LMG proposal seeks catastrophe bond issuance for UK foreign aid

The London Market Group (LMG) has launched a white paper that explores the potential of using the impending UK ILS regime to develop a Foreign Aid catastrophe bond (FAB), providing a more efficient solution for insuring the vulnerable against natural disasters.

The LMG and the UK government’s Treasury have been working on legislation to facilitate the growth of insurance-linked securities (ILS) business in London, developing the region into a global hub for re/insurance and ILS business.

And while the news of Brexit may have sparked discussions and uncertainty around the UK’s ILS and re/insurance business moving forward, the LMG notes that the “soon to be created UK ILS regime” will look to facilitate the use of a Foreign Aid catastrophe bond.

So it seems for now that Brexit hasn’t had any material impact on the UK ILS space or London’s ambitions for the future.

“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,” said Malcolm Newman, Chief Executive Officer (CEO) of SCOR’s London, Paris hub, and head of an LMG project dedicated on improving business environments.

The bond would see the government sponsor an insurance policy for risks in a certain peril region, designed to protect countries that currently receive development aid from the Department for International Development (DfID). Member countries would pay a risk premium and the DfID’s overseas aid budget would underwrite the catastrophe bond, explains the LMG.

The LMG says that capital would be raised from sophisticated investors for the bond issuance, although doesn’t provide any inclination as to how large a FAB could be. Catastrophe bond issuance remains on a steady path in 2016 despite slowing somewhat when compared with recent, record-breaking quarters, and investors appear willing to participate in innovative and diversifying transactions.

Catastrophe bonds have been shown to be an efficient and effective means of protecting catastrophe risks across the globe, and recent efforts from the World Bank, the U.N. and other international bodies and organisations, has highlighted the benefits that parametric insurance, cat bonds, and other ILS structures can bring to all parties.

“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,” said Newman.

The scope and reach of catastrophe bonds is growing all the time, with the World Bank stating that cat bond transactions will be used to protect pandemic outbreaks in the future, and now the LMG plans to fund its foreign aid via the issuance of catastrophe bonds, backed by third-party investor capital.

“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,” said Newman.

By passing the risk onto the capital markets the UK government can look to reduce it’s spend on foreign aid, while providing member countries within the FAB with a fully-collateralized source of protection that if structured on a parametric trigger, for example, would ensure rapid payout post-event.

The fully collateralized nature of catastrophe bonds could provide member countries with a clearer idea of how much aid they will receive in the event of a catastrophe, and the deal could be designed to payout straight away, which would support global resilience efforts and speed up the recovery process for affected countries.

“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,” said Newman.

As typical with a catastrophe bond, the LMG explains that a major re/insurance broker would structure and distribute the deal, ideally one that operates in the London market, which would then be managed by a specialist admin/management firm.

A custodian bank/trustee would manage the trust account, and all firms that participate in the service 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,” explains the LMG.

The white paper is scheduled to be launched today by the LMG at the House of Commons, so it will be interesting to see how the creation of a FAB develops.

The continued work of the LMG and the proposed creation of a FAB along with efforts from the World Bank and so on, further supports the increasingly important and influential role ILS is having on the global risk markets.