October 28, 2009—Over the past decade, there has been an increase in the intensity and damage caused by natural disasters worldwide. Natural disasters do not distinguish between developed and developing countries. But emerging countries have been hit the hardest, experiencing 7% GDP loss due to destruction caused by natural disasters between 1977 and 2001 alone, according to a paper co-authored by World Bank expert Eugene Gurenko.
Only three percent of potential losses in developing countries are insured (compared to 45 percent in developed countries). As a result, such events exact a devastating toll on public finances when governments have to cover the costs of emergency and relief efforts, as well as reconstruction work. And yet, most of these countries are unable to access international insurance and reinsurance markets to cover themselves against such contingent liabilities.
“High and volatile insurance premiums, the complexity of contracts, and the insurance industry’s limited capacity to absorb extreme risks bar many countries from accessing the international insurance markets,” says Ivan Zelenko, head of derivatives and structured finance at the World Bank Treasury.
Countries highly vulnerable to catastrophic natural disasters needed an innovative approach to optimize their risk coverage and premium terms, and mitigate the impact on government budgets.
Harnessing the Power of Capital Markets for Post-disaster Reconstruction
With over US$150 trillion in assets, the international capital markets have the depth and liquidity to absorb huge risks and generate timely payouts. Various financial instruments have evolved for this purpose, including catastrophe bonds. These bonds allow investors to diversify their assets and pay much higher interest rates to compensate for the risk of the issuer not repaying the principal in the event of a major catastrophe.
But many disaster-prone countries cannot access these sophisticated financial instruments.
The World Bank just launched a new catastrophe bond issuance platform —the MultiCat Program— that will allow governments and public entities in these countries to buy insurance on affordable terms in the form of a catastrophe bond. These bonds will provide a government with immediate access to liquidity to fund emergency relief operations after a natural disaster, thus reducing volatility in fiscal budgets while avoiding the need to set up idle reserves.
Mexico, one of the most experienced governments in catastrophe risk management, had already issued a catastrophe bond in 2006 to cover itself against earthquake risk. But the new MultiCat Program goes well beyond any single peril catastrophe bond by allowing governments and public entities to access the catastrophe bond markets through a framework supported by the Bank.
The MultiCat platform is flexible and can support a variety of structures, including the pooling of multiple perils (earthquake, hurricane, rainfall) in different regions. The pooling of different risks helps to attract new investors, enlarging the investor base and lowering the insurance premium over time.
Mexico: Leading in Innovative Financial Risk Management Solutions for Natural Disasters
The Bank worked in partnership with Mexico to develop the MultiCat Program. The multi-donor trust fund, the Global Facility for Disaster Reduction and Recovery, financed the risk modeling analysis needed to assess the probability and severity of catastrophic events in the country. Mexico became the first country to issue a $290 million series of notes using the MultiCat Program earlier this month.
“The demonstration effect of this transaction for other emerging market countries cannot be overstated,” says Issam Abousleiman, head of Banking Products, World Bank Treasury. “It has paved the way for other highly exposed countries to manage their fiscal volatility by transferring extreme weather-related risks to capital markets.”
Expanding Catastrophe Risk Financing
All bonds issued under the platform will carry the MultiCat brand name and use a common legal structure and documentation, with the World Bank acting as arranger. Thus, issuing countries will benefit from the Bank’s expertise in identifying and pooling risks, as well as its experience in pulling together highly complex transactions and attracting a broad range of investors.
This type of risk financing is an important component in the strategic framework for catastrophe risk management advocated by the Bank Group. Traditionally, the Bank’s work in developing countries has been limited to post-disaster reconstruction lending. The Bank now offers a suite of products and services to help countries develop approaches to managing the risk of external shocks since traditional post-disaster responses can be costly, inefficient, and difficult to manage when a country is in crisis.
“A comprehensive approach to disaster risk management involves risk assessment, institutional capacity building, investments in risk mitigation, emergency preparedness, and catastrophe risk financing,” says Phillip Anderson, acting director of Banking and Debt Management in the World Bank Treasury.
“The MultiCat Program is an important addition to the products and services offered by the World Bank to help member countries take responsibility and plan ahead of time to manage the risk of natural disasters.”
These products and services are most effective as part of a broader catastrophe risk management strategy that involves layering resources based on the severity and frequency of natural disasters for highly exposed countries. For instance, governments can cover small and recurrent losses by building national reserves. They can use contingent financing to access capital after a disaster occurs. More severe but less frequent losses can be covered by insurance and/or reinsurance; and major natural disasters can be transferred to the capital markets through insurance-linked securities such as catastrophe bonds.