Cerchia: new sources of capital to transfer emerging risks


Cerchia is creating a digital marketplace to build a bridge between capital market investors and buyers of protection, lowering hurdles of access for businesses and investors, and introducing new sources of capital. InsTech’s Henry Gale spoke to Michael Rey, CEO and Co-founder, and Fabian Buchmann, COO and Co-founder, about emerging risks for communities and businesses and how to use innovative financial structures and parametric triggers to enable sustainability investments.

Henry: What are your backgrounds and why did you found Cerchia?

Michael: I worked in risk management in investment banks throughout my career across Europe and Asia. Whilst working in Japan, I experienced regular small earthquakes. I considered all the risks that insurance would not cover if a major earthquake hit, such as non-damage business interruption (NDBI) and supply chain repercussions. This inspired me to look for new ways to transfer risks to cover previously uninsured losses.

My co-founders and I believed that transfer of risk to the capital markets was not achieving its full potential or addressing the insurance protection gap as much as it ought to. We founded Cerchia to identify more efficient and scalable ways to transfer risks to capital markets.

Fabian: I worked as a quantitative analyst in investment banks in Switzerland and Asia. I first met Michael at university, then we crossed paths at investment banks in Singapore and Switzerland, before founding Cerchia. I was becoming interested in blockchain and we both believed that this technology could enable a better form of risk transfer.

Henry: Why do insurance and risk transfer need new sources of capital?

Michael: The insurance protection gap, the difference between the total economic losses caused by disasters and the amount of losses covered by insurance, is vast and even widening. The gross protection gap is currently estimated at $2 trillion USD. Traditional forms of insurance capital cannot meet the need for coverage globally. Currently, only a small fraction of global risk is transferred to the capital markets through catastrophe bonds, with around $40 billion USD of notional outstanding (coverage limits currently active for catastrophe bonds).

Henry: What does it mean to transfer risks to capital markets?

Michael: Insurance is one form of risk transfer: individuals, businesses or public entities pay premiums to an insurance company in return for the insurance company taking on some of their financial risk. Similarly, insurance companies purchase reinsurance to transfer their risk to reinsurers. When organisations are unable to buy insurance or reinsurance to cover their risks, they can use alternative forms of risk transfer (such as catastrophe bonds) that involve paying capital markets investors, rather than insurers or reinsurers, to take on some of their financial risk.

A catastrophe bond transforms insurance risks into a security which can be bought and traded by capital markets investors. It is an example of an insurance-linked security (ILS).

The catastrophe bond market began over 25 years ago and has grown steadily. At Cerchia, we believe there is the potential for insurance-related risks to be transferred to the capital markets on a much larger scale.

Henry: Why do you believe there is greater potential for capital markets to invest in risk transfer?

Michael: Long-term investors need new sources of investment. Insurance-linked securities (ILS) can act to diversify portfolios, because insurance-related returns depend on fortuitous events such as earthquakes that do not correlate with financial markets.

Much of what is invested in ILS today comes from dedicated insurance-linked securities funds. Many other capital markets investors have considered investing in catastrophe bonds but have so far chosen not to do so. There are also institutional digital asset investors who are looking to diversify into real-world assets. Cerchia is developing products to make insurance-related risks more appealing to capital markets and digital asset investors.

Henry: What is Cerchia doing differently to encourage more investment in risk transfer?

Michael: Some capital markets investors see catastrophe bonds as opaque. For example, bonds with an indemnity trigger pay out depending on the losses experienced by the bond issuer (the organisation buying coverage). Although effective for catastrophe bond issuers to avoid basis risk, this is difficult for investors to value.

Another challenge with existing catastrophe bond structures is the risk of trapped capital. Cerchia recently published an analysis from consultancy Kriesch Advisors, showing challenges for investors in industry loss warranties (ILWs, a type of collateralized reinsurance agreement that uses industry-wide insurance loss estimates as a trigger). The delay in a final industry loss estimate being reported means that capital can be trapped for many months beyond a bond’s maturity. This prevents investors from reinvesting their capital for an extended period.

Cerchia is focused on using parametric triggers to transfer risk, because these are more transparent and therefore attractive to investors. Parametric risk transfer pays out predefined amounts based on event triggers, meaning that there is more certainty about the probability, size and timing of a pay-out.

Henry: What risks is Cerchia looking to transfer?

Fabian: The existing catastrophe bond market already uses parametric triggers to transfer some risks, such as earthquakes and hurricanes in the US. There are opportunities to extend these principles to other parts of the world affected by the same perils, but where there is lower insurance uptake, such as for example earthquakes in Indonesia.

Michael: There are also new and emerging risks that catastrophe bonds have not covered before. There is a large protection gap for non-damage business interruption (NDBI) losses, and these can be covered with parametric triggers that correlate with consumer activity and demand. It is possible to cover pandemic risks with parametric triggers, for example the World Health Organisation issued a parametric pandemic catastrophe bond back in 2017, triggered by the COVID-19 pandemic in 2020. Cerchia is also looking into new indices including river water levels, air quality indices and sustainability indicators, to name a few.

Henry: Who has the greatest need to transfer these risks?

Michael: Businesses are currently exposed to many risks that cannot or are reluctantly covered by insurance. The COVID-19 pandemic showed that traditional insurance would not pay for business interruption losses caused by disease outbreaks.

One of Cerchia’s pilot projects used water levels on the Rhine river as a trigger. Shipping is restricted or halted if river levels exceed a high watermark or drop below a low watermark. Companies such as cement factories need to procure hundreds of truckloads to transport their goods daily if they cannot ship them on the river, which comes at a high cost. During Cerchia’s pilot in January 2021, high temperatures in Switzerland up to 20 degrees Celsius resulted in major amounts of snow melting into the Rhine, which together with extended rainfall resulted in the high watermark trigger being met.

Fabian: As well as businesses, entire societies and governments are exposed to risks that can be transferred with parametric triggers. For example, Pakistan’s floods in 2022 resulted in losses across society, with billions of dollars needed to rebuild infrastructure alone. In disasters like this, communities need access to funds quickly for emergency relocation expenses and basic needs. Traditional insurance and reinsurance often does not pay out fast enough, or is not even present in sufficient size in these regions of the world.

Henry: What are the challenges in transferring these risks and how can they be overcome?

Michael: The protection gap is caused by issues with both supply of protection (which Cerchia aims to solve by making risk transfer more appealing to investors) and demand for protection. When it comes to demand, businesses or communities may not buy risk transfer because the premium is unaffordable or due to cultural issues where they are unwilling to buy a product such as insurance where there is no certainty that they will receive any benefit. There are ways to change the financial structuring of the risk transfer product that can overcome these challenges.

For example, one project Cerchia is currently working on involves mangrove reforestation in Myanmar. Mangrove forests help to remove carbon dioxide from the atmosphere and protect local communities against tsunami damage. Tsunamis, however, can also devastate mangrove reforestation projects. To overcome issues with affordability and willingness to buy insurance, it is possible to wrap a parametric trigger around the loan used to fund the reforestation project. This means that the premium for risk transfer is paid for within the investment, and if there is a tsunami, the community does not need to repay the loan.

Henry: What stage is Cerchia at today and what are your plans for 2023?

Michael: Cerchia is working on several transactions, including placing a catastrophe bond. We are in advanced stages with non-traditional investors to offer up to $200 million USD in new capacity for ILWs.

Another key milestone Cerchia will achieve soon is the completion of our digital risk exchange platform, which is currently being audited. The platform will be a secure way for anyone to transfer risk in a transparent way and trade or hedge positions on catastrophe bonds

Henry: Why has Cerchia joined InsTech as a corporate member?

Michael: We have been following InsTech’s newsletters and research with great interest for some time. Cerchia joined InsTech to build our presence and interact with the community.

Henry: What sort of companies would Cerchia like to connect with?

Fabian: Cerchia’s core conviction is to use innovative technologies to make risk transfer more efficient and scalable. By doing that we enable new types of risks to be covered with new market participants. Anyone who would benefit from this technology or would like to collaborate on bringing more clarity to the risk transfer market should get in touch with us.

Michael: We want to reach out to like-minded companies and build innovative partnerships. Cerchia is particularly interested to connect with anyone interested in buying or selling protection with new sources of capacity, or enabling new types of protection with parametric triggers, such as corporates, insurers, reinsurers, brokers and investors. You can contact Cerchia at instech@cerchia.io and learn more about our plans to offer new capacity for ILWs here.