91821 the world bank Catastrophe Risk Financing in LCR: Recent Solutions and IBRD Results Challenges Ahead Synopsis The International Bank for Reconstruction and Development has helped several Latin American and Caribbean countries access financial markets to provide funds to cope with future disasters. Innovative financial initiatives supported by the IBRD enabled Costa Rica to quickly access funds after an earth- quake in January 2009. Such initiatives will also allow Haiti to quickly draw upon desperately-needed money in the wake of the catastrophic earthquake there. Challenge potentially greater tragedies both in terms of human life and financial losses when catastrophes strike. Accordingly, many As the massive earthquake that struck Haiti early in 2010 developing countries have placed disaster mitigation high illustrated so tragically, many countries in Latin Amer- on their development agendas and are increasingly inter- ica and the Caribbean are highly exposed to a range of ested in a variety of risk financing solutions to better protect natural disasters. According to the United Nations’ recent their fiscal balances and improve response capacity. Global Assessment Report, nine of the world’s top twenty countries that are most exposed to disaster economically are in the Latin America and Caribbean Region, with an an- Results nual expected loss for the region of more than US$2 billion. As more countries have taken pro-active steps to address Natural disasters have too often derailed development the risks related to adverse natural events, the World programs, erasing gains accumulated over years of effort. Bank, through the International Bank for Reconstruc- Emerging economies are particularly impacted, as they gen- tion and Development (IBRD) has responded by creating erally experience rapid growth in infrastructure and eco- a suite of products and services, many of them developed nomic activities without the means to establish appropriate and tested in Latin America and the Caribbean. By using planning and building standards. Growing populations pre-arranged financing mechanisms, countries are better and a greater concentration of assets in disaster-prone areas able to respond when a disaster strikes, rehabilitating es- are resulting in more severe disaster-related losses. The ex- sential services to pre-disaster economic production levels pected increase in the frequency and intensity of hazardous more quickly and thereby diminishing the economic im- weather events because of climate change is likely to exacer- pact of the disaster. New financial instruments are also used bate this trend. to buffer the impact of disasters on fiscal balances while eco- nomic activity recovers. World Bank member countries have increasingly asked the institution for assistance with catastrophe risk financing ÔÔ Following the 6.2 magnitude earthquake that hit Costa before disasters occur. Without systems in place to mitigate Rica in January 2009, the government was able to draw the impact of natural disasters, governments are faced with down US$15 million of a special credit line (a Catas- March 2010 2 Catastrophe Risk Financing in LCR by the Bank that allows for the issuance of cat bonds with multiple perils, regions and countries. Mexico issued a US$290 million series of notes in October 2009 using this platform, which was well received and oversubscribed in the market. The 2009 issuance pro- vides US$290 million of coverage over three years for three specific risks—earthquakes (three areas around Mexico City), Pacific hurricanes (two areas) and At- lantic hurricanes (namely the area around Cancun). “The partnership between Mexico and the World Bank, under its MultiCat Program, has allowed us to efficiently transfer a pool of catastrophic risk —earthquake and hurrican—to the market for the first time, and we are very satisfied with the results trophe Deferred Drawdown Option or Cat DDO) for achieved,” said Alejandro Werner, Vice Minister of disaster recovery. The World Bank was able to provide Finance, Government of Mexico. “We are also very funds within 24 hours following the request from the proud to have contributed to the creation of this Government. Guillermo Zuñiga, Minister of Finance, platform that also makes a new set of catastrophe talking after a visit of the earthquake-affected area, indi- risk management instruments available to other cated that “the type of assistance offered by the Bank is members of the World Bank.” beneficial to Costa Rica as it involves an efficient way ÔÔ In 2007, the World Bank Group helped the Carib- to insulate our economy and have resources available bean Community (CARICOM) establish the Carib- in advantageous conditions, if they were to be need- bean Catastrophe Risk Insurance Facility (CCRIF), a ed.” Since the World Bank created Cat DDOs in 2008, Caribbean-owned “parametric” insurance pool, which three countries—Costa Rica ($65 million), Colom- offers fast payout to its 16 Caribbean member countries bia ($150 million), and Guatemala ($85 million)— upon occurrence of pre-defined hurricane strengths have signed up for the innovative financing vehicles. For and earthquake magnitudes within defined geographi- Costa Rica, the Cat DDO was a timely addition to its cal locations. The instrument allows for fast payout menu of catastrophe risk financing products. In addi- because it is independent of actual damages. This type tion to the access to immediate liquidity, the Cat DDO of parametric instrument will normally be attractive has offered Costa Rica a possibility to improve and con- for governments to finance early rehabilitation activi- solidate its risk financing strategy for the country. ties and to fill the public financing gap in the period ÔÔ Over the last ten years, Mexico developed a self- where governments will be raising additional funding insurance fund for financing disaster recovery (Fondo for reconstruction purposes. CCRIF offers participat- de Desastres Naturales or FONDEN), that relies on ing countries an efficient and transparent vehicle to ac- market-based financial instruments. In 2006, as part cess the international reinsurance and capital markets. of this strategy, Mexico, with the technical assistance The facility became operational on June 1, 2007, and of the World Bank Group, issued a catastrophe bond has been recognized by the insurance/reinsurance in- —the Cat-Mex bond—with a historically low inter- dustry for its innovation. As a self-sustaining entity, est rate spread. The US$160 million issue provided CCRIF relies on its own reserves and reinsurance to cover against the risk of earthquakes in three regions finance itself. surrounding Mexico City. This was the first time a The donor community contributed to initial re- sovereign country had issued a catastrophe bond. serves and participant countries paid one-time par- Mexico was the first country to use the MultiCat pro- ticipation fees. In 2009, its third year of operation, gram, a flexible catastrophe bond platform developed CCRIF successfully placed more than US$130 million IBRD RESULTS 3 of coverage in the international reinsurance and capital ciently address small and recurrent losses. Insurance and/or markets. As part of CCRIF’s reinsurance placement, reinsurance more efficiently cover larger, but less frequent, the World Bank Treasury placed a portion of the ca- losses while losses from major natural disasters can be trans- tastrophe risk in the capital markets through a cat swap ferred to the capital markets through securities like catas- in 2007, 2008 and 2009. The US$30 million swap be- trophe bonds. Naturally, international donor assistance in tween IBRD and CCRIF was the first transaction to the aftermath of catastrophe remains an essential element enable emerging countries to use a derivative transac- of the strategy for financing recovery from major disasters. tion to access the capital market to insure against natu- The following table outlines key characteristics of different ral disasters. It was also the first time a diversified pool risk financing instruments. of emerging-market countries’ catastrophe risk was placed in the capital markets. While the creation of Cost of CCRIF was supported by IBRD and largely driven by financing IBRD member countries, participation in the insurance (multiplication pool is not limited to IBRD countries. The CCRIF Instrument Disbursement factor) is preparing to make a payout of US$7.75 million to Reserve Funds Fast 1–2 the Government of Haiti as a result of the magnitude 7.0 earthquake which struck close to Port-au-Prince, Budgettary Moderate 1 reallocation Haiti, in January 2010. The recent earthquake was of sufficient magnitude to trigger the full policy limit for Contingent Credit Fast 1 the earthquake coverage. CCRIF is hopeful that the Line (CAT DDO) rapid payment of funds under Haiti’s policy will assist Loans (World Bank Slow 1 the government and people of Haiti in addressing im- and others) mediate needs as they begin the recovery and rebuild- Donor contributions Slow 0–1 ing process. Traditional Insurance Slow 2–6 ÔÔ The Central American Weather Risk Management Parametric Fast 2–5 Program, which offers index-based crop insurance Insurance products, has been developed in Guatemala, Hondu- Catastrophe Bonds Fast 2–5 ras, and Nicaragua. The program is currently operat- ing in Nicaragua, where 2500 hectares of export crops, with a value of US$41.6 million, were insured in 2008. World Bank Group financial solutions for catastrophe risk management package knowledge, convening power, finan- cial expertise, lending instruments and South-South part- Approach nership for knowledge exchange or risk pooling that can help governments plan for and reduce the human and fi- The World Bank Group advocates catastrophe risk financ- nancial costs of disaster recovery. ing as an important element of the strategic framework for disaster risk management. Catastrophe risk financing is most effective when a government adopts a strategy of Summary Timeline retaining some risks on its balance sheet and transferring others to the private sector. The World Bank Group team ÔÔ In 2005, the World Bank established a regional co- works with the client to determine what instrument or ordinator for Latin America and the Caribbean who combination of instruments is most appropriate depend- coordinates all activities related to disaster risk in the ing on the probability and the severity (the expected losses) region. of the specific catastrophe risks. National reserve funds, ÔÔ June 2007: World Bank assists CARICOM in estab- supplemented by contingent financing if needed, can effi- lishing CCRIF. 4 Catastrophe Risk Financing in LCR BOX 1 Innovation in Catastrophe Risk Financing The Bank has played different roles in assisting countries access catastrophe risk financing instruments available in the market. IBRD acted as an arranger in the structuring of a Catastrophe Bond, provided advice in establishing Risk Insurance Facilities, acted as an intermediary with the market in a CAT swap, and provided direct financing through contingent loans. Contingent Credit Lines: The CAT DDO (Catastrophe Deferred Drawdown Option) is a contingent policy loan instru- ment offered by IBRD that allows countries that are pro-active about reducing their risk to adverse natural events to draw funds immediately after a disaster. It offers IBRD-eligible countries immediate liquidity of up to US$500 million or 0.25 percent of GDP (whichever is less) at regular IBRD lending rates to respond to natural disasters. This instrument is also the first to address the problem of moral hazard in donor funding of disaster recovery, by requir- ing countries to establish and maintain a disaster risk management program that is monitored by the World Bank. Catastrophe Bonds: Cat bonds transfer risks to capital market investors by allowing the issuer to not repay the bond principal and instead use these funds for disaster recovery if a major disaster occurs. The MultiCat Program allows governments to use a standard framework to buy insurance on affordable terms by issuing catastrophe bonds. The objectives of the program are to facilitate public access to affordable insurance coverage, enlarge the traditional investor base for catastrophe bonds by offering yields uncorrelated with financial markets, and ensure govern- ments’ access to immediate liquidity to finance emergency relief and reconstruction work after a natural disaster. The program supports a wide variety of structures, including the pooling of multiple risks (earthquakes, floods, hurricanes and other wind storms) in different regions. Each bond issued under the platform carries the MultiCat brand name and uses a common legal structure and documentation, with the World Bank acting as arranger.1 Risk Insurance Facilities: Self-sustaining insurance pools offer parametric coverage, akin to business interruption insurance, against natural disasters. The WBG provides advisory services to help countries establish national or regional vehicles to pool risks and access international catastrophe reinsurance markets on competitive terms. CAT swaps: Swaps are contracts whereby parties agree to exchange cash flows. In a catastrophe swap, an insurer agrees to make periodic payments to another party, and the other party agrees to make payments to the insurer in the event of a specific catastrophic event. IBRD executed a CAT swap with the CCRIF and a back-to-back swap with the market, effectively transferring the catastrophic risk to the market. ÔÔ March 2008: IBRD offers contingent financing access. This supports two complementary catastrophe risk through Cat DDO to middle income countries (Sep- financing product lines: the Cat DDO and emergency tember 2008: Costa Rica contracts first Cat DDO). lending; and advisory services in areas such as strength- ÔÔ October 2008: IBRD intermediates first weather de- ening domestic property insurance markets, helping es- rivative for a developing country. tablish multi-country facilities, and intermediating in the ÔÔ October 2009: World Bank launches MultiCat catas- market. trophe bond issuance platform. In the case of the Cat DDO, the Bank leverages its balance sheet to provide middle-income countries with an instru- IBRD Contribution ment that is not otherwise available in the financial mar- ket. It also draws on its technical expertise to advise client IBRD’s contribution to catastrophe risk financing is countries in the design and implementation of risk manage- grounded in its expertise, convening power and market ment programs. In the case of the MultiCat (Cat Bonds), IBRD RESULTS 5 development of the MultiCat Program. The World Bank acts as arranger for the bonds issued under the program. ÔÔ Caribbean Catastrophe Risk Insurance Facility. CCRIF is the result of two years of collaborative work between CARICOM governments, key donor part- ners (i.e., Japan, United Kingdom’s Department For International Development, the Canadian Interna- tional Development Agency, the Agence Française de Développement, the Caribbean Development Bank, Ireland, Bermuda and the European Union), and the World Bank Group. the Bank acts as technical advisor and intermediary in the processing of highly innovative transactions. Next Steps The World Bank Group also provided advisory services to CARICOM to establish the CCRIF. In addition, it used its ÔÔ Cat-DDO. Several countries in Latin America and the convening power to bring donors and participating coun- Caribbean and other regions have expressed interest in tries to join the initiative and the IBRD provided US$10 Cat DDOs and Peru is currently in the early stages of million to the initial reserves of the CCRIF. It also financed preparation of a possible Cat DDO. El Salvador, Pan- US$14.2 million in IDA special credits to the governments ama, and the Dominican Republic are other countries of four Caribbean countries (Dominica, Grenada, St Lucia, that have discussed the instrument with the Bank. Bo- and St Vincent and the Grenadines) and a US$9 million gota has indicated potential interest in a sub-national IDA grant to the government of Haiti to finance the pay- Cat DDO. Discussions are ongoing on how these ment of entry fees and of annual insurance premiums for could be included in country programs. CCRIF during the first years of operations. ÔÔ MultiCat Program. With this latest addition to the World Bank’s catastrophe risk financing tool box, the The World Bank Group is providing technical assistance World Bank Treasury will continue outreach to staff to Colombia, Costa Rica and Mexico to review the ca- about MultiCat’s financial features and the program’s tastrophe risk exposure of public assets and infrastructure place in designing comprehensive catastrophe risk and develop effective and affordable catastrophe insurance management programs. In parallel, Treasury will re- programs to protect these assets. In Costa Rica the World sume dialogue with a small group of more advanced Bank Group is working with the national insurance com- countries on possibilities for using MultiCat and will pany (INS) to design a dedicated vehicle to insure public deepen its dialogue with market participants and capi- assets. Results of preliminary work show that the proposed tal market investors to bring more investors to catastro- vehicle would improve coverage with a net savings of at phe bond markets. least US$50 million over ten years. ÔÔ Caribbean Catastrophe Risk Insurance Facility. CCRIF is currently developing a series of innovative products including: excess rainfall parametric insur- Partners ance for member countries and hurricane coverage for the distribution grid of power utility companies in ÔÔ MultiCat Program. The World Bank leveraged its the region. The feasibility of a similar vehicle is being market expertise and contacts, partnering with the investigated for the Pacific basin, at the request of the main players in catastrophe bond/reinsurance markets South-Pacific Island Countries (Pacific Catastrophe —Swiss Re, Goldman Sachs, and Munich Re—in the Risk Financing Initiative). 6 Catastrophe Risk Financing in LCR learn more The Caribbean Catastrophe Risk Insurance Facility http://www.ccrif.org/ MultiCat program http://treasury.worldbank.org/bdm/pdf/Handouts_Finance/Financial_Solution_MultiCat.pdf Colombia CAT DDO http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:22016811~menuPK:34463~pagePK: 34370~piPK:34424~theSitePK:4607,00.html Guatemala CAT DDO http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:22141932~pagePK:34370~piPK:344 24~theSitePK:4607,00.html Costa Rica CAT DDO http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:21903367~menuPK:51062077~page PK:34370~piPK:34424~theSitePK:4607,00.html MULTIMEDIA Haiti Earthquake: World Bank Support http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:22442021~menuPK:51416191~page PK:64257043~piPK:437376~theSitePK:4607,00.html Turkey: Earthquake protection http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:22334324~menuPK:51416191~page PK:64257043~piPK:437376~theSitePK:4607,00.html Disaster risk management in Malawi (agriculture insurance), Indonesia (tsunami response) and Haiti (vulnerability reduction). http://gfdrr.org/index.cfm?Page=9&ItemID=99