introduction to concepts and development of options · 2015-01-08 · introduction to concepts and...

1 CONFIDENTIAL ©2014 AIR WORLDWIDE

Disaster Risk Financing:

Introduction to Concepts and

Development of Options

Dr Simon Young, Consultant to AIR

The views expressed in this report/presentation are the views of the author(s) and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors or the governments they represent. ADB does not guarantee the source, originality, accuracy, completeness or reliability of any statement, information, data, finding, interpretation, advice, opinion, or view presented, nor does it make any representation concerning the same.


- Four ‘pillars’ of DRF identified, all underpinned by risk modelling/assessment • Sovereign governments have a primary role in one, a leading role

in another, agricultural insurance, and a facilitative role in the remainder

Disaster Risk Financing, a short overview


- Pillar 1 - Direct Government use of ex ante risk financing mechanisms • Offsetting defined and often un-defined contingent liabilities • National AAL is ~2.5% of GDP, govt. liability probably around 1-

1.5%

- Pillar 2 - Property-catastrophe insurance market development • Government support through regulation and mandating

- Pillar 3 - Government support for agricultural insurance schemes • Public-private partnerships • Premium usually heavily subsidised – often part of a broader

social protection programme

- Pillar 4 - Micro-insurance • Individuals taking responsibility for risk management reduces

burden on the government • Index-based weather insurance is most relevant micro-insurance

development in Asia at present

Sovereign role in Disaster Risk Financing


Characteristics of DRF Summary

Cost

(Mult) Volume Short Term (<3 months)

Medium Term (3-9

months) Long Term (>9 months)

Ex post Financing

Contingency budget 1-2 Small

Donor assistance (relief) 0-1 Uncertain

In-year budget reallocation 1-2 Small

Domestic credit 1-2 Medium

External credit 1-2 Large

Donor assistance (reconstr.) 0-2 Uncertain

Ex ante Financing

Reserve fund 1-2 Small

Contingent debt 1-2 Medium

Parametric insurance 1-2 Large

Traditional insurance 2+ Large


- Donor Funds (relief and reconstruction) • Traditionally have been dominant portion of response costs

• Cost and availability becoming increasingly uncertain as donors concentrate more on assisting Sovereigns in improving their own response and risk financing mechanisms

• Other than immediate response resources, other funding often takes many months

- Internal budget (contingency fund and re-allocations) • For Bangladesh, budget resources for any response are highly

limited - contingency funds are hard to defend

- re-allocations to an emergency response negatively impact other programmes

- Raising new debt (Domestic and External) • As we have heard, this is highly challenging at present, even when

the Govt has control over the timing – immediately after a natural disaster, borrowing would be very difficult and/or very expensive

Characteristics of DRF Pros & cons of ex post options for Bangladesh


- Sovereign Reserve Fund • As with contingent budgetary allocation, finding resources for

launching and maintaining a Reserve Fund does not appear feasible for Bangladesh at present

• Very high opportunity cost of Reserve Funds mean that they are generally only able to cover a small proportion of losses for major disasters

- The other three ex ante options discussed all have the advantage of low up-front cost, so leveraging sparse budgetary resources to provide substantial capital influx should a disaster occur. Those options are: • Contingent debt • Traditional risk transfer • Accessing capital markets for cat risk transfer

- These options are relevant to both public and private sectors – the microfinance sector bears significant burden and must be part of the solution • Outstanding Loans US$3.3 B; Savings US$1.2 B

Characteristics of DRF Pros & cons of ex ante options for Bangladesh


- Contingent debt provides the ability to raise debt

financing quickly, on pre-agreed terms (e.g. rate, tenor,

capacity), after a disaster shock • It may or may not be linked to active debt financing (e.g. re-

structuring of committed resources)

• It generally requires an ongoing fee to maintain the ‘window’

• Available from IFIs, bi-lateral donors and commercial banks

• Only generally applies to Sovereign DRF, though large

corporates and public entities may utilise contingent debt also

- Bangladesh’s current credit status will limit options for

sovereign contingent debt, although different products

may be available from various MDBs

Ex ante DRF instruments I Contingent Debt


- Traditional risk transfer utilises the global re /

insurance markets, usually via a broker • Flexible with regard to form of risk transfer (indemnity /

parametric), and duration (though usually annual)

• Relatively standardised contracting and highly experienced and

efficient claims settlement

• Has covered most of ex ante SDRF in development context

• Severe pricing volatility has all but disappeared

Ex ante DRF instruments II Traditional Risk Transfer


- Alternative risk transfer includes a rapidly expanding universe of instruments (generally termed insurance-linked securities, or ILS) and capital market investors • Vast majority of ILS volume

remains in peak risk zones (US wind, Europe wind, Japan quake, US quake)

• Rapidly expanding capacity for diversifying investments (e.g. developing world risk)

• Growing sophistication of investors and market-makers means that ILS is converging more and more with traditional reinsurance

Ex ante DRF instruments III Alternative Risk Transfer


- Risk transfer is the most accessible DRF tool for

Bangladesh • Risk transfer can occur with little or no reference to sovereign

credit rating

• Raising external funding for the technical work required in risk

assessment/modelling is usually relatively straightforward

• There are a variety of structures available across both

traditional and alternative markets, with a proven record of

implementation by and for developing nations

• The customisation of risk transfer parameters allows coverage

to be designed to meet the particular needs, particularly for

parametric products

• Coverage can also be customised to meet the premium funding

availability

Requirements for Risk Transfer


- Mexico’s FONDEN programme is a multi-faceted natural disaster response funding mechanism which utilises both ex post and ex ante tools and accesses global risk markets • Substantial time and commitment in its development; triggered

by 1985 Mexico City earthquake, formed in 1996, still developing

• Core budget codified in law and tied to overall government budget

• Supports State-level mechanisms in addition to Federal needs

• Annual funding leveraged via risk transfer direct to international markets

- Parametric cat bond deal first placed in 2006

- Traditional indemnity programme to provide additional capacity first placed in 2011

• R-FONDEN catastrophe model developed to underpin DRM

Case Study I Individual sovereign solution – Mexico


- Simple parametric structure • Storm has to reach trigger

intensity (measured by

minimum central pressure)

within the defined area

• Two levels of payout, 50% and

100% of the policy limit,

depending on how intense the

storm gets within the box

- Catastrophe risk model

underpins the definition of

the triggers and the

probabilities used to price

the coverage

FONDEN Parametric Structure ‘Cat in a Box’


- The Caribbean’s CCRIF programme was the first multi-national risk pool and the first sovereign programme to access both traditional and capital markets for risk transfer • Pooling offers significant value to individual (small) Caribbean

states due to diversification and scaling factors on administration, operations and risk transfer

• Scheme was launched in 2007 with sovereign parametric earthquake and tropical cyclone coverage designed to respond very quickly and provide immediate response and early reconstruction financing

• Developments have included: - supported launch of one micro- and one meso-level parametric

insurance product into local markets

- launch of excess rain parametric policy

- expansion into Central America

- cat bond deal placed through World Bank Treasury’s new cat bond issuance programme

Case Study II Pooled sovereign solution – Caribbean


CCRIF Payouts

Paid out approximately US$33 million since its inception in 2007

8 payouts to 7 member governments

All payouts made in less than a month

2007 – US$1 M to Saint Lucia and Dominica

29 November earthquake in Eastern Caribbean

2010 - US$4.2 M to Anguilla

Hurricane Earl (September)

2008 – US$6.3 M to the Turks & Caicos Islands

Hurricane Ike

2010 - ~US$8.5M to Barbados

Hurricane Tomas (October)

2010 – US$7.75 M to Haiti

12 January earthquake

The first set of funds to be received by the

Government of Haiti inclusive of all pledges,

regional and international

Represented perhaps 50% of the TOTAL aid

Government of Haiti received in first 10 weeks in

the form of direct liquidity

2010 - ~US$3.2M to Saint Lucia


2010 - ~US$1.1M to St. Vincent & the Grenadines


Strong proof of concept


- Turkey’s Catastrophe Insurance Pool (TCIP) utilises the private insurance marketplace to deliver sovereign-supported coverage • Formed with international assistance after the 1999 Izmit

earthquake, with the aim of providing government backed, compulsory earthquake insurance for property owners

• Earthquake insurance had a penetration rate of less than 3% in 1999 and was close to zero amongst the middle and low income population

• TCIP has expanded market penetration to more than 25%, with around 40% covered in the highest-risk areas through offering standardised coverage and low premium rates through existing property insurance channels

• TCIP has itself used multiple risk transfer channels: - Retention in early years was backed by contingent credit line from WB - Has used traditional reinsurance throughout - Accessed capital markets in 2013 via a parametric cat bond issuance

to complement traditional reinsurance

Case Study III Private market solution with public assistance – Turkey


Pricing Considerations


- Analysing and packaging risk • Initial risk assessment results were presented earlier; these

start to provide the basis for formulating ideas about quantum of risk and potential risk financing structures

• National annual averag loss around 2.5% of GDP

• 100-year loss for flood and tropical cyclone around 10% of GDP

• Government burden likely to be at least 25%

- Identify specific need • Funding gap analysis is important

- Is managing disaster response budget volatility a key concern for Government?

• What mechanisms are in place and can they be scaled up through accessing international risk markets?

- Waiting for donor response is not a sustainable nor efficient mechanism

Options for Bangladesh Setting the Scene


Building Blocks Towards a DRF Solution


Preliminary Funding Gap Results


- Biggest funding gaps are non-

emergency response and MFI

sector

Where are the Gaps?

Illustrative

Overall 50% funding gap


- Portfolio insurance for microfinance sector • Substantial risk resides in the loan portfolios of the MFI sector

• This can reduce the direct burden on Government and catalyse

economic activity

- Sovereign options • Contingent credit

• Transfer of cyclone and/or flood risk to international markets –

to provide early liquidity for 1 in 10+ year events

- Micro-insurance • Expanding scope of micro options in agriculture and weather

index insurance

Options for Bangladesh What might be possible?


- There are a number of contingent debt products that would have relatively low barriers to entry (in terms of risk analytics and triggering mechanism)

- Indemnity risk transfer not an option for Government other than for individual government buildings • Would need huge investment in data collection and modelling

- Parametric risk transfer into traditional or ILS markets is possible • For tropical cyclone risk, model to support parametric transaction

could be developed quite quickly and relatively low cost

• Flood parametric much more challenging, but may be able to use existing work or develop a hedge based on externally-sourced weather data

- First target probably response/early recovery financing to cover first 3 months or so – not trying to manage all of the risk

Options for Bangladesh Sovereign Solutions


- Assume government portion of losses is 25%

- Simple parametric cover, TC and Flood covered

independently

Initial Quantification of RT


Selecting a Coverage Slice


- Based on ‘typical’ sovereign cat programme risk transfer parameters (e.g. CCRIF cover)

- Coverage Limit and RoL based on known international market pricing for comparable deals

- This type of cover can provide rapid liquidity in time of need but is NOT a comprehensive risk management financing programme

Coverage/Pricing Estimate

Parameter TC Flood

Attach RP (yrs) 10 10

Exhaust RP (yrs) 100 100

Premium $10,000,000 $10,000,000

Coverage Limit 152,790,576 143,766,638

Rate on Limit 6.54% 6.96%


- Helping the population to help themselves is a highly efficient way of reducing the burden on Government

- Traditional property/catastrophe and agricultural markets are not well developed and will not quickly scale up

- Micro-insurance and weather index insurance are likely to be most appropriate tools for expanding private insurance market in Bangladesh

- Building on micro-finance platform, index-based weather products at both the individual and especially at the portfolio level could be useful targets for Government (and donor) support • Index-based flood insurance pilot is transferring ~USD150,000 of

risk

• Scaling up will require meso-level coverage, of portfolios of micro-loans for example

Options for Bangladesh Non-Sovereign Solutions


- Work on catastrophe micro-insurance, including weather index insurance, has begun to identify the sweet-spot as being at the portfolio level

- MFI sector in Bangladesh has strong insurance element – but catastrophe exposure of MFIs must be managed very differently to credit/life or health (which are the predominant forms of insurance)

- Portfolio protection for MFIs would bring a rapid influx of new liquidity after major loan-stressing events • This would enable not only re-structuring but more importantly,

distribution of new loans

• New capital influx through existing channels to existing (good) MFI clients has a massive multiplying effect in generating economic activity and allowing the long-term reconstruction financing to run through local markets, not by-pass them

Portfolio Catastrophe Protection for MFIs


- Capacity building at sovereign level - develop

understanding of: • Bangladesh’s risk profile and historical impacts

• Tools for managing risk, including financing tools

• Links between risk reduction and risk transfer

• Impacts of climate change on risk profile

- Ultimately, a comprehensive risk management

programme should be developed to identify the most

cost-effective blend of risk reduction and risk transfer

- Private market participation in catastrophe insurance

within Bangladesh will be most efficient through the

micro-finance sector so these linkages need to be built

Next steps I Capacity Building and Private Market Participation


- Risk is costly – for Bangladesh, around 2.5% of GDP per year, every year – and with a high likelihood of it getting worse due to climate change

- Just because that number has not been readily available in the past does not mean that the risk wasn’t there • Risk is borne in the form of direct donor response to disasters

(quantifiable) • But most of the risk is borne through lost economic growth – at micro-,

meso- and macro- levels

- Risk reduction directly addresses the amount of risk – and should be prioritised (through cost-benefit analysis of what investments most quickly reduce the risk quantum)

- Risk transfer does not make the risk go away, but it can be an efficient way to manage the inter-annual variability in response and recovery needs

- At the end of the day, though, someone has to pick up the risk tab,

and paying for disaster risk financing has to be an early part of any conversation!

Next steps II Paying for Risk Transfer

introduction to concepts and development of options · 2015-01-08 · introduction to concepts and...

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