Sovereign cat bonds can help governments borrow, improve welfare

by Artemis on February 17, 2017

For sovereign governments, having a source of disaster risk financing and insurance provided by catastrophe bonds can help the government to borrow more on the capital markets, improve its standing with debtors and ultimately provide welfare gains to the population, according to a study.

The study authored by Eduardo Cavallo, a Lead Economist at the Research Department of the Inter-American Development Bank (IDB), alongside Eduardo Borensztein also of the IADB and Olivier Jeanne from Johns Hopkins Uni., finds that as well as providing a source of immediate post-disaster insurance capital, catastrophe bonds can also have wider-reaching benefits for a government’s ability to borrow, which can help to enhance welfare.

Cavallo explains that cat bonds can provide key advantages over other forms of insurance and reinsurance, as they can be structured to payout almost immediately based on the severity of a disaster if using a parametric trigger and the capital is held securely in order to support the quick payout.

This provides numerous benefits, from enabling a government to provide emergency relief quickly, often before foreign aid flows into the country, offering rapidly disbursed capital that can help to pay for immediate infrastructure repairs as well.

Therefore rebuilding and repair can begin quickly, which is essential after catastrophic natural disaster or severe weather events, as has been evidenced in the Caribbean through parametric insurance covers provided by the CCRIF and other reinsurance deals using parametric triggers.

Of course the cat bond also offers the benefits of capital markets financing, often more efficient and sometimes cheaper than traditional insurance or reinsurance markets can provide, as well as certainty in terms of funding, as they are fully collateralised instruments with the collateral invested in safe assets.

But broader benefits are also available to government sponsors of catastrophe bonds, the papers authors believe, with a model developed for the paper showing that cat bonds can help governments to increase their external borrowing.

The authors explain that countries which are at risk of being hit hard by natural catastrophes and disasters are also more at risk of defaulting on their debt when disaster strikes.

This can lower the capital markets perception of these governments ability to borrow and repay, resulting in debt being sold at lower rates and having to offer capital market investors higher yields.

Cat bonds can reverse that equation, the authors suggest, saying that by having catastrophe bond protection in place the risk of default on non-contingent debt, which still has to be repaid after a disaster occurs, can be reduced.

In fact, a baseline calibration of the model featured in the paper shows that cat bonds can support increased borrowing, enabling governments to increase their use of externally sourced debt from around 30% to over 60% of GDP.

That’s a considerable increase, helping to provide greater certainty of funding and continuity of capital market access to the government sponsors of catastrophe bonds.

But there are also more tangible benefits for the population of these sovereign sponsors of cat bonds as well, as the results of an improved ability to borrow is, according to the model, an improvement in welfare gains equivalent to several percentage points of consumption.

The authors note that this is not huge, but compared to a forecast in the paper of a permanent fall in output of about 4 percent associated with natural disasters, this is “economically significant” they say.

While the benefits are tangible and clearly attractive to governments, Cavallo notes that the cost of issuance remains a key issue that prevents more governments from becoming catastrophe bond sponsors.

The model revealed in the paper shows that catastrophe bonds can cost over four times what governments are willing to pay to secure welfare gains of this level, so while economically significant they are not significant enough to encourage more issuers to the market.

Cavallo highlights the cost of data acquisition and research in order to develop the models necessary to structure a catastrophe bond as a key issue holding back sovereign government uptake.

“The result is an information-starved environment in which investors shy away and coverage is expensive. But here the public sector could play a critical role. Governments and multilateral institutions could subsidize the necessary research and help grow the market,” he explains.

Finally, Cavallo explains that investment in mitigation and adaptation are key, as cat bonds, other forms of disaster insurance and reinsurance, or contingent financing are not going to assist a country as much economically on their own.

“A deeper market for catastrophe insurance could play a valuable role by helping countries raise money on the capital markets and buffering the worst of a calamity. But it will only ever be a part of the mix,” he concludes.

The study is well worth reading, if you have access, as the financial model it discusses helps to explain the benefits of catastrophe bonds for sovereigns and the linkages between a predictable source of disaster contingent financing from the capital markets with a government’s ability to borrow and ultimately the welfare benefits that can bring to a country.

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