By Michael Bennett, Head of Derivatives and Structured Finance, World Bank AOA Seminar Colombo, Sri Lanka. August 2014

1. NATURAL DISASTER RISK TRANSFER SOLUTIONS
Michael Bennett
Head of Derivatives and Structured Finance
August 2014

2. Fiscal Impact of Disaster Events in Emerging Countries
1

3. 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

4. NATURAL CATASTROPHES WORLDWIDE 1980-2011OVERALL AND INSURED LOSSES WITH TREND
3
Source: Munich Re Geo Risks Research

5. IMPACT OF NATURAL DISASTERS(UNINSURED LOSSES AS A PERCENTAGE OF ANNUAL GDP)
4

6. Importance of Integrating Disaster Risk in Fiscal Risk Management Framework
5

7. 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

8. 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 Expenditures
FiscalRevenues
•Physical Risks
•AssetLoss: Directdamages 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
•ImplicitLiabilities: Recovery and reconstruction costs not explicitly budgeted
•Tariffs on imports and exports
•Commodity-related royalties
•Income, value-added, and property taxes
•EconomicRisks
•Financial Sector Risks

9. 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

10. Disaster Risk Financing Products
9

11. FUNDING NEEDS
Quick Liquidity vs. Long Term Financing
10

12. 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
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Reserves
Contingent lines of credit; Cat-DDO
Insurance-linked securities; Cat-Bond; Reinsurance; Cat Swaps
Risk
Retention
Risk
Transfer
Probability
Instrument
Severity
Low
High
High
Low

13. WORLD BANK DISASTER RISK FINANCING PRODUCTS
Addresses immediate liquidity needs + other resource gaps; manages and transfers financial risks to the market
12
Risk Transfer
Risk Retention
MultiCat
Program
Insurance-
linked
Securities
Facilitates issuance of multi
region, multi-peril cat bonds;
eg. Mexico (earthquake & hurricane)
CCRIF/Pacific
Insurance
Pools
Regional facility pooling risks to
cover against natural disasters
different countries
Cat DDO
Contingent
Loans
Provides immediate liquidity
following a natural disaster
eg: Philippines, Colombia, Costa Rica
Cat Swap
Probability of Event
Severity of Impact
Minor
Major
High
Low
Insures against weather + geological related losses, based on an index;
eg. Uruguay (drought and high oil prices)
World Bank
Cat Bond
World Bank direct issuance of Cat Bonds;
eg. CCRIF (earthquake & tropical cyclone)

14. 13
Structure of the transfer mechanism
Cat Swaps
Cat Bonds
Market Overview
Cat Bond Alternatives
World Bank Cat Bonds

15. 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

16. 15
Structure of the transfer mechanism
Cat Swaps
Cat Bond
Market Overview
Cat Bond Alternatives
World Bank Cat Bonds

17. 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
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Client
Country
IBRD or IDA
Insurer
Premium
Contingent 100% of Notional
Premium
Contingent 100% of Notional

18. CASE STUDY: WORLD BANK CAT SWAP FOR PACIFIC INTERMEDIATION
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WORLD BANK
Samoa
Vanuatu
Solomon Islands
Marshall Islands
Tonga
CookIslands
Insurer n
.
.
.
.
Insurer 1
Insurer 2
.
.
.
.
Cat Swap
Premium
Payout
Cat Swap
Premium
Payout
Cat Swap
Premium
Payout
Cat Swap
Premium
Payout
Cat Swap
Premium
Payout
Cat Swap
Premium
Payout
Cat Swap
Premium
Payout
Cat Swap
Premium
Payout
Cat Swap
Premium
Payout

19. 18
Structure of the transfer mechanism
Cat Swaps
Cat Bonds
Market Overview
Cat Bond Alternatives
World Bank Cat Bonds

20. Market Overview
19

21. CAT LANDMARK TRANSACTIONS
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* Atlantic Wind is not presented here because it is unique peril with high market multiples given the correlation to US Wind
A multipleis 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

22. 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

23. OUTSTANDING BY REGION
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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

24. PRICING TRENDS
23

25. Cat Bond Alternatives
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26. MULTICATISSUE
MultiCatStructure
The coverage sourced through the MultiCatis 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 MultiCatprogram can be re-used as a shelf for other issuers
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Client
Insurance
SPV
AAA
Collateral
IBRD
Advisory
Insurance Contract
Re-Insurance contract
100%
100%
Premium
Investors

27. PRICE PERFORMANCE MEXICO MULTICAT2012
26
Source: Swiss Re Capital Markets as of March 7, 2014

28. 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
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Country
Insurance Contract
or
ISDA Swap
or
IBRD Debt Security
Local Re- insurance
or
IBRD
Re
Re
Re
Re
Re
Multiple Insurance Contracts
Re

29. 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 Country
b) 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
Investors
Investors
Investors

30. OTHER ASPECTS TO BE CONSIDERED
•Issuance Format: When an issue will be purchased entirely by a small pool of sophisticated investors, a “RegD” format can be considered.
Pro: RegD issuance reduces costs significantly because it requires very little in the way of disclosure/documentation and no credit rating.
Con: RegD 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 putablefloater can be used.
•Use of MultiCatProgram: For any issue by a SPV, the SPV could be established under the MultiCatProgram and carry the MultiCatbrand.
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31. World Bank Cat Bonds
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32. 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

33. WORLD BANK CAT BOND
32
Country
Insurance Contract
or
Cat Swap
or
IBRD Debt Security (not for SPV)
World Bank Bond
Cat Bond
Investors
Investors
Investors
Investors
Investors
Investors

34. WORLD BANK’S FIRST CATASTROPHE BOND ISSUANCE
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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

35. COMPARISON OF RISK TRANSFER ALTERNATIVE PRODUCTS
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TraditionalRe
Country issuance of
Cat Bond
IBRD
Cat Bond
Duration of Coverage
Up-to 3 years
Rarely 5 years
Up-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 issuesthe Cat Bond
WBissues 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- insurersdirectly or via IBRDinthe form of:
Insurance Contract
AnISDA Swap
A Debt Security
The Country enters intoa re- insurance contract with the SPV
The Country entersinto a swap contract with the SPV
The Country receives insurance from the Re- insurersvia IBRDinthe form of:
Insurance Contract
AnISDA Swap
A Debt Security
Transaction Costs
Insurance’s Capital and Administrative Transaction Costs
Underwriting fees, Legal, Model, SPV, Rating Agency
Underwriting fees, Legal, Model, Rating Agency

36. FOR MORE INFORMATION CONTACT
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Internet
treasury.worldbank.org
Phone:
+1 202 458 5099
Fax:
+1 202 280 8355
Email:
mbennett1@worldbank.org
Mailing Address
1818 H Street, NW
MSN # C7-710
Washington, DC 20433, USA
Physical Address:
1225 Connecticut Avenue, NW
Washington,DC 20433, USA