NATURAL DISASTER RISK TRANSFER SOLUTIONS Michael Bennett Head of Derivatives and Structured Finance August 2014
Fiscal Impact of Disaster Events in Emerging Countries 1
FISCAL IMPACTS AFTER A NATURAL DISASTER • Following a natural disaster, governments face: - a smaller revenue base due to decreased economic activity; and - rising expenditures for emergency relief and recovery operations • Resources often need to be diverted from other economic priorities to fund disaster relief and recovery, so planned strategic investment (eg. infrastructures) are postponed • Most governments do not have sufficient access to insurance against natural disasters due to high costs and limited insurance industry capacity to absorb the risks 2
NATURAL CATASTROPHES WORLDWIDE 1980-2011 OVERALL AND INSURED LOSSES WITH TREND Source: Munich Re Geo Risks Research 3
IMPACT OF NATURAL DISASTERS (UNINSURED LOSSES AS A PERCENTAGE OF ANNUAL GDP) 4
Importance of Integrating Disaster Risk in Fiscal Risk Management Framework 5
VALUE IN BROADER RISK MANAGEMENT FOR SOVEREIGNS Improves debt management capacity; supports country creditworthiness Improve transparency and public accountability Reduce volatility of inflows and outflows Strengthens resiliency against food/fuel price shocks Strengthens resiliency against natural disasters Relying solely on “in - crisis” response can be costly, inefficient, and difficult to finance and implement 6
TOTAL COST TO GOVERNMENT OF A GIVEN RISK Type of Impact Type of Risk Economy- Budget Fiscal Revenues wide Expenditures • • • Physical Asset Loss: Contingent • Direct damages liabilities: Tariffs on imports and Risks to public and Social programs exports • Economic private sector e.g. subsidies, • Risks assets safety net payout Commodity-related royalties • Financial • • Output Loss: Implicit Liabilities: Sector Risks • Incapacitation of Recovery and Income, value-added, other sectors, reconstruction and property taxes interrupted costs not explicitly services, budgeted disruption of economic flows * Source: LAC Integrated Risk Management BBL, Carter Brandon, May 2013 7
DESIGN OF FISCAL RISK MANAGEMENT STRATEGY • Government analyzes alternatives for managing risk (ideally net risk, by netting assets and liabilities) at different government levels, taking into account: - Risk avoidance/reduction using policy measures - Risk retention - Risk transfer - Coherence with macroeconomic policy - Potential constraints (e.g. financial market) - Institutional capacity for risk management strategy design and implementation 8
Disaster Risk Financing Products 9
FUNDING NEEDS Quick Liquidity vs. Long Term Financing 10
RISK LAYERING APPROACH • No single financial product can mitigate disaster risk Probability Severity Instrument completely Insurance-linked Low High Risk • A “bottom - up” approach securities; Cat-Bond; Transfer Reinsurance; Cat allows borrowers to select Swaps an optimal mix of instruments based on: desired coverage Contingent lines of available budget credit; Cat-DDO Risk cost efficiency Retention Reserves • Reserves continue to be a High Low key financing source for recurring events 11
WORLD BANK DISASTER RISK FINANCING PRODUCTS Addresses immediate liquidity needs + other resource gaps; manages and transfers financial risks to the market Low Major World Bank World Bank direct issuance of Cat Bonds; eg. CCRIF (earthquake & tropical cyclone) Cat Bond Insurance- Facilitates issuance of multi MultiCat Risk Transfer region, multi-peril cat bonds; linked Probability of Event Severity of Impact Program eg. Mexico (earthquake & hurricane) Securities Insures against weather + geological Cat Swap related losses, based on an index; eg. Uruguay (drought and high oil prices) Regional facility pooling risks to Insurance cover against natural disasters CCRIF/Pacific Pools different countries Retention Provides immediate liquidity Contingent Risk following a natural disaster Cat DDO Loans eg: Philippines, Colombia, Costa Rica High Minor 12
Structure of the transfer mechanism Cat Swaps Cat Bonds Market Overview Cat Bond Alternatives World Bank Cat Bonds 13
POTENTIAL SOURCES OF RISK TRANSFER Countries may have the ability to tap into both traditional re-insurance and capital markets The traditional re-insurance market is a well-established segment leveraging on: • Portfolio diversification • Flexible execution • Standardized documentation The capital markets is becoming more and more competitive with pricing often below re-insurance leveraging on: • Broader investor base • Diversification appeal for new perils for dedicated cat investors • Ability to lock in rates for multiple years 14
Structure of the transfer mechanism Cat Swaps Cat Bond Market Overview Cat Bond Alternatives World Bank Cat Bonds 15
CAT SWAP Premium Premium Client IBRD or Insurer Country IDA Contingent 100% of Contingent 100% of Notional Notional Cat Swaps are the simplest vehicle used by the Bank to transfer risks to the reinsurance sector Cat swaps are parametric risk insurance transfer vehicles, used so far to transfer catastrophe risk including earthquakes, wind and, just lately, tsunami The Bank has used Cat Swaps under the CCRIF and the Pacific Catastrophe Risk Insurance Pilot programs Ideal for smaller risks or for risk pooling Low legal and documentation costs, but generally short maturities Contrary to cat bonds, cat swaps introduce counterparty credit risk. Thus far IBRD has signed only one ISDA with a reinsurer 16
CASE STUDY: WORLD BANK CAT SWAP FOR PACIFIC INTERMEDIATION Payout Marshall Cat Swap Islands Payout Premium Cat Swap Insurer 1 Payout Premium Samoa Cat Swap Premium Payout Payout Cat Swap Insurer 2 Tonga Premium Cat Swap . . Premium WORLD BANK . . Payout Vanuatu . . Cat Swap . . Premium Payout Payout Solomon Cat Swap Cat Swap Islands Insurer n Premium Premium Payout Cook Islands Cat Swap Premium 17
Structure of the transfer mechanism Cat Swaps Cat Bonds Market Overview Cat Bond Alternatives World Bank Cat Bonds 18
Market Overview 19
CAT LANDMARK TRANSACTIONS * Atlantic Wind is not presented here because it is unique peril with high market multiples given the correlation to US Wind A multiple is the ratio of the insurance premium and the annual expected losses of the assumed peril. It is a simple statistic to compare the price efficiency of different risk transfer alternatives Insurance premiums are the sum of: 1. The pure model risk 2. Capital costs 3. Transaction Costs 20
ISSUANCE TRENDS The cat bond market continues to offer very attractive opportunities to obtain risk coverage - especially for sponsors that can bring new perils to the market: Expanding Investor Base Continued search for Higher Yields driven by low interest rates Appeal of Uncorrelated Assets Diversification appeal of new perils for dedicated cat investors Ability to lock in rates for multiple years 21
OUTSTANDING BY REGION Cat bond investors are heavily exposed to natural disasters in a few developed countries (mainly US, Japan and EU) This exposure is the same one seen in the traditional insurance market Cat bonds linked to natural disasters in emerging countries will allow portfolio diversification to these investors 22
PRICING TRENDS 23
Cat Bond Alternatives 24
MULTICAT ISSUE MultiCat Structure The coverage sourced through the MultiCat is passed to the Insured through an insurance company Proceeds of the cat bond are kept in a collateral account invested in US Treasuries or other AAA liquid assets The MultiCat program can be re-used as a shelf for other issuers AAA Collateral IBRD 100% Advisory Re-Insurance Insurance contract Contract Insurance SPV Client Premium 100% Investors 25
PRICE PERFORMANCE MEXICO MULTICAT 2012 Source: Swiss Re Capital Markets as of March 7, 2014 26
ACCESSING TRADITIONAL RE-INSURANCE Re Local Re Re- insuranc Re Country e Multiple Insurance Insurance Contract Re or Contracts or Re ISDA Swap IBRD or Re IBRD Debt Security Countries could transfer catastrophe risk to the traditional re-insurance market directly or via IBRD or a local re-insurer, depending on the legal and regulatory requirements Given the size of the transaction, the Country may need to transact with multiple reinsurers The insurance contract with the re-insurance markets could be funded or unfunded 27
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