What if catastrophe bonds could be used to prevent losses, instead of paying for them?
That’s the impulse behind RE.bound, a collaboration among Goldman Sachs, The Rockefeller Foundation, Swiss Re, risk modeler RMS and consultancy re:focus partners.
Cat bonds have been used primarily by insurance companies to offload the risk of natural catastrophe — an earthquake or hurricane, for instance — to capital market investors. If an event covered by a bond happens and trips a pre-set trigger, then the sponsor of the deal uses money that would otherwise go to bondholders to pay for its losses.
Launched last April, RE.bound is searching for a way to structure a “cat-like” bond for infrastructure that’s designed to make cities more resilient to natural catastrophe such as seawalls or environmentally-friendly storm water projects.
While growing significantly in the last few years, insurance companies or pools remain the overwhelming majority of cat-bond sponsors, with the occasional exception such as a $200-million deal from New York’s MTA in July 2013.
ASR recently spoke about RE.bound, and other applications for cat bonds, with Ben Brookes, vice president of capital markets at RMS, which services a range of clients, including cat bond sponsors.
ASR: What might the infrastructure targets of RE.bound be?
Brookes: There are currently eight cities exploring potential projects such as a sea wall in Miami, recycled water systems in San Francisco, and storm-water collection in Hoboken. The feasibility studies are available in more detail on the re:focus partners' website. In the case of Hoboken, New Jersey, for example, one idea is to use an underground parking facility as a way of collecting storm water—like a giant bathtub. The idea is to let that fill up and reduce the floodwater that might otherwise overwhelm the existing storm-water systems.
ASR: Is there a precedent for this approach?
Brookes: One example I’ve heard of is investments to produce energy savings around street lighting. A large provider offers to replace the light bulbs in street lights for more efficient energy consumption. The resulting savings can be partially shared with the provider of the financing as a kind of premium, making it an attractive investment. Over time it pays itself back; over a long time it becomes profitable.
ASR: The question then is: what does a catastrophe version of that look like, as opposed to, say, a cat bond that simply transfers the risk of losses from an event like an earthquake or hurricane without having to deal with factoring in the cost savings of a certain infrastructure project?
Brookes: First you have to understand that risk today. That’s where RMS comes in — modeling the economic impact of events today. Then you look at how feasible it is to have the proposed infrastructure implemented and whether it’s possible to model those improvements for financial savings. Once you know the savings, you can pre-finance the project.
ASR: Why not just go in the direction of the kind of cat bonds we’ve already seen? For example, the one issued by the MTA, in which the breach of a trigger — in the MTA’s case a storm surge of a certain size — allows the sponsor to use the cat bond proceeds to cover its losses and reduce its payments to bondholders. Isn’t this simpler?
Brookes: It certainly doesn’t take that off the table. The RE.bound project is about finding ways to improve the infrastructure that reduces the loss potential in the future as opposed to just making sure you get paid back if you have a big loss. It’s trying to find a way in which you stop the loss from happening in the first place. There’s a post-disaster financing view of the world — which is what cat bonds typically provide — but there are also investment opportunities in projects that increase the resilience against these disasters. We’re trying to bring those two together.
ASR: In the case of cities, what about the potential for post-disaster aid from the state or federal government? Does this create the hazard of not fully protecting against catastrophes?
Brookes: Cities or companies have to decide if it’s better to be holding enough capital, buying insurance, or waiting for loss. RE.bound is attempting to tackle the problem where cities are exposed and then federal bailout happens after a disaster. There has to be an incentive for cities to work at their own level, which is where the cost-savings from RE.bound projects come in.
ASR: What other new frontier is out there for cat bonds?
Brookes: There’s potential with pandemic risk. With last year’s outbreak of Ebola, people are asking: what could happen if the next infectious disease is far more transmissible than Ebola was? Ebola mostly stayed in West Africa, but the finance of the management of that disease was not quick enough to control it as fast as it might have been. There were initial appeals to raise about $70 million in September of last year and then six weeks later they needed ten times that to control the disease because it spread so quickly.
ASR: What might the trigger of such a cat bond be?
Brookes: It could something as simple as reported cases of a new disease in a particular region.
ASR: Who would sponsor such a cat bond?
Brookes: The World Bank has been looking at this as a way to raise money to respond to these crises. [There’s a precedent with Multicat]. But it’s also an idea that might be interesting to corporations; a pandemic is going to have a huge impact on the business of a big multinational airline. Another area ripe for cat bonds is business interruption risk and supply chain risk, where businesses can protect against the impact that events have on their business as opposed to direct loss to their assets. That’s something that hasn’t been fully explored yet.
ASR: This would be more parametric? [a specific trigger for the cat bond to withold payments to bondholders, such as a certain size earthquake.]
Brookes: Exactly. For example, a big earthquake hits a region; a company in the area is going to have issues but they’re not necessarily easily quantified in terms of a direct loss measure of property damage even though it will have a big impact on the running of my business.
ASR: What about non-insurance companies or transportation authorities issuing the kinds of cat bonds we’ve already seen? Since the MTA did its deal there’s been talk, including from Boston’s MBTA, but no follow through yet.
Brookes: There are a fair number of hurdles that companies need to get over in order to issue a cat bond: building up a picture of the assets that you want to cover and understanding in what way you want to cover those assets — will the trigger be parametric or indemnity [based on losses from the covered event], or somewhere in between? You need is a way of modeling the risk so you can describe it to investors, and a way of triggering the risk so you can objectively state that a claim is being made. And of course, you need to transfer that risk or economically it wouldn’t make sense.
ASR: And then there’s the cost of traditional insurance as a rival to cat bonds. The outstanding has dipped a bit so far this year following a few years of rapid growth.
Brookes: One of the interesting dynamics in the marketplace at the moment is the degree to which reinsurance is being priced very competitively versus the ILS [insurance-linked security] cover out there. There have been deals recently that were in the market as catastrophe bonds and were actually placed as reinsurance because there was a more competitive offer on a reinsurance basis. That’s a reversal from a longer-term trend of insurers and reinsurers being undercut by new capital coming in. The reality is that alternative capital has begun to draw a line in the sand in terms of pricing, and insurers and re-insurers are now competing to keep that business and winning it back in some cases.