London Market Group (LMG) is launching a white paper today, at a roundtable in the House of Commons, to discuss the creation of a Foreign Aid catastrophe Bond (FAB). This would use the soon to be created UK ILS regime to address the risk of natural catastrophes in under-insured emerging markets to provide a more cost effective approach to catastrophe relief backed by commercial capital.
Malcolm Newman, CEO of SCOR’s London / Paris Hub and leader of the LMG workstream which is focusing on building a better business environment, said: “The idea behind the FAB is a joint initiative between the Government and LMG to provide a cost effective response to catastrophes currently supported by the UK foreign aid budget.
“We are looking to emulate other government-led forms of insurance which already exist in areas such as Mexico and the Caribbean to cover damage from the major natural perils of windstorm and earthquake. The LMG envisages a similar form of insurance to improve resilience in developing countries or regions which are under-insured against similar catastrophes. The Nepal earthquake is a recent example where a FAB could have provided a more cost effective approach to catastrophe relief backed by commercial capital. It is also in line with recent innovations in the market, such as the Pandemic Emergency Financing Facility (PEF) sponsored by the World Bank
“There are some clear benefits from this proposal, for example the government could provide a more predictable and transparent source of funding for short term disaster relief and potential longer term resilience against climate change. It also reduces the amount spent on short term disaster relief, while freeing up funds for longer term development as the bond will replace post disaster aid. Ultimately it could allow developing countries to fully take over the premium payments as their economies develop and underlying insurance penetration grows, linking to initiatives that may come from the new Insurance Development Forum.
“This is exactly the type of creative thinking that a cross market body like the LMG can foster, creating an environment in which the market is able to respond to new client demands and existing and emerging risks.”
How would it work?
The proposal suggests the government sponsor the issue of an insurance policy to cover the risk of catastrophes in a specified country or region. The risk premium would be paid by the protected countries and the Department for International Development’s (DfID) overseas aid budget would underwrite the bond issue. Countries protected by the bond would be selected from those currently receiving development aid from DfID. Capital raised from sophisticated investors via the issue of a bond, would be placed in a trust account to secure the maximum level of risk in the policy. Investors would receive the risk premium as a yield (above a “risk free” reference rate) to compensate investors for the modelled level of risk within the policy. Capital, minus any payments triggered by the policy, would be returned to investors at the end of the policy.
The FAB would be structured and distributed by a specialist investment advisory firm (such as those that exist in the major insurance broking houses), then managed by a professional administrator/management firm. The trust account (and securities invested from the bond proceeds to generate the risk-free reference rate return) would be managed by a trustee/custodian bank. All service firms would be selected through a competitive tender process. They would work with DfID and the Treasury to ensure the risk premium is paid and sufficient capital is held by the bond to meet the maximum amount of risk covered by the policy.
The LMG envisages the FAB transaction would be managed by service providers operating in the London market. The selected investment advisory firm would be responsible for structuring and marketing of the bond to potential investors, and would provide guidance to the Government on all key aspects to the transaction; including price guidance, risk modelling and investing the proceeds of the bond issuance to generate the “risk free” return and protect the principal value.
If the contract expires and no catastrophe has occurred, investors would receive their invested capital, plus any yields over the duration of the policy. In the event of a catastrophe, the capital held by the trustee/custodian, for the benefit of the UK Government or the insured countries governments as beneficiaries of the trust, will be released to the relevant government. The funds will be available for distribution following usual practices for disaster relief, including rebuilding communities to be more sustainable for any future events.