‘Resilience bonds’: A secret weapon against catastrophe

The costs of natural disasters are becoming too much to bear – and it’s driving up premiums no matter where you live. The solution may be a transformative type of insurance never seen before.

In a conference room overlooking downtown Miami, British executives are talking about why they know south Florida’s streets so well. It isn’t because of the sunshine. It’s because of the area’s risk for disasters like hurricanes and flooding.

“There are hundreds of my colleagues… who know the zip codes of these counties in this part of the world almost as well as the residents here,” says Rowan Douglas, head of capital, science and policy at the London-based risk management group and insurance broker Willis Towers Watson. “This area of the world is protected to some degree by a global community of everyone else who buys their insurance policy. My mother-in-law in northwest Spain is sharing risk with Florida."

No policy or premium stands alone. Our global economy is so intertwined that if you buy insurance, you’re helping to cover the fallout from far-away crises, whether an earthquake in Mexico or flood in Louisiana. As a result, nearly everyone’s pocketbook is affected by one simple fact: rebuilding after a major catastrophe nearly always costs more than preparing for it in the first place.

And climate-related disasters (like droughts and tropical storms) are getting more common. From 2005 to 2015, the UN found there were 335 weather-related disasters each year across the globe, almost twice the number seen from 1985-1994. The average catastrophe also is getting more expensive. While the inflation-adjusted cost of natural disasters was about $30 billion annually in the 1980s, it’s now more than six times that: an average of $182 billion a year.

Governments have improved at implementing policies that protect against some types of disasters. For example, zoning laws can restrict the population living in hurricane-prone areas. But it hasn’t been enough. From 2003 to 2013 alone, natural disasters caused $1.5 trillion in damages, killed more than 1.1 million people and affected more than 2 billion. At the same time, it’s not as if governments are finding they have more room in their budgets to clean up a crisis – or to build the resilience measures that could help prevent them.

Enter a new idea that could transform not only the global economy, but how disasters affect us: a resilience bond. As well as guaranteeing help to communities after a catastrophe, it would help fund projects and strategies they need to become less vulnerable to begin with. “Resilience bonds are, in my view, the next exciting and innovative frontier in infrastructure and resilience finance,” says Samantha Medlock, former senior advisor to the Obama White House on resilience and now senior vice president at Willis Towers Watson.

The concept is part of an overall trend, experts say, that could transform how communities work: as risk modelling has become more and more sophisticated, the private sector is getting closer to being able to turn not only risk, but resilience, into numbers.

It’s like a life insurance company being able to tell you not only how likely you, specifically, are to have a heart attack in the next five years, but also exactly how much walking a half hour a day or cutting out red meat could reduce that risk… and what that increase in health is likely to be worth, in cash, to your future.

It will be a financial and scientific revolution, and it will save billions of dollars and thousands, if not millions, around the world of lives – Rowan Douglas

That ability to put ‘hard numbers’ on what previously have been seen as ‘soft’ concepts, like the value of resilience, is huge, industry insiders say. “It will be a financial and scientific revolution, and it will save billions of dollars and thousands, if not millions, around the world of lives,” says Douglas.

Fix-it mentality

When it comes to preparing for future disasters, humanity tends to be woefully optimistic. In the same way that it’s difficult to convince individuals to fork out money for a life insurance policy, it’s tough to get governments to carve out spending for just-in-case scenarios when they also need to prioritise streets and schools.

Worldwide, just 26% of economic losses due to natural disasters were covered by insurance in 2016. “That means people dying or suffering, and governments and aid agencies and charity and philanthropy filling that gap. Or not filling that gap, as the case may be,” says Daniel Stander, managing director of consulting company Risk Management Solutions (RMS), which works with companies and governments to model and manage catastrophe risk.

Buying insurance for your household (or city) is one thing. Another is making your community resilient to begin with. Here’s the problem: it’s difficult to pay for something when the risk of doing nothing is hard to quantify.

In other words, it’s not enough to only determine how likely a city is to experience a magnitude eight earthquake at a specific depth. You also have to know how many buildings that would destroy, lives it would disrupt – and the likelihood and extent of that financial loss. Without figuring out both the cost and the probability of risk, you can’t determine the value of resilience – like adopting an earthquake-resistant building code.

The resulting lack of hard numbers means communities historically haven’t been rewarded upfront for thinking ahead – whether by credit ratings agencies, insurance companies or even their own central governments. And that’s made it difficult to decide to spend on resilience now… rather than kicking the decision to the next mayor or CEO and hoping a disaster won’t happen on your watch.

Buying insurance for your household (or city) is one thing. Another is making your community resilient to begin with

But that tends to be a bad move long-term – especially as for major crises, making the needed changes now tends to be cheaper than rebuilding after. One recent study reported that each dollar spent by the Federal Emergency Management Agency (Fema) on disaster preparedness in the US saved $4 later. Other cases can be more extreme. One analysis of flood prevention measures in Kinshasha in the Democratic Republic of Congo found that every dollar spent on measures like constructing small dams, cleaning drainage canals and seeding watersheds with grass saved at least $45.58 during the following rainy season.

But with a fix-it ethos still more common than a plan-ahead one, it’s no wonder that governments have found themselves vulnerable to big financial losses. In the US, flooding is the largest source of financial exposure for the federal government after only Medicare and social security. That has led to struggles. In 2011, the worst global natural catastrophe loss year on record, the country had $116 billion in damage claims. Fema’s National Flood Insurance Programme (NFIP), which provides insurance to flood-prone communities, is more than $24 billion in debt. But it wasn’t until September 2016 that NFIP bought its own re-insurance programme, effectively transferring more than $1 billion of risk out of taxpayers’ wallets and into the reinsurance market.

People will have to shift their entire thinking about how disaster recovery is funded – and by whom, experts say. “There’s a perception that, following a disaster, the federal government’s role is to make you whole and rebuild homes and infrastructure and community at the federal taxpayer’s expense. And that is simply not true,” Medlock says. “There are limits to what the federal government can – and should – do.”

Fat cat

The insurance industry itself, which dates back at least 14th-Century Genoa, may make sense for helping to cover that gap. “No one understands the risk of loss from climate hazards better, I would argue, than the insurance industry,” Stander says. “They’ve become experts at translating hazard into damage, and then damage into cold, hard cash.”

But many traditional insurance products aren’t quite right for governments. Take a homeowner’s policy. You pay an insurer, who keeps your money, just in case of, say, a burglary. If you do get burgled, you tell the insurer what you lost and they pay back the value of the items. But as anyone who has had to make a claim knows, that process can take weeks or months. You also run the risk that the insurer could argue over the value… or decide to not pay out at all, as New York University found out to its detriment after a 2015 flood, leading it to sue its insurer for $1.5 billion in denied coverage.

Governments can’t run the risk of losing taxpayers’ money. And when it comes to disaster response, no one wants a delay – not least of all because, with each passing day, losses can escalate. Medlock points out Hurricane Sandy. After it hit the east coast of the US in 2012, it took the US Congress about 90 days to agree on an appropriations package for federal disaster assistance. “That three-month delay is very inefficient,” Medlock says. “It creates tremendous uncertainty for survivors, for communities – and for regional economies.”

With a fix-it ethos still more common than a plan-ahead one, it’s no wonder that governments have found themselves vulnerable to big financial losses

One innovation developed in response is a parametric catastrophe (or ‘cat’) bond. When you buy a cat bond, the insurer doesn’t hold the money in their bank account – it sits in an account beyond their control, so there’s no chance of it disappearing when you need it. There’s another twist, too: whenever there’s a crisis, you don’t have to tell the insurer (let alone prove) exactly what was lost. Instead, the payout happens automatically as soon as a certain parameter is reached – often as quickly as 48 hours later. For a storm cat bond, it might be when storm surge reaches a certain height. That was the trigger chosen by New York’s Metropolitan Transit Authority (MTA) for its first cat bond, which it issued in response to Hurricane Sandy in 2013. (According to reports, the MTA is now issuing its second cat bond). It's worth noting that to have an immediate payout, the parameters that trigger a cat bond, like minimum strength of the storm, require certainty and clarity -- a lesson learned, according to reports, after a Mexican cat band took more than three months to pay out after Hurricane Patricia in 2015.

The first federal government to purchase a cat bond was Mexico, which bought a parametric bond in 2006 that was structured by reinsurer Swiss Re to cover damage from earthquakes (and later, hurricanes). Today, says Nikhil da Victoria Lobo, Swiss Re’s Americas leader for global partnerships, some 40 federal governments worldwide have purchased similar protection. “When we started this discussion in 2006, it was about one risk – earthquakes; one country – Mexico; and one transaction – Mexico’s first cat bond. Today, there are so many sovereign nations doing this,” he says.

But that’s still only one-quarter of countries worldwide. And whenever governments are unprepared for a catastrophe, the consequences get even worse. The knock-on effect of a disaster can include everything from disrupting supply chains to a power outage that stops production. So far, most entities have been able to manage disruptions, Standard & Poor wrote in a recent report. But “looking ahead,” it added, “the picture is less certain.”

If a disaster causes an economic cascade effect, S&P wrote, in the most extreme cases, certain governments could see a downgrade of four-to-five notches in their credit rating – the equivalent of moving from investment-grade to junk bond status. By affecting everything from car insurance payments to homeowners’ insurance, that’s enough to send a country’s economy into a tailspin.

The trick is to prevent disasters from becoming so deadly and damaging to begin with. And that’s where the resilience bond comes in.

Pilot project

A resilience bond is “an innovative variation on the cat bond”, says Medlock. It would work like this: imagine City X wants to build higher seawalls or fix its levee, but doesn’t have access to funds. When it goes to buy a multiyear, parametric cat bond for flooding, the insurer takes the expected impact of that planned investment into account and lowers the premium the city has to pay. With that cost saving in the budget, City X now has the money to fund its seawalls and levee – even if no disaster ever occurs.

At the moment, this hasn’t happened yet. But it’s close. “We’re probably not years away from this sort of a concept becoming real,” says Medlock. “We could be months away.”

One government leader interested in piloting the concept is Greg Guibert, the chief resilience officer of Boulder, Colorado. He recently partnered with the Stanford Urban Resilience Initiative for a workshop on innovative solutions for resilience finance. Just a few days later, he says “my head is kind of spinning” from the potential tools he was introduced to – especially the concept of a parametric resilience bond.

Like many other local leaders, Guibert has had difficulty with funding resilience. Disaster recovery money came in after a devastating 2013 flood, he says, “but the federal funds have dried up. So we’re looking at more innovative avenues for financing.”

A resilience bond appeals because you could use a dividend from a resilience bond to capitalise even less infrastructure-based types of resilience programmes, like community-building exercises that strengthen disaster response by encouraging neighbours to look out for one another. “I’m never going to be able to add enough zeros to a city budget required to achieve that otherwise,” Guibert says.

But as long as a resilience bond remains untested, it can be a hard sell to others at the local level.

“The ultimate value of local government is to protect the residents and property,” says Guibert. “So if you make a large alteration in how you do that, you really want some assurance that you’re making an appropriate choice for our citizens. That can be a hard leap when we’re talking about really major investments.”

It isn’t just local governments that would need to come on board before the first resilience bond actually makes a trade. Other entities that are integral for providing financing – like the US Government Finance Officers Association, or rating agencies – will have to agree in the innovation’s merit, too. “Until those people give credit to that decision-maker, and thereby bring down their financing costs, you’re never going to create a tangible and monetised cash flow” to fund the project, says da Victoria Lobo.

But from the amount of excitement around the products to S&P’s increasing recognition of climate change, da Victoria Lobo says, “I think we’re a lot closer than we think we are.”

No one knows exactly how much of an effect a product like this could have on encouraging resilience investment. But with both the number and the expense of natural disasters on the rise, it seems fair to say that this kind of incentive won’t come a moment too soon.

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