Transferring pandemic BI risk to capital markets? It’s possible
Consider the following possibility: an insurer discovers reinsurance accounting irregularities that require a relook at multiple years of reinsurance processing to identify variances.
Capital markets solutions can help transfer and manage business interruption (BI) risk that arise from pandemics. Catastrophe bonds, for example, can provide a starting point for discussion.
Last year, many countries came to a standstill at different times and places. Businesses were unprepared for the period of prolonged business uncertainty that led to widespread BI events.
Neither were insurers.
In 2020, drastic lockdown measures taken by governments to combat the spread of the virus led to an estimated US$4.5 trillion hit to the global economy. However, less than 1% of that amount was covered by BI insurance, according to the Geneva Association, a leading international think tank in the insurance sector. Such policies are generally intended for, and triggered by, physical damages.
As overwhelming as COVID-19 was for all our lives, scientists had been predicting a pandemic for years. Rising global travel patterns, fast-paced urbanisation, increased human-animal contact (partly due to urbanisation and changing land-use including deforestation) and under-investment in health infrastructure borne out what once seemed like a dire prediction.
More pandemics or other ‘black swan’ events cannot be ruled out.
If constructed properly, a forward-looking pandemic business interruption insurance solution that leverages capital markets can be part of a multi-faceted solution to bolster society’s capacity for bearing pandemic risk beyond traditional insurance mechanisms.
It requires a nuanced understanding of the unique characteristics of pandemics as capital market participants will want a structured solution that considers their concerns.
A different type of catastrophe
Given the large protection gap for pandemic risk, one part of a multi-faceted solution can take the form of alternative risk-transfer solutions, including insurance-linked securitisation (ILS). An instructive example is how catastrophe bonds help to transfer risks that arise from natural disasters to institutional investors – after all, a pandemic is just a different form of a disaster or a catastrophe.
However, there are differences particular to pandemics.
Unlike natural disasters like typhoons or earthquakes, pandemic-related business interruption losses may not be random. Losses could be driven by government decisions or consumer behaviours, which would complicate the structuring of ILS solutions.
Pandemics are also positively correlated with economic cycles as a global pandemic such as COVID-19 often sparks a recessionary cycle potentially reducing the attractiveness of pandemic bonds as a way to diversify market risks.
Even if investors are willing to purchase an ILS like a pandemic bond, they would be concerned about liquidity risk if they lose value under a ‘fire sale’.
If pandemic bonds are designated as eligible assets to borrow from central banks, liquidity concerns, however, may not be as high.
But is there capital market interest?
For now, investor interest is expected to be low due to the uncertain COVID-19 environment. Nonetheless, we believe opportunities will arise for transferring pandemic BI risk to capital markets.
The European Insurance and Occupational Pensions Authority, an advisory body to the European Union, estimates the total capital base of the global commercial non-life re/insurance industry at around US$2 trillion, a fraction of global capital markets worth over US$180 trillion.
Through careful construction of ILS, there could yet be demand from capital market participants to take on pandemic BI risk to enhance investment yields and diversify investment risk thereby improving society’s capacity during crises.
As catastrophe bonds have shown in the past, innovative alternate risk transfer solutions can be constructed.
Given the experience of a recent pandemic, a lot of data has been collected that can now come of use.
Structuring a strong ILS solution is possible
Now, we know better how bond investors with portfolios that include economic sectors that can be resilient even during a pandemic like IT equipment manufacturing, micro-chip producers and social media, will do better lowering the correlation of pandemic risk with financial market risk.
It can also be easy to arrive at an objective trigger mechanism if declarations by international bodies of pandemics and a measure of operational losses suffered by insured companies is used instead of lockdown announcements by governments.
Meanwhile, the lack of adequate risk modelling and actuarial expertise for pandemic risk assessment will improve with the explosion of data made possible by the accelerated digitalisation of the broader economy.
There has clearly been a realisation across insurance firms that existing private insurance solutions cannot ensure or cover all business losses from a pandemic.
Apart from public-private partnerships, capital market solutions can be one of many ways to push the frontier of insurability. Close collaboration with stakeholders including InsurTechs and governments as well as business continuity plans at companies can form a comprehensive solution.
Construction of effective ILS solutions will ensure the insurance industry learns and adapts quickly ahead of the next crisis, which could possibly be yet another pandemic.
