Global Assessment Report on Disaster Risk Reduction 2013
From Shared Risk to Shared Value: the Business Case for Disaster Risk Reduction









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206 Part III - Chapter 13
13.1) —now one of the few markets with a net inflow of fundsvii . In the first quarter of 2012, for example, the issuance of catastrophe bonds viii reached a record level, driven by an ‘excess supply of capital’ for which investment opportunities have to be found (Aon Benfield, 2012d
x

Aon Benfield. 2012d.,Insurance-Linked Securities. Evolving Strength 2012., Aon Benfield Securities Report., Chicago,USA: Aon Benfield Securities.. .
). The growing interest in these and other insurance-linked securities is expected to increase further (WCMA, 2012
x

WCMA. 2012.,ILS Market Update. Strong Momentum Continues Into 2012 Hurrican Season., Willis Capital Markets & Advisory, July 2012.. .
).
This market growth is neither driven by disaster risk reduction objectives nor directly requires that insured or reinsured parties reduce or manage their risks. The demand-side incentive comes from pension funds and institutional asset managers who seek to diversify their investment portfolios with alternative products that have uncorrelated risks and yieldsx . The incentive for the insurance industry includes the spreading of disaster risk over a wider capital base through a diversity of securities and other financial products. This extra capacity is especially attractive considering increased need to cover intensive risk. The multi-year fixed price capacity also makes investment planning of insurance companies more sound and easy compared with the usual annual term coverage of reinsurance (WEF, 2008
x

WEF (World Economic Forum). 2008.,Convergence of Insurance and Capital Markets., World Economic Forum in collaboration with Allianz, Barclays Capital, Deloitte, State Farm, Swiss Re, Thomson Reuters, Zurich Financial Services., New York and Geneva: World Economic Forum.,. .
).
The use of capital markets is not limited to insurers seeking alternatives for reinsurance. To smooth catastrophic risk, some countries issue catastrophe bonds instead of purchasing insurance, as shown in the Mexico example. In addition, companies such as Tokyo Disney, Universal Studio and Electricité de France have sponsored catastrophelinked securities (OECD, 2011
x

OECD (Organisation for Economic Co-operation and Development). 2011.,Future Global Shocks. Improving Risk Governance., OECD Review of Risk Management, OECD Territorial Reviews., Paris,France: OECD.. .
).
Despite significant insurance losses in recent years, the insurance-linked securities market remains strong as most contracts to date cover wind events in the United States of America rather than Asian earthquakes, floods and tsunamis (Aon Benfield, 2012a
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Aon Benfield. 2012a.,2011 Thailand Floods Event Recap Report: Impact Forecasting, March 2012.. Available at http://thoughtleadership.aonbenfield.com/Documents/20120314_impact_forecasting_thailand_flood_event_recap.pdf.
; WCMA, 2012
x

WCMA. 2012.,ILS Market Update. Strong Momentum Continues Into 2012 Hurrican Season., Willis Capital Markets & Advisory, July 2012.. .
). However, this may change with an increasing flow of capital into securities covering other regions and new hazards, and for which reliable catastrophe models are only now being developed.
Catastrophe bonds have been diversified in line with increasing investment trends (WEF, 2008
x

WEF (World Economic Forum). 2008.,Convergence of Insurance and Capital Markets., World Economic Forum in collaboration with Allianz, Barclays Capital, Deloitte, State Farm, Swiss Re, Thomson Reuters, Zurich Financial Services., New York and Geneva: World Economic Forum.,. .
). Their indices and premiums are based on detailed industry catastrophe models and risk assessments, which are regularly revised and updated, sometimes, as Box 13.6 shows, in real time. However, this risk information is very difficult for potential investors to
Box 13.6 Pricing risk in real time – lessons from Hurricanes Irene and Gustav
Insurance-linked securities are traded not just before or after disasters happen, but also during events. In such cases, the pricing of risk, via the pricing of securities, takes on a dynamic that is directly based on the evolution of the hazard event. For example, when Hurricane Irene was categorised as a Category 3 storm in August 2011, the prices of several catastrophe bonds fell by 30–50 percent. Once Irene was downgraded to a Category 1 storm and then subsided, prices quickly rebounded.

Thus, while risk modelling underpins the pricing of insurance-linked securities, trading is reactive to real events and on a real-time basis. So-called Live CAT Bonds have now been developed where trading takes place while the event, usually a hurricane, develops. Such Live CAT Bonds are commonly industry loss warranties, i.e. insurance products where payout is triggered by a predefined loss limit across an entire industry rather than an individual company’s loss.

During Hurricane Gustav in 2008, US$9 million Live CAT Bonds were made available based on a new real-time hurricane index, through contracts between reinsurers and investment banks, hedge funds, etc.

The real-time aspect of the hurricane index and because it is fungible enabled the issuer to settle trades within three business days of hurricane landfall. Although this meant a cash-flow benefit to clients on both sides of the process, the simplicity of the index trigger may imply that risk levels may have been underestimated or not correctly priced, encouraging risk-increasing investment behaviour.
(Source: UNISDR, based on Aon Benfield, 2012d
x

Aon Benfield. 2012d.,Insurance-Linked Securities. Evolving Strength 2012., Aon Benfield Securities Report., Chicago,USA: Aon Benfield Securities.. .
andxii )










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