Catastrophe bonds as a tool for financing the risk of climate change is set to become reality as the African Risk Capacity (ARC) announces the launch of the Extreme Climate Facility (XCF), a multi-year funding mechanism that will issue climate change cat bonds.
We’ve written many times about the catastrophe bond structures potential to be used as a tool to transfer the risks associated with climate change, while providing much-needed risk financing to those most exposed and at risk of severe financial losses as a result of a changing climate and weather variability.
Now, the African Risk Capacity (ARC), a facility launched to help African Union Member States to bolster their capacities to better plan for, prepare and respond to extreme weather events and natural disasters, has announced the launch of a new facility designed to do exactly that. Issue catastrophe bonds to protect African states against climate related risks.
Catastrophe bonds, as a financial structure which allows for the securitisation of risks and their transfer to investors in the capital markets, such as pension funds and other institutional investors, are well-suited to being structured to protect against increasing severe weather extremes which may be caused by climate change.
The trigger design of a catastrophe bond, with the ability to link it to actual weather or disaster conditions (parametric triggers), or an index constructed from actual weather or disaster variables (index or weather-index triggers), allows for the risk to be transferred while the capital buying the securities provides a source of contingent weather or disaster risk capital.
Also, the direct transfer of these weather and disaster risks to the capital markets is perhaps a more efficient way to secure the contingent risk capital required, rather than traditional insurance or reinsurance approaches. Cat bonds and ILS provide ways to access this capital more directly, using indices and weather parameters as the metrics defining payouts, while bringing the lower-cost of ILS and capital markets money to regions that really need it.
ARC has launched the Extreme Climate Facility (XCF) today, to coincide with the UN Climate Summit in New York today, to issue multi-year climate change catastrophe bonds.
The bonds, which are planned to be issued in 2016, will target the provision of additional financing to covered countries as a way to enhance their climate adaptation investments, in the event that weather shocks such as extreme heat, droughts, floods or cyclones increase in occurrence and intensity across the continent.
“Africa needs solutions. The XCF will offer African nations a new financing mechanism to manage climate risks by providing direct access to new private capital and by leveraging development partner contributions. We are leading the way in innovative climate finance,” commented Dr. Ngozi Okonjo-Iweala, Nigeria’s Minister of Finance and Chair of ARC’s Governing Board.
ARC will work alongside African States and their partners towards having an effective and fair XCF design in place when nations convene in Paris next year for the UN Climate Change Conference. We would assume that ARC will also engage the insurance-linked securities (ILS) investment community to ensure the design of such instruments meet with investors diversification and portfolio needs and to build demand for the climate cat bonds.
The XCF will be designed to be objective and data-driven, using a baseline of 30-year climatology data for Africa. Consistent meteorological information covering the entire continent is available since the start of the satellite era in the early 1980s and will be used to calculate a multi-hazard extreme climate index for each region in Africa.
So the climate cat bonds will use a trigger structure linked to a parametric index constructed from various types of climate and weather data, which will parametrize increases in the severity and impacts of weather events, so the bonds will trigger should the index reach above pre-defined levels.
ARC explains that; The index will track increases in the frequency and magnitude of extreme weather events over and above an established baseline in each climate region of the continent. Should the index exceed a pre-defined threshold, bond maturity payments will be automatically made to countries in the affected regions and used to boost adaptation efforts or scale up existing disaster risk management mechanisms.”
“Climate change knows no borders. We need operational solutions that will channel climate change funds and increase direct access to climate finance. It is vital to minimize the risk to the most vulnerable. I wish ARC every success,” the United Nations Executive Secretary of the UN Framework Convention on Climate Change Christiana Figueres said.
The XCF is designed to access private sources of capital and to diversify the sources of funding available for climate risk financing. It will be structured as a catastrophe bond program, with its financial obligations to countries over a three- to five-year term will be securitized, issued as cat bonds and financed by the capital sourced from private investors and the capital market.
It’s possible that the World Bank Treasury could get involved in the issuance, thus cheapening the cost of getting the cat bonds structured and into the market, given its involvement in initiating and launching the ARC facility in the first place.
ARC says that at first it expects to see “several hundreds of million dollars” of cat bonds issued, which it says will set the foundation for the future issuance of more than US $1 billion of African climate change catastrophe bonds over a period of 30 years.
That is big news for the ILS and catastrophe bond market, as it will provide a completely new source of diversification for investors seeking to support the XCF issuances. As with a normal cat bond, should the bonds reach maturity without the index reaching the trigger point, the bonds will return their capital to investors as you would expect, as well as the yield from coupon payments.
“XCF will ensure that African countries and the international community appropriately monitor climate shocks and will be financially prepared to implement specific adaptation measures in an effective and accountable manner, leveraging ARC’s existing public-private infrastructure. The XCF allows us to leverage private capital against the risk of increased frequency of severe climate events, while using public money to fund immediate and certain adaptation requirements,” said Dr. Richard Wilcox, founding Director General of ARC.
Participating countries will be chosen based on criteria that include their current involvement with ARC in managing weather risks through its disaster insurance company, ARC Ltd., and having robust and investment-ready climate change adaptation plans in place.
“As pioneers in promoting innovative finance solutions for climate change, The Rockefeller Foundation is proud to have been an early supporter of the African Risk Capacity. With a smart deployment of the power of the capital markets, the XCF will be an important addition to efforts to build climate resilience across Africa,” said Dr. Judith Rodin, President of The Rockefeller Foundation.
If successful, this could set a precedent for other developing regions of the world and climate change exposed communities. The use of catastrophe bonds as a financing vehicle for climate resilience is one of the promises of the structure and it is pleasing to see it being pushed as a solution.
For the ILS market, the prospect of more diversification opportunities, greater levels of issuance, new risks coming to market while at the same time being able to leverage their capital in the knowledge that they are providing climate risk mitigation and resilience financing will be exciting.
It will be interesting to see what else is announced on the sidelines of the Climate Summit this week. The role of the reinsurance, insurance-linked securities (ILS) and catastrophe bond market is certain to be central to discussions related to the links between weather extremes and climate change.