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The budget announcement raising the foreign direct investment (FDI) limit in the insurance sector from 49% to 74% is most welcome. With greater capitalisation, together with ongoing reform of the corporate bond market, we can efficiently boost not just provision of long-term funds for infrastructure but also the market for high-yield debt instruments such as catastrophe bonds, to better manage disaster risks.
The recent landslide and glacier burst in Uttarakhand’s Chamoli district, and other extreme events nationally, point to the express need to leverage financial markets for improved risk mitigation. Catastrophe bonds, or cat bonds, provide a sound mechanism to transfer hazard risks to wide section of investors. The bonds offer a sufficiently attractive coupon to cover for the heightened risk, and have a short maturity period of 3-5 years.
In the event of a disaster, the principal is written off or suitably renegotiated. For the issuer of cat bonds, insurers, reinsurers and, increasingly, sovereign entities, it can mean large financial protection. It should be possible for all regions prone to natural hazards to insure themselves. They could either buy insurance from a sufficiently large and versatile insurance company, which would issue cat bonds, or the relevant local or state governments could directly issue cat bonds.
Of course, how high the coupon on cat bonds has to be to attract investors would be a function of the probability of extreme events, and which, in turn, call for heightened awareness and attendant best practices when it comes to infrastructure and built spaces. The bottom line is the speedy need for innovation to proactively manage a whole gamut of risks using new financial instruments and products.
The National Disaster Response Fund could, perhaps, buy policies against specific kinds of disaster, for specific areas. Note that assets under management by pension funds and insurance companies here are now over `55 lakh crore, and what’s required is systematic allocation of resources to better insure extreme events well.
This piece appeared as an editorial opinion in the print edition of The Economic Times.