The First Terrorism-Linked Bonds

The first insurance companies were launched in the 18th century, the first reinsurance companies in the 19th, and the first insurance-linked securities in the 20th. This steady development in the insurance market helped make property and casualty insurance universally accessible and competitively priced. It has also reduced the riskiness of insurance operations, bringing stability and predictability to what might otherwise be a very risky business. Despite these advances, the market for terrorism insurance has gotten off to a rougher start. Terrorist attacks are a difficult peril to provide coverage against but new terrorism-linked bonds aim to change that.

Terrorism and Insurance

Terrorism is notoriously difficult to insure against. It is not simple to confidently model terrorism risks and few firms offer such services. Even those models that do exist are relatively new and untested, suppressing the confidence needed to further develop the market for terrorism insurance. This can be contrasted with the risk posed by wind events like hurricanes and tornados. These are better understood and are perils for which much more investment has been made in improving prediction abilities.

It can also be difficult to define terrorism for insurance purposes. How can it be distinguished from other acts of violence, or even war? Further challenging prospective terrorism insurers, the scale of terrorism-related losses can seem so large as to make it unmanageable for a private firm to reliably offer comprehensive coverage. As a result of all this, many find terrorism coverage expensive and the available options few. The gap in the market for terrorism coverage had been growing for years and governments have attempted to fill this gap, often by public intervention in the market for terrorism insurance.

Pool Re

One example of state involvement in the market for terrorism coverage is Pool Re. A UK based company, Pool Reinsurance Company Limited or ‘Pool Re’, is a government-backed terrorism insurance firm active in Britain. It was established in 1993 after a bombing of the Baltic Exchange on St Mary Axe in London by the Irish Republican Army caused £650 million in losses. The firm was established, with government backing, to maintain continuity of terrorism insurance coverage in a market that was increasingly abandoning such a product. To this day, Pool Re offers insurance against terrorism risk partly through government support along with agreements with private reinsurers.

Not all are pleased by the extent of government intervention in the market and Pool Re has attempted to transfer terrorism risk back to the private sector and in the process lessen the chance that British taxpayers could experience losses as a result of terrorism. Catastrophe bonds are one way the company is attempting to achieve just that.

In the event a covered peril materializes, money invested in a catastrophe bond would compensate the bond’s issuer, usually an insurance or reinsurance company. In this way, catastrophe bonds provide insurance against certain perils which, should they materialize, would cause the bonds’ investors to lose their investment, in whole or in part. To investors, the bond is a way of betting against the occurrence of a covered peril. To the issuer, catastrophe bonds are a means of offloading some of their risk to others. The market for such bonds, a type of ‘insurance-linked security’, was born in 1996. Today it is a booming market with $93 billion invested in it as of 2018 as compared to just $18 billion in 2009.

Baltic PCC Limited

Pool Re has waded into the catastrophe bond market with its first such bond issue, Baltic PCC Limited (Series 2019). This security was the first catastrophe bond of its kind. Years in the making, the deal closed in 2019. The Baltic PCC Limited bond was the first standalone and publicly-issued terrorism-linked bond in history.

There were past catastrophe bond transactions that covered terrorism but only partially and always as part of larger insurance programs that also covered other perils. Also, these issuances were privately offered and for which less information was publicly available. One 2003 transaction, Golden Goal Finance Ltd., covered only the risk of event cancelation prompted by a terrorist attack or certain other events. This bond was issued by FIFA, the governing body behind football/soccer, to insure against the risk of a natural disaster or terrorist attack prompting a cancellation or interruption of the 2006 World Cup in Germany.

By contrast, the Baltic PCC Limited bonds provided broader coverage for physical damages arising from terrorist attacks on the British mainland, along with some business interruption related losses. It also covered not just bombings or shootings but even nuclear, chemical, biological, radiological, or cyber-attacks. Should such an attack cost Pool Re over £500 million in losses in a single year then the bonds would trigger and absorb a fraction of any excess costs up to £700 million, a form of trigger called an ‘indemnity’ trigger in the catastrophe bond world. The trigger event would occur whether that £500 million in losses would arise from a single attack or several smaller ones.

The Baltic PCC Limited transaction saw £75 million worth of bonds issued. Bondholders were paid interest of 5.9% per annum over a three-year term for the risk they were taking. The deal was oversubscribed. Completion of the Baltic PCC Limited deal allowed Pool Re to complement its reinsurance agreements and government support, opening up a new channel through which to offload risk. The transaction also helps the firm achieve its goal of minimizing the chance of a loss to British taxpayers caused by a terrorist attack.

Modeling Risk

Completing the transaction required overcoming some of the challenges to insurance posed by terrorism. These included modeling terrorism risk in a way that proved satisfactory to investors, building confidence in such models. The risk to Baltic PCC Limited investors was modeled by Pool Re’s in-house actuarial term in concert with experts at Cranfield University in Oxfordshire. The model used suggested a 3.05% probability of a trigger event occurring and, because a trigger event would not necessarily result in a full loss, ‘only’ a 2.71% corresponding expected loss. The assessment made by investors was that this compared favorably to an interest rate of nearly 6%. Such assessments will no doubt have to be made several times over before a market for terrorism-linked bonds fully develops.

Lesson

When the British government intervened in the insurance market to establish Pool Re, it did so with the belief such intervention would be temporary. It has not turned out that way. A development that may provide a light at the end of the tunnel, that may one day allow terrorism insurance to be a product readily offered by private firms without government assistance, may be on the horizon though. Terrorism-linked catastrophe bonds are a novel creation. Should they succeed or fail, they will nonetheless stand as yet another testament to the obstacles associated with predicting the occurrence of some of the largest and unfortunately frequent man-made disasters. If successful, they will be another milestone in the development of insurance.

More from the Tontine Coffee-House

Learn more about Pool Re and read about the pandemic-linked catastrophe bonds which triggered losses to investors during the Covid-19 pandemic. Lastly, consider subscribing to this blog’s newsletter here.