily would not have access to such resources, but who can best use them to build companies, create jobs, and solve long-standing social and economic problems; and social capital—the bonds of society, including schools, health care, cultural institutions, and government services that underlie economic advancement. By creating ways to spread the benefits of human, financial, and social capital to as many people as possible—the democratization of capital—we hope to contribute to prosperity and freedom in all corners of the globe. We are nonprofit, nonpartisan, and publicly supported. © 2008 Milken Institute Ta ble of Con t en t s Introduction..........................................................................................................5 Part I: Issues & Perspective............................................................................7  Funding Challenges for Catastrophic Risk Management  The Financial Innovations Lab  The Catastrophe Bond Market: Overview  The Broader Catastrophic Risk Market: Overview and Outlook  Barriers to Growth in the Catastrophic Risk Market PART II: FINANCIAL INNOVATIONS FOR MANAGING CATASTROPHIC RISK......................................................................................... 27  Barrier: There Is an Insufficient Supply of Issuances Solution 1: Address the Needs of the Issuer Solution 2: Securitize Low-Risk Events Solution 3: Diversify Risk Securitizations  Barrier: There Is Insufficient Demand from Mainstream Investors Solution 4: Legitimize Catastrophe Bonds as an Asset Class Solution 5: Improve Risk Management Tools, Develop Appropriate Benchmarks, and Issue More Collateralized Debt Obligations Solution 6: Increase Liquidity and Transparency in the Secondary Market Solution 7: Promote Increased Participation from Rating Agencies  Barrier: Transaction Fees Are Too High Solution 8: Standardize Transactions, and Lower Legal Fees  Barrier: Regulation Hinders Growth Solution 9: Address Regulation That Promotes Growth  Barrier: Large Markets Remain Untapped Solution 10: Expand to Emerging Markets and Attract New Issuers Conclusion............................................................................................................ 39 Appendix I: Participants in the Lab..................................................... 40 APPENDIX II: Literature Review.............................................................. 41 APPENDIX III: Glossary of Terms........................................................... 44 Bibliography.......................................................................................................... 46 Endnotes.................................................................................................................. 48 For the period covering 1970 through 2006, ten of the world’s costliest catastrophe insurance losses occurred between just 2001 and 2005. And of those ten, nine occurred in the United States. 5 In t rod uct ion I n October 2007, the Milken Institute held a Financial Innovations Lab in New York to address ways to expand and share insurance risk in the area of catastrophe coverage. In particular, participants looked at catastrophe risk bonds, also known as cat bonds. These are securities that offer an alternative source of funding for reinsurance, which occurs when a primary insurer contracts with another insurer to diversify risk. Cat bonds return high interest rates to investors while providing insurance companies with the capital to pay out the huge losses that may arise from natural disasters like hurricanes, droughts, and earthquakes, or man-made calamities, such as terrorism. When such catastrophes occur, the consequences may be so severe, and not only to the insured, that they can drive insurance companies into insolvency. The Lab brought together representatives from institutional investment firms, academia, the legal profession, and insurance, reinsurance, and reinsurance intermediary companies to explore innovations in capital market insurance solutions. If these kinds of instruments can achieve greater acceptance in the larger capital and investor markets, insurers should be able to offer wider and more affordable disaster coverage. Participants tackled a variety of questions through presentations, case studies, and moderated discussions. The Lab identified five primary barriers to financing and managing catastrophic risk: ■ There is an insufficient supply of issuances. Issuances of catastrophe bonds have increased in the past few years, but in both size and amount, they have lagged behind expectations, despite the advantages of virtually no credit risk and a potential market capacity greater than that of the traditional reinsurance market. The product’s novelty—cat bonds have only been in existence since the mid-1990s—and the need to go offshore to execute the transactions were identified as barriers to increased issuance, not only of cat bonds but also of other capital market insurance solutions. ■ There is insufficient demand from mainstream investors. Catastrophe bonds have shown generally high returns and a low correlation to other asset classes, two highly desirable characteristics for investors. But for many institutional investors, they remain unattractive due to small market volume. And the lack of risk management tools and available benchmarks serve as deterrents to increased demand. ■ Transaction fees are too high. The issuance costs of catastrophe bonds currently run high compared to traditional reinsurance solutions. Legal expenses and regulatory requirements were blamed for higher costs. ■ Regulation hinders growth. In the United States, the state and federal governments have a long history of regulatory involvement in the insurance industry, and have provided earthquake and flood insurance, as well. While close publicprivate partnerships are necessary to protect individuals and the economy from natural and man-made catastrophes, the increasing federal role in the insurance market could discourage private-sector development and dissemination of new products. ■ Large markets remain untapped. Insurance and reinsurance companies have been responsible for more than 80 percent of new catastrophe bond issuances since the instruments were introduced. More recently, governments and companies have been among the new issuers, but again, the novelty of the product deters new entrants. For more exotic products, such as weather derivatives, this tendency is amplified. Climate change and demographic shifts are realigning catastrophic risk exposure, yet in developing nations, insurance covers less than 2 percent of the costs of disasters. 7 Part I Is s ues & Persp ect i ve Funding Challenges for Catastrophic Risk Management C atastrophe bonds came onto the radar in the early 1990s, after Hurricane Andrew left affected insurers with a bill of more than $23 billion. A number of insurers went bankrupt,1 and alarms sounded across the industry worldwide. Florida, like most of the coastal United States, and coastal Europe and Asia, has seen a building boom, and the concentration of population and wealth in regions vulnerable to hurricanes, typhoons, floods, and earthquakes was forcing insurers and reinsurers to rethink their exposure. Traditional risk models had been built around the idea that the industry could absorb one catastrophic event with losses of $30 billion every decade. But advancements in catastrophe modeling were predicting much greater losses occurring at increasing frequencies.2 The models proved correct, but the industry was unprepared. Figure 1 shows the twenty most costly catastrophe insurance losses from 1970 through 2006. In 1994, the Northridge earthquake in California resulted in insurance losses of $19 billion. A 1999 typhoon struck Japan and cost insurers almost $5 billion. The 2004 Atlantic hurricanes Ivan, Charley, Frances, and Jeanne left insurers cleaning up nearly $20 billion in damages. Katrina, Rita, and Wilma—the fiercest of storms during the most violent hurricane season on record—slammed the Gulf Coast during the late summer and fall of 2005. Katrina alone, the most expensive natural disaster in the history of insurance losses worldwide, left the industry reeling, with $66.3 billion in claims and expenses.3 Nor were catastrophes limited to the natural realm. The terrorist attacks of September 11 resulted in more than 3,000 deaths and created an economic toll of $35.5 billion for the insurers who helped rebuild damaged property, businesses, and lives. F igure 1 Twenty most costly catastrophe insurance losses, 1970–2006 US$billions (indexed to 2006) Event Year Victims 66.3* 35.5 22.9 19.0 13.6 12.9 10.4 8.6 8.4 7.4 7.2 7.0 5.5 5.5 4.9 4.9 4.4 4.1 4.1 3.8 Hurricane Katrina 9/11 terrorist attacks Hurricane Andrew Northridge earthquake Hurricane Ivan Hurricane Wilma Hurricane Rita Hurricane Charley Typhoon Mireille Hurricane Hugo Winterstorm Daria Winterstorm Lothar Hurricane Frances Storms and floods Winterstorm Vivian Typhoon Bart Hurricane Georges Tropical Storm Alison Hurricane Jeanne Typhoon Songda 2005 2001 1992 1994 2004 2005 2005 2004 1991 1989 1990 1999 2004 1987 1990 1999 1998 2001 2004 2004 1,326 3,025 43 61 124 35 34 24 51 71 95 110 38 22 64 26 600 41 3,034 45 Source: Wharton Risk Center. Area of primary damage U.S. and Gulf of Mexico U.S. U.S. and Bahamas U.S. U.S. and Caribbean U.S. and Gulf of Mexico U.S. and Gulf of Mexico U.S. and Caribbean Japan Puerto Rico and U.S. France and U.K. France and Switzerland U.S. and Bahamas France and U.K. Western and Central Europe Japan U.S. and Caribbean U.S. U.S. and Caribbean Japan and South Korea *This figure includes $20 billion paid for flood coverage by the National Flood Insurance Program (NFIP). 8 Financial Innovations The accelerating pace of climate change may trigger weather systems that strike more frequently, and with greater intensity. And explosive population growth in desirable areas spells greater exposure to natural disaster. More than 50 percent of Americans are now living in coastal regions vulnerable to floods and storms—a total of 153 million people, up 33 million since 1990.4 Ninety percent of Americans live in regions considered “seismically active.”5 And the insurance safety net has frayed. Two pieces of information stand out from figure 1: For the period covering 1970 through 2006, ten of the world’s costliest catastrophe insurance losses occurred between just 2001 and 2005. And of those ten, nine occurred in the United States. Insurance companies, finding it hard to access capital to underwrite their payouts and expenses, reacted by raising premiums and deductibles, eliminating coverage, and abandoning certain markets altogether—no longer selling earthquake or flood insurance, for example, in some disaster-prone areas.6 For whatever reason, from affordability to other budget priorities, Americans are not keeping up with their insurance needs. Just 10 percent to 15 percent of American homeowners purchase earthquake coverage, according to a report by the insurance rating agency A.M. Best.7 And despite congressional intervention to fill gaps through federally regulated insurance programs, a 2006 RAND study found that only 63 percent of homeowners in coastal flood zones, and 35 percent of homeowners in river flood zones, bought federal flood insurance, often the only kind of flood insurance available to them.8 As of 2004, the value of insured coastal exposure totaled $1.93 trillion in Florida and another $1.90 billion in New York.9 In eighteen Eastern and Gulf Coast states, exposure to hurricanes alone totals $6.90 trillion, or 16 percent of insurers’ total U.S. exposure.10 Elsewhere in the world, climate change and demographic shifts are also realigning catastrophic risk exposure. Yet when levees fail in New Orleans or freeways buckle in Los Angeles, residents often turn to private or public insurance safety nets. The tsunami slamming into Indonesia and Sri Lanka, and high-magnitude quakes in Turkey or El Salvador, hit populations and communities for the most part unprotected and uninsured. In developing nations, insurance covers less than 2 percent of the costs of disasters, while in the United States, that figure increases to 50 percent.11 Figure 2 illustrates this impact on emerging economies. Insurance has traditionally protected individuals and businesses by spreading risk among a large number of entities. But all risks are not equal. The vast majority of policies are written for well-defined markets: similar pools of clients who face similar risk exposure. Insurers work with “the law of large numbers”; the larger the group insured, the more accurate the predictions for specific kinds of loss, and how much to charge for protection. Automobile insurance is a prime example. Insurers can compute and predict the number and severity of automobile accidents and calculate with great precision the expected losses against the premiums they collect. In eighteen Eastern and Gulf Coast states, exposure to hurricanes alone totals $6.90 trillion.