Insuring against catastrophe

The October floods in Thailand are proving to be one of the worst natural disasters in modern economic history and have already clocked up around $15 billion in insured losses so far, causing a slump in factory production of more than 36 per cent. Widespread supply chain disruptions caused by the floods serve as a sombre reminder that economic wellbeing can be culled by a single natural catastrophe.

Our community and our economy cannot withstand a natural calamity without the protection of insurance- Matthew Mizzi

The challenge of dealing with catastrophes is set to intensify as developing economy growth quickens and international trade patterns condense. The impact of natural catastrophes is no longer confined to their immediate environs. It follows that if their impacts are global the resulting challenge to mitigate their effects is a global one too. For instance, the quake and tsunami in Japan earlier this year saw car producers across the globe jolted by the sudden impact of supply chain disruptions. These events intensify economic volatility and exacerbate risks.

Malta is hardly immune to natural catastrophes. A single event – a flash-flood or oil-spill off our coast – could rock local economic production and cause damage to people, homes and vehicles. Losses of human and economic capital can disrupt the development of our community for decades. Our risk of loss is only set to increase as our economy grows and matures.

Dealing with the risk of a natural catastrophe is no mean feat: Traditionally states employed reactionary strategies and tools with the aim of dealing with calamitous events. However, focus is slowly shifting to prevention and insurance. In fact, both states and private enterprise are turning to financing techniques normally associated with the banking industry to develop insurance policies which will pay out on the occurrence of a natural catastrophe.

One of these techniques, known as insurance securitisation, involves the transfer of risk from a party wanting to protect itself against catastrophe to a special entity or “vehicle” set up specifically for the purpose of providing this protection. The vehicle raises money from institutional investors –pension funds, banks and other insurance companies – through the issue of bonds, fittingly called catastrophe bonds.

Despite being a relatively recent development, catastrophe bonds have already been harnessed by states and enterprises. Mexico developed a catastrophe bond whereby the vehicle commits itself to provide insurance protection to the Mexican state in the event of earthquakes of a pre-defined magnitude were to hit the country.

The utility of innovative insurance solutions is recognised by experts and practitioners alike. The World Bank, spurred by its positive experience with the insurance model and building on the success of the Multilateral Investment Guarantee Agency, which provides political risk insurance to investors and lenders against losses caused by non-commercial risks, has now introduced an insurance facility known as the Caribbean Catastrophe Risk Insurance Facility – a state sponsored insurer which is anticipated to raise funds from the capital markets through the issue of catastrophe bonds and similar instruments.

European and American enterprises are also spurring an active primary and secondary market in catastrophe protection with notable contributions on the European continent from AXA, Munich Re and Swiss Re. All these enterprises have sought insurance protection through the capital markets.

The European Union is encouraging its member states to foster a market in the protection against costly natural calamities. In 2006, the prescient drafters of the Reinsurance Directive gave member states the option to develop laws for special purpose entities set up for the sole purpose of an insurance securitisation transaction.

Analysts at global investment firms forecast growing volumes of insurance securitisation transactions as laws become more robust and more suppliers offer such solutions. The early leaders include Ireland, Bermuda and the Cayman Islands, familiar faces in international finance, but it’s still early days to pin-point a definite standout.

These developments should push Malta to act on two counts. Firstly, our government should actively consider the potential of developing a national insurance facility to provide insurance cover for extreme, statistically anomalous events that occur once every two hundred years and which fall outside traditional insurance cover. Secondly, our government should also foster a market where local and international insurance companies can seamlessly connect with capital market players. Our laws require intelligent design to foster market activity of this nature to protect against calamity.

Our community and our economy cannot withstand a natural calamity without the protection of insurance. It is time we start thinking of protection, before it’s too late.

mmizzi@jmganado.com

Dr Mizzi is a member of the insurance and private pensions team at Ganado & Associates, Advocates.