Crisis capital

IFR Asia 1086 - Asian Development Bank SR 2019
7 min read
Steve Garton

When Papua New Guinea was rocked by a 7.5 magnitude earthquake in February 2018, the resulting damage forced the country’s biggest liquefied natural gas project to shut down for almost two months. GDP growth tumbled from 3.0% in 2017 to just 0.2% in 2018 as the hit to exports and the massive clean-up bill took a toll on the economy.

Smaller countries fare even worse. Cyclone Gita – a severe tropical cyclone with winds reaching over 230km/h – caused damage equivalent to 38% of Tonga’s annual GDP in the same month, while losses in Vanuatu from cyclone Pam in 2015 reached 64% of annual output.

Asia is littered with similar examples, where natural disasters have had a severe impact on government finances. And, as climate change increases the intensity of storms and floods, it is little wonder that ministers are looking for ways to protect their national budgets.

Catastrophe bonds may be part of the answer. Cat bonds allow sponsors – typically governments or insurance companies – to transfer insurance risk for natural disasters such as earthquakes and hurricanes to the capital markets.

The idea first took off in the late 1990s in the US, where big insurance companies were struggling to manage the risk of hurricanes and wildfires in the reinsurance market. The capital markets offered a way to offset the exposure with a new group of investors, who would accept the risk of principal losses in return for a higher premium. The securities mainly trade based on event risk, and can appeal to investors for their lack of correlation to other financial assets.

Unlike traditional insurance cover, which typically pays out well after the fact based on actual losses, cat bonds typically pay out as soon as an event occurs that meets certain objective criteria, such as the location and severity of an earthquake or tropical cyclone. That means they can be structured to provide a quick boon to national budgets in the event a disaster hits.

Cat bonds made their debut in Asia in 2003, when Taiwan successfully issued a landmark US$100m deal to buttress its earthquake insurance scheme. (The three-year bond matured on schedule three years later.) Japanese property insurers have also increasingly turned to the capital markets to lay off some of their earthquake exposure in the wake of the devastating earthquake and tsunami of 2011, and interest is growing elsewhere in Asia.

Singapore welcomed its first cat bond in February, thanks in part to a government subsidy that covered the upfront issuance costs – part of the city state’s efforts to establish itself as Asia’s reinsurance hub. The bond provides A$75m (US$53m) of Australia and New Zealand catastrophe protection to Insurance Australia Group through Orchard ILS, a special purpose vehicle, boosting IAG’s reinsurance lines.

David Priebe, vice chairman at brokerage Guy Carpenter, which structured and placed the deal, said he hoped it would provide “a springboard for greater use of insurance-linked securities to close the protection gap in Asia”.

MDB TEMPLATE

The World Bank has issued cat bonds several times on behalf of governments in Central and South America, offering a template that could be applied to Asia.

In this example, the World Bank acts as the issuer and effectively holds the proceeds in escrow until a disaster occurs. If the trigger points are hit, the principal is immediately transferred to the beneficiary government to provide emergency funding; if there is no disaster, the principal is returned to the bondholders at maturity.

“By having a Triple A institution act as the issuer, you are effectively separating sovereign risk from the event risk,” said Jason Elder, a Hong Kong-based partner at Mayer Brown focusing on US securities law. “Cat bond investors would then use their own models to assess pricing based on the risk of a qualifying event, such as an earthquake.”

The World Bank sold US$1.36bn of cat bonds in February 2018 to provide earthquake protection to Chile, Colombia, Mexico and Peru – the biggest issue of cat bonds on record.

The deal comprised five tranches of World Bank notes: a US$500m 2021 for Chile coverage at 250bp over Libor; a US$400m 2021 for Colombia at 300bp; a US$200m 2021 for Peru at 600bp; and two 2020 tranches for Mexico totalling US$260m at 250bp and 825bp. A higher spread indicates a greater likelihood that a payout will occur.

Joint bookrunners Aon Securities, Citigroup and Swiss Re placed the bonds to 45 investors after building an order book of US$2.5bn.

The ADB could do something similar, fronting a programme for one or more of its member governments. Concessional funding could even be put towards coupon payments, if the beneficiary countries qualify.

“Technically the idea sounds interesting,” said ADB treasurer Pierre van Peteghem. “There is plenty of interest, not only in terms of the final beneficiary, but also from the investor base.”

Pakistan appears the most obvious candidate, given that the government established the National Disaster Risk Management Fund in 2016 (with ADB funding), with the goal of developing a disaster financing strategy and piloting new instruments to address catastrophe risk.

The concept of catastrophe insurance is also gaining traction in the Pacific Islands, where the ADB, World Bank and other partners are supporting advanced risk modelling for 15 countries under the Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI).

The ADB has also rolled out a Pacific Disaster Resilience Program in the Pacific Islands, starting with the Cook Islands in 2016 and expanding to Tonga, Samoa and Tuvalu in 2017. The next phase in 2019 will support the Federated States of Micronesia (FSM), Marshall Islands, Solomon Islands, Tonga and Vanuatu, and calls for the development of a collaborative multi-country mechanism to provide contingent financing in the event of natural disasters.

“Asia’s insurance market is still developing as the region becomes more affluent,” said Elder at Mayer Brown. “In the long run, governments and insurers themselves may see value in accessing the cat bond market.”

Outstanding cat bonds and insurance-linked securities worldwide rose to US$37.9bn at the end of March 2019, according to reinsurance portal Artemis.bm. Issuance in 2018 hit a record US$13.9bn, showing that demand remained strong despite heavy losses during the US hurricane season in 2017.

PNG’s case also underlines the value of being able to move quickly to repair infrastructure and restore vital revenue streams. Had the LNG trains been offline for longer, the hit to the economy would have been far more serious.

To see the digital version of this roundtable, please click here

To purchase printed copies or a PDF of this report, please email gloria.balbastro@tr.com

Crisis capital