The people of Chile are relieved that last weekend’s earthquake—the fifth most powerful in the last century—didn’t exact a higher toll. Insurance companies aren’t: They could be on the line for losses up to $8 billion, making this the second costliest earthquake for them in history.
Illustration: Jayachandran / Mint
Insurers in the West have been trying to mute the risk of such Black Swans—events that almost no one predicts but that everyone suffers from—for some time. In the late 1990s, they developed a new product called a catastrophe or “cat” bond. After hurricane Katrina in 2005, activity in this market on Wall Street jumped from near zero to $14 billion. Now, the office of India’s chief economic adviser has noticed it, too. Last week’s Economic Survey notes that “there is scope for introducing (this instrument) in countries like India”. There are grounds for scepticism here, but it’s worthwhile for regulators to at least examine this bond.
Before that, let’s understand what it is. To hedge or transfer their risk, insurers traditionally make alternative investments or sell pools of claims to reinsurers who, in turn, can repeat this. But that puts a few insurers or reinsurers on the line. Instead, catastrophe bonds floated by an insurance company transfer risk to global capital markets—a much wider cushion.
The next Black Swan would then act as a default for the bond: The investor would forfeit his principal, which the insurer would use to pay claims. That certainly makes it a high-risk instrument (the yield on it is higher), prompting concerns.
The first is that of India’s immature capital markets. It’s true that the low level of financial literacy dampens much financial activity; however, this bond caters to a sophisticated investor set, offering a security unlinked to the usual market volatility. So regardless of the weak bond market, this bond can thrive, depending on insurance.
Though, second, the current state of the insurance market isn’t promising either. According to a paper last year by Crisil and Assocham, India’s insurance business commands 0.6% of its output, against the world average of 2.14%. Still, as incomes rise and as more employers offer benefits, this market has only room to expand.
Third, India’s regulators, who have been conservative enough to realize that innovation aimed at diversifying risk can end up increasing it, may not warm up to it immediately. But just as they have slowly but surely allowed interest rate futures or currency swaps, catastrophe bonds could pass muster.
All of this points to a long time horizon. Which, given the risks of overnight financial liberalization, is surely a relief.
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