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E-MailSteven L. Schwarcz is Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law. This post is based on his recent paper.
Insurance is the tried-and-true strategy for protecting against infrequent but potentially devastating losses. In theory, governments could protect against the potential economic devastation of future pandemics by requiring businesses to insure against pandemic-related risks. In practice, however, insurers do not currently offer pandemic insurance. Insurers fear their industry does not have the capacity to provide coverage.
In Catastrophe Bonds, Pandemics, and Risk Securitization, I focus on using risk securitization—a relatively recent and innovative private-sector means of insuring otherwise “uninsurable” risks—to insure pandemic-related risks. Risk securitization depends on investor demand to purchase catastrophe (“CAT”) bonds. Capital market investors have shown high demand, for two reasons. First, CAT bonds provide a diversified return because natural catastrophes occur randomly and are not correlated with standard economic risks; therefore, CAT-bond returns are largely uncorrelated to the returns of equity securities and conventional corporate bonds. Second, CAT bonds have provided strong returns to investors.
CAT bonds do not, however, represent a win-win deal for investors. If the covered catastrophe occurs, investors may lose part or all of their investment. To date, though, the combination of diversified and strong returns has more than offset investor perception of that risk. Indeed, the CAT bond market has seen strong growth, and Moody’s reports that CAT bond issuance is surging.
This paper analyzes how risk securitization could help to socialize pandemic-related risks by allocating them to sophisticated global investors who choose to purchase the associated pandemic-related CAT bonds and, presumably, are able to absorb those risks. The paper does not claim that risk securitization could become a panacea to solve the problem of pandemic-created economic catastrophes. It merely argues that risk securitization could offer at least a partial solution to that problem.
The analysis starts by explaining how pandemic risk securitization could work. An insurer (or reinsurer, government catastrophe fund, tec.) that wishes to insure parties suffering the catastrophic risks of a pandemic would create a special purpose vehicle (“SPV”) to issue CAT bonds to capital market investors. The SPV would invest the proceeds of its bond issuance in liquid and highly-rated debt securities. In exchange for premium payments, the SPV—acting effectively as a special purpose reinsurer—would promise to indemnify the insurer should the covered event occur, e.g., a particular pandemic of specified magnitude. The CAT bonds would bear interest based not only on the SPV’s investment returns but also on its receipt of the premium payments. Repayment of the CAT bonds would be subordinated, however, to the insurer’s right to indemnification, subjecting the investors to a potential loss of principal and/or interest under those bonds.
CAT bonds provide investors with a diversified return because the occurrence of natural catastrophes is not correlated with standard economic risks. Admittedly, the occurrence of a pandemic would negatively impact the value of pandemic CAT bonds while also potentially causing a financial decline. However, pandemics—like other natural disasters—occur randomly. Therefore, absent a pandemic, there would be no correlation during the normal life of pandemic CAT bonds between their value and financial sector conditions. If there were a pandemic, there could well be a correlation, but investors in those bonds explicitly bargain to take that risk.
The paper also compares the theoretical basis for pandemic risk securitization with actual risk-securitization transactions, including the precedent of a recent pandemic risk securitization structured by the World Bank. Additionally, the paper addresses future challenges to using risk securitization to protect against pandemic-related risk. There are legal challenges and economic challenges.
The legal challenges include, for example, whether the SPV should be regulated as a reinsurer, and also whether a government requirement that businesses purchase pandemic insurance could survive constitutional challenges. The economic challenges include developing a large enough market for CAT bonds to enable risk securitization to fund the level of pandemic insurance that businesses should be required to purchase. That challenge itself raises a host of questions, including what pandemic-related risks, if any, should the government share and how should it share those risks, e.g., pari passu, or by taking a first- or second-loss risk position. The answers affect not only public policy but also the ratings that credit-rating agencies, such as Moody’s and Standard & Poor’s, might assign to the bonds.
The paper analyzes and attempts to resolve those challenges and to answer those questions. It also explains how risk securitization could be used to supplement public-private catastrophe insurance schemes, such as Chubb’s recently proposed pandemic-coverage plan, to reduce the government’s shared exposure.
The complete paper is available for download here.
