NATURAL DISASTER RISK TRANSFER SOLUTIONS Michael Bennett Head of - - PowerPoint PPT Presentation

NATURAL DISASTER RISK TRANSFER SOLUTIONS

Michael Bennett Head of Derivatives and Structured Finance

August 2014

Fiscal Impact of Disaster Events in Emerging Countries

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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
• ther 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

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NATURAL CATASTROPHES WORLDWIDE 1980-2011 OVERALL AND INSURED LOSSES WITH TREND

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Source: Munich Re Geo Risks Research

IMPACT OF NATURAL DISASTERS (UNINSURED LOSSES AS A PERCENTAGE OF ANNUAL GDP)

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Importance of Integrating Disaster Risk in Fiscal Risk Management Framework

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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

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Relying solely on “in-crisis” response can be costly, inefficient, and difficult to finance and implement

TOTAL COST TO GOVERNMENT OF A GIVEN RISK

* Source: LAC Integrated Risk Management BBL, Carter Brandon, May 2013 7

Type of Risk Type of Impact

Economy- wide Budget Expenditures Fiscal Revenues

• Physical

Risks

• Asset Loss:

Direct damages to public and private sector assets

• Output Loss:

Incapacitation of

• ther sectors,

interrupted services, disruption of economic flows

• Contingent

liabilities: Social programs e.g. subsidies, safety net payout

• Implicit Liabilities:

Recovery and reconstruction costs not explicitly budgeted

• Tariffs on imports and

exports

• Commodity-related

royalties

• Income, value-added,

and property taxes

• Economic

Risks

• Financial

Sector Risks

DESIGN OF FISCAL RISK MANAGEMENT STRATEGY

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• 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

Disaster Risk Financing Products

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FUNDING NEEDS

Quick Liquidity vs. Long Term Financing

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RISK LAYERING APPROACH

• No single financial product

can mitigate disaster risk completely

• A “bottom-up” approach

allows borrowers to select an optimal mix of instruments based on:  desired coverage  available budget  cost efficiency

• Reserves continue to be a

key financing source for recurring events

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Reserves Contingent lines of credit; Cat-DDO Insurance-linked securities; Cat-Bond; Reinsurance; Cat Swaps

Risk Retention Risk Transfer

Probability Instrument Severity

Low High High Low

WORLD BANK DISASTER RISK FINANCING PRODUCTS

Addresses immediate liquidity needs + other resource gaps; manages and transfers financial risks to the market

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Risk Transfer

Risk Retention

MultiCat Program Insurance- linked Securities

Facilitates issuance of multi region, multi-peril cat bonds;

• eg. Mexico (earthquake & hurricane)

CCRIF/Pacific Insurance Pools

Regional facility pooling risks to cover against natural disasters different countries

Cat DDO Contingent Loans

Provides immediate liquidity following a natural disaster eg: Philippines, Colombia, Costa Rica

Cat Swap

Probability of Event Severity of Impact

Minor Major High Low

Insures against weather + geological related losses, based on an index;

• eg. Uruguay (drought and high oil prices)

World Bank Cat Bond

World Bank direct issuance of Cat Bonds;

• eg. CCRIF (earthquake & tropical cyclone)

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Structure of the transfer mechanism

• Cat Swaps
• Cat Bonds
• Market Overview
• Cat Bond Alternatives
• World Bank Cat Bonds

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

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Structure of the transfer mechanism

• Cat Swaps
• Cat Bond
• Market Overview
• Cat Bond Alternatives
• World Bank Cat Bonds

CAT SWAP

• 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

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Client Country IBRD or IDA Insurer

Premium Contingent 100% of Notional Premium Contingent 100% of Notional

CASE STUDY: WORLD BANK CAT SWAP FOR PACIFIC INTERMEDIATION

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WORLD BANK Samoa Vanuatu Solomon Islands Marshall Islands Tonga Cook Islands Insurer n

. . . .

Insurer 1 Insurer 2

. . . .

Cat Swap

Premium Payout

Cat Swap

Premium Payout

Cat Swap

Premium Payout

Cat Swap

Premium Payout

Cat Swap

Premium Payout

Cat Swap

Premium Payout

Cat Swap

Premium Payout

Cat Swap

Premium Payout

Cat Swap

Premium Payout

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Structure of the transfer mechanism

• Cat Swaps
• Cat Bonds
• Market Overview
• Cat Bond Alternatives
• World Bank Cat Bonds

Market Overview

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CAT LANDMARK TRANSACTIONS

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* 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

ISSUANCE TRENDS

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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

OUTSTANDING BY REGION

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• Cat bond investors are

heavily exposed to natural disasters in a few developed countries (mainly US, Japan and EU)

• This exposure is the same
• ne seen in the traditional

insurance market

• Cat bonds linked to natural

disasters in emerging countries will allow portfolio diversification to these investors

PRICING TRENDS

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Cat Bond Alternatives

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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

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Client

Insurance

SPV

AAA Collateral IBRD

Advisory Insurance Contract Re-Insurance contract 100% 100% Premium

Investors

PRICE PERFORMANCE MEXICO MULTICAT 2012

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Source: Swiss Re Capital Markets as of March 7, 2014

ACCESSING TRADITIONAL RE-INSURANCE

• 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

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Country

Insurance Contract

• r

ISDA Swap

• r

IBRD Debt Security

Local Re- insuranc e

• r

IBRD

Re Re Re Re Re

Multiple Insurance Contracts

Re

ACCESSING CAPITAL MARKETS

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Countries could issue a cat bond in two forms: a) Cat Bond issued by Special Purpose Vehicle (SPV) sponsored by the Country b) Cat Bond issued by IBRD linked to the Country catastrophe risk The main difference between the two alternatives is that under IBRD cat bond much of the legal and technical work will be done by the World Bank Treasury, thus significantly simplifying the whole transaction IBRD cat bond would be probably more cost effective with less transaction costs

Country

Insurance Contract

• r

ISDA Swap

• r

IBRD Debt Security (not for SPV)

SPV

• r

IBRD

Cat Bond Investors Investors Investors Investors Investors

Investors

OTHER ASPECTS TO BE CONSIDERED

• Issuance Format: When an issue will be purchased entirely by a small pool
• f sophisticated investors, a “Reg D” format can be considered.

 Pro: Reg D issuance reduces costs significantly because it requires very little in the way of disclosure/documentation and no credit rating.  Con: Reg D issues permit only limited transferability and can only be sold to highly specialized investors who can perform their own analysis and do not require a credit rating.

• Collateral: As an alternative to traditional collateral of Treasury money

market funds, a World Bank putable floater can be used.

• Use of MultiCat Program: For any issue by a SPV, the SPV could be

established under the MultiCat Program and carry the MultiCat brand.

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World Bank Cat Bonds

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WORLD BANK CAPITAL AT RISK NOTES PROGRAM

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• The World Bank Capital at Risk Notes program facilitates risk transfer

solutions for the World Bank and its clients using the capital markets

• Under this program, the World Bank issues notes where some or all of the

investors’ principal may be at risk, such as catastrophe bonds ('cat bonds')

• Capital at Risk Notes are issued under the World Bank’s Global Debt

Issuance Facility and receive the same tax and securities law exemptions, but they may not be assigned any security rating or may be assigned a lower security rating than the Facility

• Benefits to investors:
• Potential yield enhancement
• Opportunity to include new perils and regions to diversify portfolios

WORLD BANK CAT BOND

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Country

Insurance Contract

• r

Cat Swap

• r

IBRD Debt Security (not for SPV)

World Bank Bond

Cat Bond Investors Investors Investors Investors Investors Investors

WORLD BANK’S FIRST CATASTROPHE BOND ISSUANCE

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Issuer: World Bank Nominal amount: USD30,000,000 Redemption amount: The nominal amount reduced by all principal reductions as a result of applicable Caribbean tropical cyclone

• r earthquake events (as defined in

the terms of the notes) Settlement date: June 30, 2014 Coupon: 6 month LIBOR + 6.30%, floored at 6.50%, quarterly Maturity date: June 7, 2017 Listing: Luxembourg

COMPARISON OF RISK TRANSFER ALTERNATIVE PRODUCTS

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Traditional Re Country issuance of Cat Bond IBRD Cat Bond Duration of Coverage

Up-to 3 years Rarely 5 years Up-to 5 years Up-to 5 years

Transfer Mechanisms

The Country buys insurance from the Traditional Re-insurance market The Country sponsors an SPV which issues the Cat Bond WB issues an IBRD Cat Bond linked to the Country risk with the Country paying premium to WB, and WB to Investors

Legal Arrangements

The country receives insurance from the Re- insurers directly or via IBRD in the form of:  Insurance Contract  An ISDA Swap  A Debt Security The Country enters into a re- insurance contract with the SPV The Country enters into a swap contract with the SPV The Country receives insurance from the Re- insurers via IBRD in the form of:  Insurance Contract  An ISDA Swap  A Debt Security

Transaction Costs

Insurance’s Capital and Administrative Transaction Costs Underwriting fees, Legal, Model, SPV, Rating Agency Underwriting fees, Legal, Model, Rating Agency

FOR MORE INFORMATION CONTACT

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Internet treasury .worldbank.org Phone: +1 202 458 5099 Fax: +1 202 280 8355 Email: mbennett1@worldbank.org Mailing Address 1818 H Street, NW MSN # C7-710 Washington, DC 20433, USA Physical Address: 1225 Connecticut Avenue, NW Washington,DC 20433, USA