Canadian Underwriter

How transitioning from cat bonds to resilience bonds can reduce insurance costs

December 9, 2015   by Canadian Underwriter

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Financial instruments structured in a similar manner to catastrophe bonds could provide a reduction in insurance costs by recognizing the value of community resilience projects such as flood barriers, a paper released Tuesday suggests.

re:focus partners LLC – in conjunction with Swiss Re, Risk Management Solutions (RMS) Inc. and The Rockefeller Foundation – published a paper titled Leveraging Catastrophe bonds as a Mechanism for Resilient Infrastructure Project Finance. [click image below to enlarge]

A new paper, titled Leveraging Catastrophe bonds as a Mechanism for Resilient Infrastructure Project Finance, was released by RMS, Swiss Re, the Rockefeller Foundation and re:focus partners LLC

“In principle, resilience bonds can be structured similarly to conventional cat bonds except that they explicitly anticipate the impact that resilience projects can have on the chances of a trigger event occurring,” re:focus stated in the paper.

Examples of resilience projects include coastal flooding protection projects and flood barriers.

Catastrophe bonds cannot actually protect against insured risks, re:focus suggested, but “can only reduce their financial consequences for asset owners and the indirect impacts on the broader community.”

However, “every cat bond sponsor has an interest in protecting against physical risks, and mobilizing investments into projects that provide real, on-the-ground protection from perils, such as storm surge and flood,” re:focus stated. “Transitioning from cat bonds to resilience bonds can offer sponsors additional value by providing financial protection plus resilience rebates to support investments into physical protection, including resilient infrastructure projects.”

With resilience bonds, “the basic relations between sponsors, issuers, investors, and the collateral account are similar to those in conventional cat bonds,” re:focus explained. “The difference is that resilience bonds explicitly evaluate the impact of the resilience project on the investor’s expected loss. Assuming that the resilience project reduces the expected loss to investors, then the project can create a resilience rebate from the reduced cost of coupon payments to investors.”

Those rebates could be used in a project fund. They could also be used to reduce insurance costs if they are directed towards a sponsor’s general fund. Rebates could also be used to increase sponsors’ coverage, re:focus stated.

Resilience bonds would have to specify which projects are eligible to generate potential rebates and how risk reductions that are generated by resilience projects would be qualified under the bond program. The bonds must also “specify the mechanics of rebate transactions and how the rebate funds will be used.”

The rebates “could be credited directly back to resilience bond sponsors, they could be collected by the issuer or a broker, or they could be distributed to an independent or 3rd party ‘depository’ that is empowered to receive and distribute rebate funds according to specified rebate management protocols,” re:focus stated in the paper.

“Eligible projects can be defined in terms of specific capital projects already underway, such as a seawall under construction at ‘Location L’, funded by ‘Source S’, being built by ‘Contractor C’, to be completed by ‘Date D,'” according to the paper. “Alternatively, projects can be defined in terms of general features, for example, a coastal protection within ‘Area A’ designed to provide protection against storm surge up to at least a ‘Surge Height H’, as measured at ‘Tide Gauge G.'”

Resilience bonds can have single or multiple sponsors.

An intermediary, (in addition to the issuer of the special purpose vehicle), “would typically be used to facilitate the issuance of resilience bonds with two or more co-sponsors,” re:focus explained. “The role of this intermediary is to collect premiums from the co-sponsors and to distribute any payouts to the co- sponsors if a bond is triggered by a catastrophic event. Premiums and payouts can be allocated among resilience bond co-sponsors in a number of ways.”

Catastrophe bonds are “regularly used by government-sponsored insurance programs,” re:focus noted.

Examples include the New York Metropolitan Transportation Authority’s, Florida Citizens Property Insurance, the California Earthquake Authority, Louisiana Citizens, Texas Windstorm Insurance Association and passenger rail service Amtrak.

However, resilience bonds “can serve as a financial incentive to help local governments set clear objectives for project completion in order to recognize the potential value of reduced insurance costs and associated rebates,” re:focus contended. “For example, if a four-year bond is designed with an anticipated reset beginning in year three, after the point of project completion, a delay in construction or operation would result in a lower financial benefit across the bond term due to a delay in the coupon reset.”

Resilience bonds “could not only support a faster recovery, but would also help to improve preparedness in a very substantial way, and to fast-track resilience from idea to reality,” Swiss Re vice president Alex Kaplan stated in a press release.

However it is “critical” that resilience bonds “be underpinned by accurate risk modeling,” stated Ben Brookes, vice president of capital markets at RMS. “It’s only through meticulous risk quantification using advanced catastrophe modeling methodologies that the design criteria of the instrument, as well as decisions around future risk mitigation and resiliency investments, can be agreed with confidence.”