As regular readers of The Risks of Hazard know, this blog focuses on the primary underwriting of cat risk, and the benefits of better underwriting that can be realized by insurers and society at large. Thus, catastrophe bonds are a topic that rarely come up in our discussions. However, the protection gap does (and does and does!). When The Intelligent Insurer published this paragraph-length headline - ILS Leads the Way ... and May Help Closing the Protection Gap - it was inevitable that cat bonds would make their debut in the blog.
Cat bonds, or Insurance Linked Securities (ILS), are far removed from the act of underwriting a cat risk – in fact, they are at opposite ends of insurance. Cat bonds are the final divestment of risk from the insurance industry into capital markets, (unless they bypass insurance completely, as with the MetroCat cat bond), while underwriting is how the risks get into the industry. Granted they are so far apart, how does underwriting relate to cat bonds?
The answer is that underwriting has everything to do with everything in the insurance industry. Without underwriting, there is no risk. With no risk, there is…nothing. Not only is underwriting how risk is brought into the insurance space, it quantifies that risk. And there is no activity throughout the life-cycle of a risk more important than underwriting because establishes the value and uncertainty of the risk for all the other activities that will be based on that risk – accumulation, reinsurance, and any eventual bond created with it will all be influenced by the quality of the underwriting.
The article from The Intelligent Iinsurer is right – cat bonds are definitely helping fill the protection gap. And they will fill more of the protection gap, and they will fill it more efficiently if the risks are accurately assessed – if they are well underwritten. The price of the bond will be an accurate reflection of the risk therein. And this is why those who work in cat bonds need to be aware of how underwriters can improve their risk assessment – they don’t underwrite individual risks themselves, but they depend upon accurate underwriting on all of the risks they work with.