- 93 -

The second instrument proposed for development in the Caribbean region, is based on financial pay-outs linked to measurable weather events (or physical parametric triggers). The advantage of these instruments which can be structured under 'catastrophe bonds' is their relative ease of implementation once a reliable weather measurement mechanism is in place. Thus they bypass the traditional insurance loss adjusting function which requires evaluation of losses on a site-by-site basis before indemnity payment is provided. With parametric or indexed triggers'5, the payout is simply based on the index or physical parameter having reached a specific level or range, while the premium or spread is fixed in advance.

The main risk with weather indexed instruments is what is termed 'basis risk', i.e., the risk that the basis on which the loss payment is triggered (that is, the weather event such as a high windspeed or excessive rainfall) is not directly linked with the loss experience (e.g.: damage to a specific house or building). In other words, the event indexed instruments can have the risk that (a) payment is made (or the bondholder loses part of the bond payment) when the index is triggered even though no loss is experienced by the 'insured', or (b) a loss is experienced by the 'insured' party (e.g.: due to a lower than threshold windspeed) but the index is not triggered so no indemnity/relief is provided.

Given the proximity to the 'damage sites', it is more reasonable to expect that local insurers would take on this basis risk, while international reinsurers would generate the market in these instruments. The burden of the 'local basis risk' could also be shared the govermnent, or alternatively the local insurers could purchase additional insurance to protect against such basis risk. The latter arrangement, however, would likely increase the cost of coverage to the ultimate customer, and thus make the scheme less attractive. Catastrophe bonds could also be triggered based on reported losses/indemnification claims in the industry rather than weather indexes, however, investor appetite might lessen without direct knowledge of local insurance industry characteristics, hence the attractiveness of the easily verifiable weather indexed triggers. The basic elements of such a structure are outlined below:

**Scheme 2: Weather Indexed Catastrophe Bonds** - **Securitization of Catastrophe Risk**

**Objective: Establish easily measurable weather indexed insurance/bond contracts which would attract international investors given the risk-diversifying characteristics these have vis-a-vis global debt and equity markets, while permitting catastrophe risks to be spread into the broader capital markets.**

# **Financial Structure:**

**a. A multilateral development institution would examine the possibility of sponsoring, with the assistance of international investment and reinsurance companies the**

> **15** It should be clarified that "parametric" measures generally refer to physically measurable (parametrized) phenomena such as wind speed, rainfall, or earthquake intensity. The term "index" is usually used in the context of summarizing insurance/financial loss data across a certain region or a number of companies in the industry. In the case of temperature degrees, this can also be considered a special type of index since the temperature scale is a standardized measure. Similarly, with earthquake events, the Richter scale can be considered as a specialized index reflecting a number of factors contributing to that measurement. For risk securitization terminology though, direct physical data measurements are normally known as 'parametric' while the term 'index' is generally used for expressing aggregations of insurance dollar losses across a specified sector or region.