The European Central Bank (ECB) and European Insurance and Occupational Pensions Authority (EIOPA) recently published a discussion paper on policy options to reduce the climate insurance protection gap. Headline points are:
- Catastrophe bonds (cat bonds) can help reduce the climate insurance protection gap
- European perils represent a small proportion of international cat bonds
- Ireland is the EU jurisdiction of choice for EEA cat bond sponsors
- EU and national authorities could consider measures to foster a vibrant cat bond market
The paper takes a 'ladder approach' to loss sharing from natural disasters, with various parties bearing the loss at different layers. The first loss layer is private insurance, followed by reinsurance and alternative risk transfer, then national public/private partnerships to supplement private sector cover and finally an EU component in excess of national measures.
Private insurance, as the first ‘rung’ on the ladder, is the first line of defence to cover losses from climate-related natural disasters. For this layer, the paper focuses on the economic benefits of catastrophe insurance and on “impact underwriting”, which is aimed at providing risk-based incentives to policyholders to implement climate change adaptation measures – for more detail, see my previous post on this topic here.
The paper’s discussion of the second ‘rung’ of reinsurance and alternative risk transfer will be of interest to insurers who are looking to use financial markets to transfer natural catastrophe risk via the issue of insurance-linked securities (ILS), in particular cat bonds.
As noted in the paper, cat bonds can complement insurance schemes by providing prompt liquidity for reconstruction after natural disasters. Used with traditional reinsurance, they provide two key benefits – diversification of sources of capital to meet insurance risks and helping to lower the overall cost of coverage (and therefore lower premiums).
There are also diversification benefits for investors, as cat bonds benefit from low correlation with equity and debt markets. They can also be used as impact investments for ESG purposes, where the collateralised assets backing the cat bonds are invested in green initiatives, allowing for a double benefit of impact underwriting and impact investment.
However, the ECB and EIOPA point out that European perils represent a relatively small proportion of cat bonds currently outstanding internationally, due in part to high transaction costs for cat bond transactions and the time involved to set up the special purpose vehicle (SPV) required to issue ILS.
Despite this, a number of well known (re)insurers in the EEA have chosen to issue cat bonds via Irish SPVs, which simplifies the calculation and reporting of regulatory capital requirements for Solvency II (re)insurers.
The paper explains that public authorities at national and EU level could consider measures to help foster a more vibrant cat bond market to reduce the climate insurance protection gap, by putting in place faster authorisation processes for ILS SPVs or providing grants to cover the upfront issuance costs.
It remains to be seen what action will be take on foot of the proposals set out in the paper. As the ECB and EIOPA make clear, the aim of the paper is to solicit feedback on the policy options set out – they are seeking comments by 15 June 2023.
Should such measures be implemented at a national or EU level, Ireland would be well placed to be the EEA jurisdiction of choice for cat bond issuances by Solvency II (re)insurers, given the Central Bank of Ireland’s experience of authorising ILS SPVs to date.