Catastrophe Risk Financing Instruments Abhas K. Jha Regional Coordinator, Disaster Risk Management East Asia and the Pacific
Structure of Presentation Impact of Disasters in developing Countries The Need for Catastrophe Risk Financing A Description of World Bank Instruments
Main Messages Disaster risks, Economic and Insured and Non-Insured Losses are increasing Governments cannot and should not fund ex-ante DRM and recovery costs alone. There are a number of innovative catastrophe risk financing instruments available that fund liquidity and risk transfer to the private sector.
Natural Events Becoming More Extreme
Economic and Insured Losses are Increasing [Source: Munich Re 2008] 5
Developing Countries Have an Insurance Gap Insured Uninsured Peril / Event Country Loss ($bn) Loss (% Loss) Loss % GDP % Govt. Revenues Earthquake - Izmit (1999) Turkey 22.0 5 5 21 Hurricane - Mitch (1998) Honduras 3.0 6 34 158 Floods - (1997) Poland 3.5 6 3 11 Earthquake - Gujarat/Bhuj (2001) India 0.6 2 1 7 Earthquake Northridge (1992) USA 43.0 47 0.3 2 Winter Storm (1999) France 6.2 100 6
Catastrophe Insurance Premiums are High and Volatile World ROL Rate on Line Index 450 400 350 300 250 200 150 100 50 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Rate on Line = Insurance Premium divided by amount covered The ROL Index tracks the level of catastrophe insurance premiums. 1990 = 100. 7
Protecting the fiscal balance of the State from natural disasters 100 90 80 Catastrophe Bonds Parametric Insurance Traditional insurance 70 60 50 40 30 Contingent lines of credit Loans (Standard or Emergency) Budget reallocations 20 10 0 Reserves/Calamity funds 1980 1985 1990 1995 2000 2005 Probable Maximum Loss Transfer Retention
The Financial Protection of the State : Source of Financing Post-Disaster Availability Cost Instruments of funds (multiplier) Reserves Immediate 1-2 Budget reallocations - 1-2 Contingent lines of credit Immediate 1-2 Emergency loans 3-6 months 1-2 Donor contributions 3-6 months 0-1 Traditional insurance 3-6 months 3-6 Parametric insurance Immediate 2-5 Catastrophe Bonds Immediate 2-5 How do we combine these instruments to protect the fiscal balance of the state and improve its capacity to respond in case of a natural disaster?
Liquidity gaps often emerges in the early days after a disaster 50 Financial resources available minus expenditure needs 40 30 20 10 0-10 -20 1 2 3 4 5 6 7 8 9 10 11 12-30 Months after a disaster Need for an instrument to provide liquidity early on until other sources of funds can be accessed
DDO - Board Approved on March 4, 2008 Introduced a new instrument, the catastrophe DDO (CAT DDO) - Provide immediate liquidity during an emergency, while others forms of assistance are being mobilized Option Deferring the disbursement of a DPL until a catastrophe/natural disaster happens Eligibility IBRD and Blend countries with adequate macroeconomic policy framework Satisfactory implementation of a disaster risk management program Pricing Same as applied to IBRD loans (reformed)
CAT DDO: Applications and Value-added Countries should build up reserves to cover small scale Insurance and other risk transfer instruments are usually efficient for less frequent events What about in-between losses? - Politically difficult to build up reserves above expected losses Probability Severity Instrument - Financially too expensive to purchase insurance to cover frequent events The CAT DDO: - Offers a financial bridge between reserves and risk transfer instruments - Develops borrower s capacity to manage natural disaster risk - Offers a soft trigger (declaration of state of emergency) Low High High Low Insurance Linked Securities (e.g., CAT bonds) Insurance/ Reinsurance Contingent Loans Reserves Retention Risk Transfer - Complements parametric tools Source: Financial and Private Sector Development/ Financial Markets Networks (FPDSN), 2008 12
CAT DDO: Terms and Product Structure Drawdown/ Fund Availability Terms Volume/ Optionality Repayment Terms Provides immediate liquidity after a natural disaster resulting in a declaration of state of emergency Macro framework reviewed at commitment and at renewal A disaster risk management program has to be implemented in accordance with Bank standards (client will be notified if non-compliant and funds will not be available for drawdown until back in compliance) Full loan amount is available for three years, renewable up to four times with RVP approval, for a total maximum drawdown period of 15 years Amounts repaid during the drawdown period will be available for subsequent drawdowns Maximum size of 0.25% of GDP or the equivalent of USD 500 million (exceptions possible for small countries on case-by-case basis) The client can choose among the same conversion options (interest rate, currency) that are available for IBRD loans Repayment terms can be determined at the time of commitment or drawdown Repayment schedule will commence from date of drawdown Each drawdown may have different repayment schedules Pricing Same as regular IBRD loans. No fee will be charged for extension of the drawdown 13
Comprehensive Approach to Comprehensive DRM Approach to DRM Disaster Risk Management A B C D Risk Identification and Evaluation Risk Reduction Risk Financing Disaster Preparedness & Response Data collection, hazard and vulnerability monitoring; Socioeconomic resiliency studies; Probabilistic risk modeling & mapping; Structural & non-structural mitigation; Institutional & regulatory measures: territorial planning, building codes, etc.; Territorial & sectoral planning. Risk retention (reserve funds, CAT-DDO, etc.); Risk transfer (insurance, ART, etc.); Appropriation and execution systems. Early warning systems; Institutional strengthening at local, national and regional levels : training & equipping; Simulation exercises. E Disaster Recovery Post disaster needs assessments; Rehabilitation & reconstruction plans; Restructuring of existing projects (with additional financing) & Emergency Recovery Loans;
Caribbean Catastrophe Risk Insurance Facility The Caribbean Catastrophe Risk Insurance Facility (CCRIF) was established in 2007 Preparatory studies for the establishment of the CCRIF included the development of hurricane and earthquake risk models to assess potential monetary impacts, the structuring of a risk financing strategy, and the legal and organizational design of an insurance vehicle to structure and pass excess risk to the international reinsurance and capital markets. CCRIF provides participating governments with coverage akin to a business interruption insurance.
The Caribbean Catastrophe Risk Insurance Facility A joint reserve mechanism that allows Caribbean Governments to access liquidity at short notice in case of a catastrophe: quick disbursing in case of a major earthquake or hurricane; transparent rules parametric instrument; without cross subsidization contribution are based on each island s specific risk; at the lowest possible cost leveraging the capacity of the financial markets.
Antigua Reinsurers Trinidad Jamaica CCRIF Reinsurance... World Bank Barbados Identical Disaster contingent payments Swap Counterparty Parametric insurance Cat Swaps
World Bank Support to TCIP Modeling and pricing of property risk Insurance policy design Developing TCIP policy distribution and accounting systems Underwriting, rating and operational guidelines Public relations campaign Training Investment policy and fund management Improving regulatory framework and enforcement of building codes
World Bank Support to TCIP Capital Support and Advisory Assistance to TCIP Risk capital ($180 mm contingent capital facility) Financing of reinsurance premium ($40 mm in premium costs - 2 nd year) Advisory assistance by Bank insurance staff (original design of program and ongoing modifications) World Bank s financial support to TCIP has been instrumental In making the program financially sound and affordable
Risk Financing Through Cat Bonds Catastrophe-linked-securities are risk financing instruments which allow buying insurance through the capital markets by raising funds from investors which are used to make payments against claims under the insurance contracts. Catastrophe Bonds (or cat bonds) are the most common type of catastrophe-linked-securities. Cat bonds are targeted to a very wide investor base (money managers, hedge funds, pension funds, and insurers and reinsurers). Insurance payouts are collateralized; hence investors face no credit risk. 20
The market for CAT bonds is growing The CAT bond market is 10 years old Capital markets have capacity to absorb natural disaster risks New investors continue to enter in catastrophe insurance markets in search of attractive yields and diversification Catastrophe bond market 1997-2007 15,274 19,621 Market Growth $ (m) 1,304 1,304 1,776 1,096 2,010 1,161 2,322 1,125 2,703 1,014 3,316 1,260 4,662 1,990 4,855 1,306 7,232 1,993 4,751 5,088 1997 and prior 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 9-11 Katrina Outstanding Catastrophe Issuance Catastrophe Bond Issuance
Multi-Country Catastrophe Bond (MCCB) The multi-country cat bond is structured to: Allow member countries to pool risks across different perils, reducing the cost of insurance via diversification through capital markets and collateralized coverage Provide multi-year coverage at fixed rates, resulting in lower cost volatility and less "renewal" risk Enable rapid access to capital post event based on specific coverage triggers (parametric insurance) Eliminate any incremental leverage as funds do not need to be repaid 22
Multi-Country Cat Bond Structure and Cash Flows Disaster Contingent payments Countries MCCB Principal Re-insurers & Capital Market Investors Premiums Coupons Subsidies Coupons AAA Assets Donors Collateral Trust 23
Other Insurance Programs The World Bank Group offers a range of complementary products and services to assist countries develop tailor-made catastrophe risk financing strategies. Property Catastrophe Insurance Programs The World Bank Group assisted Turkey in establishing the Turkish Catastrophe Insurance Pool (TCIP), that offers efficiently priced earthquake insurance to homeowners. Agriculture Insurance Programs The World Bank Group has provided technical assistance for the development of innovative agriculture insurance programs in several low and middle-income countries. The Index-Based Livestock Insurance Program was established by the Government of Mongolia to protect herders against excessive livestock mortality. The Government of India, with the assistance from the World Bank, established a Weather Based Crop Insurance Scheme to protect farmers against drought. Specialist Index Reinsurer The World Bank Group is supporting the creation of the Global Index Reinsurance Facility (GIRIF), a multi-donor trust fund linked with a specialized index-based reinsurance company, which will promote index-based insurance in developing markets. Weather Derivatives The World Bank Group offers weather derivatives to provide risk management products to member countries, transferring the weather risk to the market. 24
Exposure to Weather Risk Low and middle-income countries bear weather risks that can have a large impact on their GDP and their budget: Direct economic loss (e.g. damage to stock of housing) Production shocks (e.g. damage to agricultural production) Hedging products can help manage weather risks in the context of a wider risk management framework. 25
The Weather Market First weather derivative transaction in U.S. 1997 Deregulation of the energy industry Market has rapidly grown, well over $100b transacted to date (PWC Survey 2008) Non-energy applications New participants Global development Broader product offering Key Players: (Re)insurers Banks Hedge Funds Market wants to diversify and grow their portfolios, wants new risks
Weather Market Gap and World Bank s Role Market Concentration The majority of weather derivative transactions tend to be for developed markets - the US in particular High Investment Derivative transactions capacity building High cost of initial due diligence Moral Hazard Concerns about possible manipulation of weather data The WB can intermediate index-based weather derivatives for its clients (droughts, floods, high temperature). These mechanisms should be considered as one of a menu of instruments that could be used to implement a disaster risk management strategy
Value-Added of WB Intermediation Building Capacity Attracting Market Players Mitigating Moral Hazard Risk Pricing
Prerequisites for a Program in Malawi An index that captures national drought risk in Malawi faithfully Government s Maize Yield Assessment Model Rainfall-based FAO model used since 1992 High quality historical weather data and reliable real-time communication Malawi Met Office data excellent: 23 stations with over 40 years, few gaps Can provide real-time data required by market $200k invested by DFID Jan 2008 to support a pilot transaction Premium: DFID want to support initial premium cost in piloting phase starting 2008 EU and USAID interested for 2009+
Historical Payouts Example 95% Strike, $500k per % Payout Value of Contract to Market = Average Payout + Risk Margin Value of Contract to Government = Average Payout + Value of Timely, Reliable Funds
World Bank Intermediation: Value Added Building Capacity Building capacity to facilitate future direct transactions between the Government and market counterparts Legal Transaction structuring. E.g. choice of the coverage level Bidding process, execution, valuation, accounting Attracting Market Players Reduces start-up costs for private sector market players in Malawi Facilitates competition by organizing bidding process among market counterparts Mitigating Moral Hazard Concerns Market participants are concerned about possible manipulation of weather data as the data provider (Met-Office) is a Government agency. The World Bank involvement eases these concerns Pricing As risk and start-up cost is reduced for the counterparts, and the Bank facilitates competition, the pricing might benefit from World Bank intermediation
Thank You! ajha@worldbank.org +1-202-458-1050