Non-governmental organization (NGO) Oxfam is currently working with a New York-based consulting firm to explore the possibility of using capital markets structures within the context of index insurance in developing countries.
“We are still in the early stages of exploring that,” says Marjorie Victor Brans, senior private sector policy advisor for Oxfam America in Boston.
Victor Brans says Oxfam is currently working with a volunteer economist and a large economics consulting firm to explore the possibility of using catastrophe bond-like structures to cover risk in developing countries.
Oxfam declined to name the consulting firm or economist, other than to say that they study is being conducted “on a pro-bono basis.”
The study should be completed within the next several months, Oxfam says.
The use of capital market structures would take the current use of index-insurance products beyond its limited capital base.
Currently, there are several index-insurance programs — where cover is linked to an index such as temperature rainfall instead of actual loss — in a number of developing countries. For example, programs based in Africa, Vietnam and South America help protect local farmers from the effects of climate risk.
The programs are typically funded by local and international reinsurers.
Although the idea is still in early stages, one significant hurdle for the use of ILS in developing countries is the issue of scale, Victor Brans says. “In order for it to succeed you may need it to scale over a region over several countries,” she says. “Is it viable at five million farmers or 50 million? Is it viable within one country?”
Milka Kirova, a senior economist with Swiss Re’s Economics Research and Consulting Unit, says index-based insurance programs help broaden risk transfer to areas where traditional insurance is not typically available, or is prohibitively expensive.
“These are usually agricultural-based developing nations where insurance markets are not developed or traditional insurance is extremely expensive because of the high costs and moral hazard issues involved with tracking actual losses,” she says.
More often than not, Kirova says that local governments and international organizations are involved in the development of index insurance products as a way to increase the effectiveness and transparency of the program.
The first hurdle for an index-based ILS is determining the proper index.
Most indexes currently available that measure natural catastrophes are limited to peak zones in the United States and Europe, says William Dubinsky, a director with Swiss Re Capital Markets in New York.
“When you think of a nat-cat indices, what we have is very limited when it comes to developing countries,” he says. “The exceptions are pure parametric structures that can be used pretty much universally.”
A properly structured index has less to do with enticing capital markets investors than simple economics, Dubinsky adds.
“The indices are helpful regardless who is providing the capital,” he says. “Whether the risk ends up directly in the capital markets or intermediated by an insurance or reinsurance company is more a function of the underlying risk.”
Dubinsky says that with respect to non-peak risks, capital markets investors are looking for “at the money risks” that are liquid and trading at profitable levels, such as weather derivatives or seasonal drought cover.
Insurers and reinsurers, however, often provide better pricing for more “remote non-peak risks” such as earthquakes and other rare cat events in developing countries.
“There is good reason to believe that while indices provide a good amount of value and attract capital markets investors, initially the largest amount of the capital for non-peak extreme events in developing countries will remain with reinsurers,” he explains.
While the question of whether a catastrophe bond structure could work in the developing world remains to be seen, many agree its use as a risk management tool could be significant.
“Large reinsurers realize their catastrophe business has to diversify,” says Oxfam America’s Victor Brans. “And there is lots of catastrophe risk in the developing world.”
The private sector’s interest is not entirely altruistic, says Victor Brans. “There is a realization that these markets are the markets of the future,” she says. “Growth rates of insurance in developing countries is significantly higher than in industrial countries.”
When mulling the use and index in a capital markets transaction, Dubinsky says that ultimately the question revolves around pricing. “There is a decision to be made regarding the tradeoff of transparency and basis risk,” he says.
Dubinsky explains from a sponsor perspective, there are often savings in “out of pocket costs” in terms of payments to investors by using an index risk.
From an investor perspective, indexes call for a discount since they are a more transparent way to quantify the risk. “It’s just a question of how much of a discount the investor will give,” Dubinsky says.