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Green cat bond interest goes beyond collateral structures

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Collateral innovations could be an easy first step for cat bond transactions to become more green, but in the longer term, market participants are keen to see a deeper focus on underwriting disclosures.

Last week, the Italian insurer Generali told investors it would look to add “green” features to its EUR200mn Lion Re III renewal, after previously releasing a green ILS framework.

The deal will use unsecured bonds issued by the EBRD as collateral, which have previously been used by European ILS sponsors, and the insurer will use capital freed up by completing the reinsurance deal to reinvest in sustainable projects.

Debt issued by the European Bank for Reconstruction and Development (EBRD) and its international counterpart (IBRD) has played a minority role in ILS transactions to date. Its high credit quality AAA rating has previously been the main attraction, given the cat bond’s focus on minimising financial market risk to maximise diversification benefits.

But amid an increasing focus on ESG investing, the Banks’ role in supporting development and recognised approach to sustainability are taking on more prominence.

Green reporting is one of the features of the Lion Re bond, which will update investors on eligible projects funded by Generali as well as linking to EBRD reporting on its Green Project Portfolio (GPP).

One ILS manager said this transparency was the most important aspect in turning cat bonds into an investment that could start to be viewed as ESG-compliant.

This is because demonstrable evidence of the positive impact an investment is having is a better way to show its credentials, as opposed to managers simply labelling it as green.

The most used collateral solution remains US treasury T-Bills, but some strict ESG investors see these as a block. For example, they were blacklisted by a French state pension plan in 2019 because of the then-government’s stance on capital punishment and climate change.

EBRD – green enough as-is?

The question of whether EBRD/IBRD collateral is the best green collateral solution for ILS deals remains to be settled – some may see it as sufficiently ESG friendly, while others may suggest it is not.

Managing director and CEO of Willis Securities Bill Dubinsky said using EBRD/IBRD collateral was “the path of least resistance” in moving toward ESG compliance because investors and sponsors were familiar with their structures, even though it is not clear how much ESG credit the bonds would generate in isolation.

If sponsors were considering putting cat bond collateral in more specific green or blue (ocean-based) project debt, he suggested that credit guarantees could be implemented to offset the additional level of financial market risk.

Dubinsky said: “There are all sorts of ways to credit enhance things…in a sensible way, and so maybe it’s a combination approach where you do some credit enhancement around credits that are perhaps less acceptable to the traditional ILS investors.”

Testing out ESG structures will show whether a new investor base can be drawn into cat bond placements without alienating the existing investor base, he added. But both sponsors and regulators needed to be comfortable with collateral options, as well as investors, he noted.

However, Swiss Re’s head of ILS structuring for EMEA and APAC, Andy Palmer, said that given the potential liquidity constraints as well as credit risks, green collateral that was supporting direct sustainable projects could be problematic.

“Green projects can be illiquid and have a term that is much longer than the typical term of a cat bond transaction, and so consideration would need to be given to ensuring that liquidity is available in order to make a loss payment under the cat bond transaction,” he said.

“A green collateral solution would potentially only provide a marginal gain from an ESG perspective versus an investment with a development bank such as EBRD or IBRD, given the positive sustainability profile of the development banks.”

Underwriting disclosure the greater goal

However, many agreed that simply using EBRD collateral does not go far enough in way of making cat bonds a true ESG product, with some sources describing collateral as of secondary importance in comparison with ethically conscious underwriting.

For Willis Securities’ Dubinsky, the primary way the ILS market can move towards a more ethical and environmentally conscious future is if liabilities insured meet sustainable criteria.

“The next step for the industry to become ESG friendly is to define the underwriting risk that is going on and say that the portfolio is ESG friendly itself,” he said.

Swiss Re’s Palmer took a similar view.

“Better transparency, disclosure and measurement of ESG factors with respect to the sponsor or the underlying portfolio could have a much more meaningful impact on the overall ESG assessment for ILS transactions,” he said.

The process is likely to be a gradual one, one ILS manager suggested. Full ESG compliance will happen on an incremental basis, so managers should be honest about where their funds are falling short and report on how they are seeking to catch up on ESG goals.

“We can’t go to ESG compliance overnight; it’s going to be a process and a journey,” they said.

“Disclosure is the most important thing. Maybe we can’t get to the point where fossil fuels are excluded, but there can be disclosure about how big that component is.”

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