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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.
2 CONFIDENTIAL ©2014 AIR WORLDWIDE
- 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
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- 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
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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
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- 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
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- 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
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- 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
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- 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
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- 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
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- 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
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- 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
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- 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’
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- 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
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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
Hurricane Tomas (October)
2010 - ~US$1.1M to St. Vincent & the Grenadines
Hurricane Tomas (October)
Strong proof of concept
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- 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
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Pricing Considerations
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- 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
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Building Blocks Towards a DRF Solution
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Preliminary Funding Gap Results
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- Biggest funding gaps are non-
emergency response and MFI
sector
Where are the Gaps?
Illustrative
Overall 50% funding gap
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- 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?
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- 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
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- Assume government portion of losses is 25%
- Simple parametric cover, TC and Flood covered
independently
Initial Quantification of RT
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Selecting a Coverage Slice
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- 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%
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- 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
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- 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
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- 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
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- 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
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