Perspectives – Ben Fox

A conversation with Dr. Ben Fox of the World Bank Group, about the Bank’s work to reduce the economic burden of natural disasters

The World Bank logo outside of H building. WorldBank World Bank Group headquarters main office building exterior. Washington DC.. Image shot 04/2009. Exact date unknown.The World Bank has led efforts to use innovative financial structures to secure finance for disaster recovery before the event even occurs. Dr. Fox is a financial sector specialist with the group that runs these initiatives within the Bank, the Disaster Risk Financing and Insurance Program (DRFIP) which is a joint program between the World Bank and the Global Facility for Disaster Reduction and Recovery (GFDRR). In this interview, he spoke with InsuranceLinked about the work of the DRFIP and about how government-sponsored catastrophe bonds fit into the ILS landscape.

Could you tell us a little about the DRFIP’s mandate and your role?
The Bank has been developing its program since the 1999 Turkey earthquake, and we now organise ourselves around four objectives – sovereign disaster risk financing, promoting private market catastrophe insurance, developing agriculture insurance and disaster-linked social protection plans. I focus on the first objective, where we help governments construct financial tools to smooth the effect of natural disasters. Our mission is to work in close partnership with our clients, who are typically officials of middle-income countries' Ministries of Finance. DRFIP is not directly involved in market transactions but does provide high level advisory services to strengthen the capacity of the governments to improve their financial protection from disasters.

How does the World Bank promote the use of cat bonds as a tool for post-disaster financing?
Our work helps countries better prepare themselves for when a disaster strikes so that they can more readily deliver critical services to their people and begin the process of rebuilding. Following a natural disaster, there are three primary response phases for which a sovereign state needs to gain access to funds: relief, recovery and reconstruction. The funding needs and timelines are different for each of these phases. They will inevitably vary depending on the severity of a natural catastrophe.

The World Bank DRFIP promotes a risk-layering approach to disaster risk financing, not unlike that seen in the private (re)insurance industry, where risk-transfer tools such as cat bonds or cat swaps would sit above risk-retention financing instruments. National disaster funds (risk-retention instruments) are an effective way of accumulating and disbursing funds to finance the impacts of high-frequency, low-severity events; but as governments consider the impacts of less-frequent but higher-severity events, then risk-transfer products like traditional insurance and alternative risk-transfer instruments (e.g. cat bonds) have advantageous characteristics.

World Bank diagram

With these kinds of ex-ante financing mechanisms in place, if a country is affected by an especially severe event, governments have guaranteed and rapid access to funds that ultimately help protect the state budget against extreme shocks.

How do these structures compare with other types of disaster financing?
Typically these structures would sit above risk-retention instruments (natural disaster funds, contingent credit facilities). For the higher risk layers, an alternative to risk-transfer products like cat bonds might be post-disaster credit. However, depending on factors like the state of the market, the size of the disaster and the macroeconomic conditions of the affected country, these funds may not be guaranteed, may take time to be received and may come with high borrowing costs.

Which countries have successfully sponsored cat bonds?
There have only been three sovereign cat bonds brought to market to date, and all three were sponsored by the government of Mexico. The recent Mexico issuances, providing earthquake and tropical cyclone protection,  have had parametric (“cat in a box”) triggers that offer a degree of transparency to investors that other trigger types (indemnity, modelled loss, etc.) don't. To date, none of the bonds has triggered a payout – which is clearly a good thing. However, within a country, it can be challenging to analyse the perceived worth of an insurance-type product that hasn't yet provided the government with a payment.

The World Bank  played a key role in establishing Turkey’s national insurance pool TCIP which launched its own bond last year as well as the Caribbean Catastrophe Risk Insurance Facility (CCRIF) which buys reinsurance in the private market, and the DRFIP builds on these successful experiences. Over the past two years, the Program has been instrumental in helping a number of small Pacific Island Countries transfer earthquake and tropical cyclone risk to the international reinsurance market through the Pacific Catastrophe Risk and Assessment and Financing Initiative (PCRAFI).

Are there unique issues that arise when creating these structures compared to commercial cat bonds?
From a transactional perspective, a sovereign cat bond can look the same as a cat bond sponsored by a traditional (re)insurance cedent. The challenge sovereigns face is clearly defining what kind of losses they are looking to protect themselves against. It is relatively straightforward for a property cat insurance company to identify the potential source of losses (e.g. damage to physical assets) using catastrophe modelling techniques; however, the contingent fiscal liability of a state, post-disaster, is rarely clearly defined. From a commercial perspective, I would highlight a lack of familiarity with these financial products and the transaction costs as reasons why we haven't seen more sovereign cat bonds come to market.

What other factors are constraining issuance?
From a technical standpoint, across middle-income countries there is generally a lack of detailed catastrophe risk modelling solutions available for governments. Typically, commercial risk modelling firms have tended to focus on the peak zones, where they can get the greatest bang for their buck, and have steered clear of emerging markets. In the world of catastrophe risk transfer, these commercial risk models are the vehicle for designing, evaluating and pricing these instruments. Without them, investors, underwriters and ratings agencies could find it difficult to take a defensible position on pricing, which may manifest itself in higher premiums.

Are we likely to see more bonds in the future?
I would say the future is bright for the issuance of sovereign cat bond-type products. As issuance becomes more common, they will become better understood. At present, Mexico is setting the standard, not only in their use of the international markets for risk transfer, but also by placing their catastrophe bond within an overall risk-financing framework that contains other funding mechanisms, like a national disaster fund and traditional reinsurance contracts.

There are a number of middle-income countries facing a high risk of natural disasters who are interested in understanding more about their potential options for transferring this risk to the international markets. In terms of perils, earthquake and tropical cyclone risk (as in the Mexico cat bond) are the most likely to come to market. Even in the peak risk zones, flood modelling remains challenging due to the data requirements and complexity of modelling the peril. As such, although the appetite is high, I think it will be some time before we see sovereign flood risk coming to the market.

What is your view on the changes that we are seeing in the reinsurance market? Could it be an opportunity for your clients?
It is potentially a significant opportunity for sure. The flood of non-traditional capital into the reinsurance space, combined with a relatively benign cat season last year, means that commercial pricing multiples are at a historic low. As such, it makes sound commercial sense for sovereign states to consider passing some of their natural catastrophe risk to the market to take advantage of the pricing. They would be bringing diversifying risks, in terms of geography and perils, to potential investors.

As you may have read in the press recently, the Finance Secretary of the Philippines has indicated his country’s interest in continuing preparations for a risk-transfer product to provide protection against earthquake and tropical cyclone risk. In this case, the World Bank is working closely with the government of the Philippines, providing commercial and technical advice about a potential transaction – in the case of the latter, to ensure that the technical design of an instrument is aligned with the overall disaster risk financing policy objectives of the government.

Posted: Monday, May 5th, 2014