Natural Disaster Risk Transfer Solutions

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

3

Source: Munich Re Geo Risks Research

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

6

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

ExpendituresFiscal Revenues

• Physical

Risks

• Asset Loss:

Direct damages

to public and

private sector

assets

• Output Loss:

Incapacitation of

other 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

8

• 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

9

FUNDING NEEDS

Quick Liquidity vs. Long Term Financing

10

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

11

Reserves

Contingent lines of credit; Cat-DDO

Insurance-linked securities; Cat-Bond; Reinsurance; Cat Swaps

Risk Retention

Risk Transfer

Probability InstrumentSeverity

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

12

Risk Tran

sfer

Risk

Rete

ntio

n

MultiCat

Program

Insurance-

linked

Securities

Facilitates issuance of multiregion, multi-peril cat bonds;

eg. Mexico (earthquake & hurricane)

CCRIF/PacificInsurance

Pools

Regional facility pooling risks to cover against natural disasters

different countries

Cat DDOContingent

Loans

Provides immediate liquidityfollowing a natural disaster

eg: Philippines, Colombia, Costa Rica

Cat Swap

Pro

bab

ility

of

Eve

nt

Seve

rity

of

Imp

act

Minor

Major

High

Low

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

eg. Uruguay (drought and high oil prices)

World Bank

Cat BondWorld Bank direct issuance of Cat Bonds; eg. CCRIF (earthquake & tropical cyclone)

13

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

14

15


mechanism

Cat Swaps

Cat Bond

Market Overview



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

16

Client

Country

IBRD or

IDAInsurer

Premium

Contingent 100% of

Notional

Premium

Contingent 100% of

Notional

CASE STUDY: WORLD BANK CAT SWAP FOR PACIFIC

INTERMEDIATION

17

WORLD BANK

Samoa

Vanuatu

Solomon

Islands

Marshall

Islands

Tonga

Cook Islands

Insurer n

.

.

.

.

Insurer 1

Insurer 2

.

.

.

.

Cat SwapPremium

Payout

Cat SwapPremium

Payout

Cat SwapPremium

Payout

Cat SwapPremium

Payout

Cat SwapPremium

Payout

Cat SwapPremium

Payout

Cat SwapPremium

Payout

Cat SwapPremium

Payout

Cat SwapPremium

Payout

18


mechanism

Cat Swaps

Cat Bonds

Market Overview



Market Overview

19

CAT LANDMARK TRANSACTIONS

20

* 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

21

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

22

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

PRICING TRENDS

23


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

25

Client Insurance SPV

AAA

CollateralIBRD

Advisory

Insurance

Contract

Re-Insurance

contract

100%

100%Premium

Investors

PRICE PERFORMANCE MEXICO MULTICAT 2012

26

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

27

CountryInsurance Contract

or

ISDA Swap

or

IBRD Debt Security

Local

Re-

insuranc

e

or

IBRDRe

Re

Re

Re

Re

Multiple Insurance

Contracts

Re

ACCESSING CAPITAL MARKETS

28

Countries could issue a cat bond in two forms:

a) Cat Bond issued by Special Purpose Vehicle (SPV) sponsored by the Countryb) 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

or

ISDA Swap

or

IBRD Debt Security (not for SPV)

SPV

or

IBRD Cat Bond

Investors

Investors

Investors

InvestorsInvestors

Investors

OTHER ASPECTS TO BE CONSIDERED

• Issuance Format: When an issue will be purchased entirely by a small pool

of 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.

29


30

WORLD BANK CAPITAL AT RISK NOTES PROGRAM

31

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

32

Country

Insurance Contract

or

Cat Swap

or

IBRD Debt Security

(not for SPV)

World Bank

Bond

Ca

t Bo

nd

Investors Investors

Investors

Investors

InvestorsInvestors

WORLD BANK’S FIRST CATASTROPHE BOND ISSUANCE

33

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

or 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

34

Traditional ReCountry issuance of

Cat Bond

IBRD

Cat Bond

Duration of CoverageUp-to 3 years

Rarely 5 yearsUp-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 CostsInsurance’s Capital and

Administrative Transaction

Costs

Underwriting fees, Legal,

Model, SPV, Rating Agency

Underwriting fees, Legal,

Model, Rating Agency

FOR MORE INFORMATION CONTACT

35

Internet treasury.worldbank.org

Phone: +1 202 458 5099

Fax: +1 202 280 8355

Email: [email protected]

Mailing Address 1818 H Street, NW

MSN # C7-710

Washington, DC 20433, USA

Physical Address: 1225 Connecticut Avenue, NW

Washington, DC 20433, USA

Economy & Finance

Natural Disaster Risk Transfer Solutions