INSURING THE 'UNINSURABLE': CATASTROPHE BONDS, PANDEMICS, AND RISK SECURITIZATION.

• Author: Schwarcz, Steven L.

ABSTRACT

In principle, governments could protect against the potential economic devastation of future pandemics by requiring businesses to insure against pandemic-related risks. In practice, though, insurers do not currently offer pandemic insurance. Although they may well be able to obtain sufficient actuarial data to set pandemic underwriting standards and rate tables, insurers are concerned that they lack sufficient capacity, as an industry, to cover those risks, which are likely to occur worldwide and to be highly correlated. Pandemics therefore are in the class of risks, like war, terrorism, and riots, that are deemed "uninsurable, " at least by private markets. This Article examines how risk securitization--a relatively recent and innovative private-sector alternative to government insurance, funded by the issuance of catastrophe (CAT) bonds--could be used to help insure pandemic-related risks. Risk securitization would utilize the "deep pockets" of the global capital markets, which have a far greater capacity than the global insurance markets, to absorb these risks. The Article also identifies and analyzes the novel legal and economic challenges that risk securitization would raise. Certain of these challenges parallel but are more complex than those arising in structuring traditional securitization transactions. Other challenges involve issues of first impression, including the extent to which risk securitization should be regulated as a form of reinsurance, the constitutionality of requiring that businesses purchase pandemic insurance, and the legality and relative prioritization of public-private risk sharing--such as Chubb 's recent government-risk-sharing proposal.

TABLE OF CONTENTS INTRODUCTION I. STRUCTURING RISK SECURITIZATION FOR PANDEMICS A. Theory B. Precedent C. Future Challenges 1. Legal challenges 2. Economic challenges II. RESOLVING THE LEGAL CHALLENGES A. Legal Challenges that Parallel Traditional Securitization Transactions 1. Establishing a bankruptcy-remote SPV and mandating its governance scheme 2. Issuing the PC AT bonds in compliance with applicable laws 3. Obtaining credit ratings for the PCAT bonds 4. Implementing a senior-subordinate structure to provide credit enhancement B. Regulating SPVs as Reinsurers C. Enforcing Government Insurance Mandates D. Analyzing Government Risk-Sharing III. RESOLVING THE ECONOMIC CHALLENGES A. Estimating the Level of Pandemic Insurance that Businesses Should Purchase B. Estimating the Market for PCAT Bonds C. Analyzing Government Risk-Sharing D. Cost-benefit Analysis 1. Fairness of the pricing 2. Moral hazard 3. Possible unintended consequences 4. Ex ante versus ex post pandemic preparation CONCLUSION INTRODUCTION

Insurance is the tried-and-true strategy for protecting against infrequent but potentially devastating losses. (1) Insurers are expert third parties that expand policyholders' loss-absorption capacity and assist them, at least indirectly, to monitor risks. (2) In theory, therefore, governments could protect against the potential economic devastation of future pandemics by requiring businesses to insure against pandemic-related risks. (3) As later discussed, that requirement would be needed because, in its absence, even businesses that otherwise view pandemic insurance as economically desirable would tend to forgo paying for such insurance, expecting a government bailout in the event of a major pandemic. (4)

Insurers currently cover certain of those risks. Standard health insurance policies cover much of the medical costs incurred by employees (and others) who contract diseases, (5) and most life insurance policies cover pandemic-caused deaths. (6) Many pandemic-related risks remain uninsured, though. For example, business-interruption insurance either explicitly excludes pandemic-related disruptions or has been interpreted to condition payments on physical damage causing the disruption. (7) Nor does insurance currently cover all of the increased unemployment (8) or pandemic-related infrastructure costs (such as installing Plexiglas barriers or reconfiguring interiors for safety). (9)

In practice, however, insurers do not currently offer pandemic insurance, certainly not at rates (i.e., "premiums") that businesses regard as reasonable. (10) Insurers fear their industry does not "have the capacity to [provide] coverage." (11) Because a pandemic by definition is worldwide, the obligation of insurers to make payments under pandemic insurance would likely be highly correlated, creating losses that would overwhelm the insurance markets. (12) Insurer unwillingness to offer pandemic insurance also may be due, in part, to the lack of sufficient statistical data to reliably set underwriting standards and rate tables reflecting the appropriate level of pandemic-related risks (13)--although some firms, such as Metabiota, Air Worldwide, Milliman, and RMS, claim to "combine leading epidemiological, statistical and actuarial techniques to quantify [global] epidemic risk." (14)

Pandemics therefore are in the class of risks that are deemed "uninsurable," at least by private markets. (15) This category includes war, terrorism, riots, economic downturns, and various other extraordinary catastrophes such as meteor strikes and sudden shifts in the gulf stream caused by climate change. (16) Absent insurance, the other responses to address these catastrophes tend to be second-best. (17) Therefore, in areas of strong public interest such as nuclear reactor accident risk, governments sometimes provide publicly subsidized insurance--i.e., government insurance of otherwise "uninsurable" risks, paid for only partly by private sector entities that benefit from that insurance.

For example, the Price-Anderson Nuclear Liability Act of 1957 was enacted to ensure nuclear operators were adequately insured. (18) The act required nuclear operators to have the maximum insurance available (then $60 million). If damages exceeded that level, a second level of government-provided funds was available (up to $500 million). (19)

The cost to taxpayers of paying for such publicly subsidized insurance could be huge. (20) This Article examines how risk securitization--a relatively recent and innovative private-sector means of insuring certain otherwise uninsurable risks--could help to reduce that cost by privately insuring pandemic-related risks. (21) Originally developed to respond to certain natural disasters that occurred in the early- to mid-1990s, including Hurricane Andrew and the Northbridge Earthquake, (22) risk securitization has been used to hedge catastrophic risks that insurance and reinsurance markets may be incapable or unwilling to bear alone (23) by allocating those risks to sophisticated global investors who choose to purchase catastrophe (CAT) bonds. (24)

Using risk securitization to hedge pandemic-related risks would raise various novel legal challenges. Certain of these challenges parallel--but due to the differences between traditional and risk securitization, are more complex than--the challenges of structuring traditional securitization transactions. These include establishing a bankruptcy-remote special purpose vehicle (SPV) and mandating its governance scheme; issuing the CAT bonds in compliance with applicable law, including securities law, disclosure and the need for transparency, and investment-company restrictions; obtaining credit ratings for those bonds; and implementing a senior-subordinate structure to provide credit enhancement. (25) Other challenges involve issues of first impression. Because the SPV's indemnifying the insurer resembles reinsurance, should the SPV be regulated as a reinsurer? Would the requirement that businesses purchase pandemic insurance raise constitutional challenges, as did the Affordable Care Act's individual mandate to purchase health insurance or pay a penalty? (26) And what should be the relative priority of any public-private risk sharing, such as the pandemic-insurance government risk sharing recently proposed by Chubb, the world's largest publicly traded property-and-casualty insurance company. (27)

Because risk securitization works by allocating risk to CAT bond investors, (28) the success of using risk securitization to hedge pandemic-related risks will depend on investor demand to purchase pandemic-related CAT bonds (PCAT bonds). (29) 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; (30) therefore, CAT bond returns are largely uncorrelated to the returns of equity securities and conventional corporate bonds. (31) Second, CAT bonds have "provided strong returns" to investors. (32)

As will be shown, however, CAT bonds do not represent a win-win deal for investors. If the covered catastrophe occurs, investors may lose part or all of their investment in those bonds. (33) To date, however, the combination of diversified and strong returns has more than offset investor perception of that risk. The "CAT bond market has seen strong growth," and "the amount of outstanding CAT bonds more than doubled between 2010 and 2017." (34) As this Article is being written, Moody's reports that CAT bond issuance is "surging." (35) The Article does not claim, though, that risk securitization will be sufficient to fully hedge pandemic-related risks, merely that it could offer at least a significant partial hedge. (36)

The Article proceeds as follows. Part I examines how to structure risk-securitization transactions to cover pandemics. Section A analyzes, theoretically, how those transactions should be structured. Section B then compares that theory with actual precedents for non-pandemic risk securitizations and the one precedent, structured atypically by the World Bank using government donations, for pandemic risk securitization. Section C then builds on that...