Uniting Disaster Risk Transfer with Sustainable Development: A Q&A with the World Bank Treasury
August 4th, 2020
Natural disasters and health related emergencies can cause significant economic and fiscal shocks for countries. Immediately after a catastrophic event, many countries receive short-term humanitarian assistance; and often they will also receive international financial aid for longer-term rebuilding. But countries can struggle to fund the interim period, the weeks to months after a disaster occurs, when most of the emergency relief and recovery efforts take place. It is this liquidity gap that insurance-linked securities, such as catastrophe (CAT) bonds, can help fill.
The World Bank issues CAT bonds for many client countries around the world. Similar to insurance, CAT bonds transfer a client’s disaster risk to financial markets. The Risk Center reached out to Michael Bennett and Naomi Cooney at the World Bank Treasury to hear about the role of CAT bonds in sovereign disaster risk financing and how the World Bank’s CAT bonds support sustainable development.
What is the role of CAT bonds in sovereign disaster response?
Responding to natural disasters and pandemics puts a significant fiscal burden on governments and can create major budget volatility. With climate change exacerbating the frequency of extreme meteorological events, the fiscal burden of natural disasters on developing countries is expected to continue to rise. Emerging markets are more vulnerable than developed markets due to weaker building codes, denser cities and minimal insurance coverage.
After a disaster occurs, economic activity decreases, resulting in lower government revenue. At the same time, governments must reallocate their budgets to finance relief and recovery efforts. Such budget reallocations, combined with lower revenues caused by decreased economic activity following a disaster, result in less money available to fund other government priorities, thereby magnifying the negative developmental impact of the event. One only has to look at the current COVID-19 induced crisis to see these effects.
The World Bank’s clients use a range of financial products to respond to disasters, such as reserve funds, contingent credit, post-disaster debt, insurance and CAT bonds. With insurance and CAT bonds, countries can transfer some of their disaster risk exposure to insurance and capital markets without increasing their sovereign debt. A country pays an insurance premium and in return receives a payout if a specified disaster event occurs. The insurance or CAT bond is pre-arranged in advance of a disaster happening and can be designed to provide a quick payout within days or weeks of an event occurring. This then provides much needed liquidity after a disaster occurs.
CAT bonds allow countries to access a much bigger pool of capital (i.e., the trillions of dollars held by bond investors), and in general, longer coverage periods, than conventional insurance. Any counterparty credit risk concerns are eliminated as CAT bonds are fully funded transactions. That is, the investors put up all their money upfront, and therefore there is no risk to the insured country of default by the investors. In a conventional insurance transaction, on the other hand, the insured party is exposed to a potential default by its insurer.
Can you provide some examples of how countries have used CAT bonds to increase their resilience from natural disasters?
The World Bank launched its Capital at Risk Notes program in 2014 and in the last three years alone issued CAT bonds providing World Bank clients with US$2.8 billion of insurance cover. These transactions have covered a range of risks including earthquakes, hurricanes, tsunamis and pandemics. The Bank provides clients with both advisory and execution services for such transactions.
Mexico is one of the world’s most exposed countries to natural disasters, frequently hit by earthquakes and hurricanes. In the late 1990s the Federal Government of Mexico established Fondo de Desastres Naturales (FONDEN – a fund for natural disasters), with the intention to support post disaster activities related to emergencies, recovery and reconstruction. FONDEN is one of the world’s most advanced financial vehicles for managing disaster risk, funding its operations through federal budget, insurance and CAT bonds. The World Bank has been supporting FONDENs disaster risk financing and CAT bond program since 2006. In September 2017, when a 7.1 magnitude earthquake hit Mexico City, FONDEN received a payout of US$150 million from a World Bank issued CAT bond. This was a full payout from the earthquake exposed CAT bond tranche issued in August 2017. The most recent Mexico CAT bond issued by the World Bank in March 2020 provides FONDEN with US$485 million of insurance cover for earthquake and hurricane events for four years.
Other countries have benefited from the leadership of Mexico, and in 2018, the World Bank issued the largest ever sovereign CAT bond, to countries of the Pacific Alliance, providing Chile, Colombia, Mexico and Peru with US$1.4 billion of insurance cover for earthquake events. A little over a year later, a magnitude 8.0 earthquake shook Peru, meeting the bond triggering requirements for an insurance payout of US$60 million to Peru.
The Philippines is frequently hit by typhoons and earthquakes, and in November 2019 it became the first sovereign in Asia to sponsor a CAT bond. The World Bank issued to capital market investors a CAT bond that provides the Philippines government with US$225 million of insurance cover for earthquakes and typhoon events for three years.
Could you explain the structure of World Bank issued CAT bonds and how this differs from other CAT bonds?
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 CAT bonds where some or all of the investors’ principal is at risk due to the transfer of client’s risk to investors.
Typically, clients (the CAT bond sponsor) enter into an insurance agreement with the World Bank under which they agree to make insurance premium payments to the World Bank. Simultaneously with the execution of that insurance agreement, the World Bank issues a CAT bond to investors with terms that mirror those of the insurance agreement. The type of events that will trigger a payout, and the payout amounts, are pre-defined based on the requirements of each client.
If a catastrophe occurs, clients will receive a payout from the World Bank, and the World Bank will deduct the same amount from the principal of the CAT bond. At the CAT bond maturity, any remaining bond proceeds are returned to investors.
Unlike a typical CAT bond structure, World Bank CAT bonds make use of all the World Bank’s existing bond issuance infrastructure and do not require a Special Purpose Vehicle (SPV) or any collateral arrangements. Therefore, the structuring is streamlined, and transaction costs are reduced for clients.
I understand the capital proceeds from World Bank issued CAT bonds while used to manage disaster risk, also supports environmental goals and sustainable development. Could you explain how that works?
CAT bonds sponsored by World Bank clients are typically designed as part of a broader disaster risk management program with sustainability objectives. Mechanisms are often put in place to ensure that payouts are used to support environmental and sustainable development goals. While proceeds are generally used for emergency relief and rehabilitation, CAT bond proceeds can also be used to build back better, thereby meeting environmental goals. Equally important are the social benefits of CAT bonds in protecting human and economic assets. We know that severe weather-related events present an increasingly significant challenge to sustainable development, particularly for the least-developed countries and Small Island Developing States, through the destruction of property, loss of income, increasing inequality, interrupting education, etc.
In addition to supporting sustainability objectives in the sponsoring country, the proceeds from CAT bonds issued by the World Bank support the financing of projects that promote sustainable development around the globe. In this way, World Bank CAT bonds contribute towards the achievement of the United Nations Sustainable Development Goals – a set of interrelated goals related to critical development priorities such as health, gender, environment and education that were adopted by the international community in 2015. All World Bank projects and programs are designed to achieve positive environmental and social impacts and outcomes consistent with the World Bank’s goals. They integrate sustainability policies and environmental and social requirements.
Do you see any other approaches that can help link sustainability with disaster risk management? Could other issuers find designs that would unite risk transfer with support for sustainable projects?
In short, “yes”. Any CAT bond designed to increase a sponsor’s resilience to climate-related hazards and natural disasters is effectively linking sustainability with disaster risk financing. Both public and private entities can leverage the capital market through the issuance of CAT bonds to support broader disaster risk management programs with specific environmental or sustainable objectives in mind.
In addition, CAT bonds can further support the United Nations Sustainable Development Goals by investing the bond proceeds in sustainable programs. In a typical CAT bond transaction, issuances are done by SPVs set up by the transaction sponsor. Since SPVs have no credit strength of their own, the proceeds of the issue must be held as collateral during the life of the transaction. Sponsors, therefore, must decide how to invest those proceeds.
In addition to acting as an arranger and issuer of CAT bonds for World Bank clients, the World Bank has become an important supplier of collateral required for CAT bonds issued by third parties. As collateral in third party transactions, World Bank bonds offer several important benefits to both transaction sponsors and investors: first they carry a triple-A rating; second they pay a premium over most other preferred forms of collateral; and third, the proceeds of the issues are used to support the World Bank’s sustainable development mission across a diverse range of sectors including health, education, transportation and renewable energy. In other words, World Bank bonds are a safe, cost-efficient and socially responsible option as collateral for any CAT bond.
Much of the capital in the CAT bond market comes from pension funds, asset managers and family offices and these investors are increasingly conscious of the environment, social and governance aspects of their investments. Given such investor concerns, the World Bank’s mission to alleviate poverty and boost shared prosperity in its member countries becomes a strong selling point for using World Bank bonds as a collateral solution.
World Bank bonds have now been used as a collateral solution for more than sixty CAT bonds in an aggregate amount of approximately US$13 billion. Such bonds have covered a variety of perils ranging from earthquakes and tropical cyclones to wildfires and longevity across a broad geographical area. By choosing World Bank bonds as a collateral solution, CAT bond investors can further enhance the sustainability of their investments, without giving up return or taking any additional risks.
How has COVID-19 impacted the CAT bond market and investor demand for such bonds?
While the COVID-19 crisis has led to increased volatility throughout the capital markets, the impact on the CAT bond market has been relatively limited. This limited impact is consistent with prior periods of extreme capital market volatility (such as during the financial crisis of 2007-08) in which CAT bond performance also remained largely stable compared to other segments of the capital markets. Such stability reflects the fact that CAT bonds are structured to perform as diversifiers to other financial market risks.
The performance of CAT bonds depends on the occurrence of loss events, which are mainly natural catastrophes, such as hurricanes, earthquakes and floods. While there is some limited life event exposure in the CAT bond market, for the most part this exposure is to extreme mortality events, and, as of now, COVID-19 has not led to overall changes in mortality rates large enough to trigger these transactions. The one exception is the World Bank’s pandemic bond and swap transaction, which triggered due to the COVID-19 outbreak, leading to a US$133 million payout from the bond (plus $63 million from the accompanying pandemic-risk linked swaps) to the least developed countries affected by the pandemic. The pandemic bond and swap transaction was designed specifically to respond to events like COVID-19.
Several CAT bonds are expected to mature throughout the rest of 2020, which suggests that there will be ample capacity in the market to absorb new CAT bond issuances. However, CAT bond and reinsurance pricing has continued to harden (still recovering from the catastrophe events of 2017, 2018 and 2019), resulting in general in increased insurance costs for sponsors.
How has COVID-19 impacted sovereign interest in disaster risk financing?
While the economic dislocations caused by COVID-19 certainly will negatively impact government budgets, this event will highlight the importance of risk management and the value of insuring against events that can have significant shocks on a nation’s economy. In many emerging countries the number of COVID-19 cases has not yet peaked, and at the same time these countries are exposed to hurricanes, earthquake, droughts and other shocks. With the concern of compound shocks growing, governments are now placing even greater importance on disaster risk financing.
We don’t anticipate a decline in interest in sovereign CAT bond and insurance transactions. However, we do expect an increased need for donor support programs such as that provided by the Global Risk Financing Facility. With developing country budgets already stretched by COVID-19, related reductions in revenues and increases in public health expenditures, the benefits of financial support for CAT bond and insurance programs costs are magnified. With reduced budgets and fiscal space, financial protection against future shocks is needed now more than ever.
You can learn more about how the World Bank supports its clients with transferring risk to insurance and capital markets by watching this video with Naomi.