A new proposal calling for a European natural catastrophe insurance pool to diversify risks across countries and perils could be further enhanced by the insurance-linked securities (ILS) market, according to the European Insurance and Occupational Pensions Authority (EIOPA) and the European Stability Mechanism (ESM).
In the paper, it is argued that a pool solution combined with an additional loan-based backstop for extreme tail events that exceed the pool’s capacity, could reduce the insurance gap to roughly 10% at European level for properties.
Moreover, the backstop would require capacity of up to EUR 65 billion to handle extreme tail events.
EIOPA and ESM’s proposed mechanism aims to reduce Europe’s significant protection gap, which in the past has reportedly left around 75% of economic losses from natural catastrophe events uninsured.
The proposal also seeks to strengthen the continent’s resilience against increasingly frequent and severe natural disasters.
“Primary insurers, reinsurers, market-based solutions, and, where available, national schemes should continue to play a key role in spreading the risk of natural catastrophes. However, their capacity may not be sufficient to absorb losses from large-scale disasters, which are becoming more likely in a warmer climate,” EIOPA and ESM explained.
As mentioned, in order to help further strengthen risk-sharing across the continent, both EIOPA and ESM have proposed the establishment of a European natural catastrophe insurance pool to diversify risks across countries and perils.
As both firms note, this approach would enable insurers to use capital more efficiently, and help expand coverage, and ultimately help to keep premiums affordable for households and businesses.
Furthermore, a loan-based backstop would supplement this European layer by providing an extra financial safety net in the event of extreme circumstances that deplete the pool. Its fiscally neutral design would enable the insurance sector to gradually absorb the expenses. It would offer predictable and affordable funding, reduce reliance on ad hoc public support and stabilise reinsurance costs, without distorting private markets or weakening fiscal discipline.
Most relevant to our readers, however, is the suggestion that this insurance structure could be expanded by ILS instruments, such as catastrophe bonds.
By utilising these securities, the required size of the pool could be reduced, effectively making capital markets a core part of the solution. Both organisations noted that the pool itself could act as a special purpose entity for the issuance of cat bonds.
“The European insurance industry could enter a reinsurance contract with the pool. The pool would issue notes in the capital markets against regular coupon payments. This way, part of the expected losses can be transferred to the capital markets with corresponding impact on the losses to be distributed among pool members,” the paper reads.
EIOPA and ESM also emphasised that while the ILS market and capital market solutions remain fairly niche and somewhat underdeveloped in Europe, they could play an important role in natural catastrophe risk transfer by tapping into the international capital markets.
“Catastrophe bonds, as well as other less common insurance-linked securities, may also serve as a useful means for a European risk pool to cede some of the risk assumed,” the paper added.
It’s important to note that over the last couple of years, the European ILS market, while representing a smaller share of the overall space compared to the US, has experienced rapid growth, which has been supported by a strong issuance pipeline of cat bonds.
Given current climate change trends, EIOPA and ESM outlined that the funding of the pool and the lending capacity of the backstop facility may have to grow over time.
“Climate-related events are increasing in frequency and severity, meaning that major catastrophes that are currently anticipated to occur once in a century may happen more frequently. Depending on the speed and severity of climate change, the backstop may require adjustments, particularly if the pool cannot accumulate sufficient reserves. While adaptation measures may mitigate the impact, sums insured could still increase (e.g. because more residential and commercial developments are being built in areas prone to natural disasters),” the paper reads.
