In a recent interview with Artemis, Victor Cardenas, a senior consultant in risk financing for climate change and natural disaster with specific expertise in the field of public sector entities, discussed various elements and complexities that require attention when considering public sector involvement in catastrophe risks.
Cardenas has worked on projects for the World Bank, the United Nations, and other global public entities, and told Artemis that “for investors or reinsurers interested in participating in CAT risk from public entities, assessing these kinds of prospectus demands considerable attention from analytics teams.”
Cardenas, continued; “It is not only the risk by itself: we have to consider the size of the risk, its complexity, what regulations are involved, and ones own level of expertise in dealing with governments. These could all make the difference between something being a great deal, or unexpected bad news.”
He explained that it’s important to realise that government risk is “a very different type of animal” than corporate risk, where “regular due diligence are significantly time consuming, in particular for those issuance from first-time sponsors. For example, demands a careful legal review of the contract, insurance policy wording, memos, risk analysis, SPV indenture, even in the form of more simplified cat bond structures.”
Artemis asked Cardenas what the main factors were that required attention.
Firstly, “the risk to be acquired should be treated as a long-term investment,” said Cardenas. While “the trustworthiness of the coupons or premium payments must be considered, and, there needs to be transparency before and after a deal is closed.”
Discussing the first point on long-term investment, Cardenas explained; “Portfolio managers typically allocate securities following specific investment guidelines. With many issues at play, making a decision is not simple. Insurers and reinsurers are very cautious when considering adding new asset to their portfolios. The modeling used to make these decisions is strongly supported by state-of-the-art techniques. After applying due diligence, once a risk instrument has passed several filters to be selected for purchase for a specific portfolio, such a long-term investment could provide a financial advantage, precisely when all the work discussed in the previous steps has been carried out.
“On the other hand, for risk instruments marketed by a public entity, it is important to consider a number of issues. Of course, one important element is the government officers’ views on disclosing risk factors during roadshows. But it is my personal view an even more relevant element to consider is what regulations support the issuance of the bonds or insurance policies. The legal teams involved should carefully review this aspect. In this regulation we can find if they are able to issue a long term investment or not. For some public entities its regulatory framework could indicates that renewals of issuances are part of the regular operation of the entity, but if not, make sense to assess how the entity explains to investors the reliability of a long-term investment. One more point to find in regulation is to assess the real possibility for public entities for considering other risk transfer instruments, beside ILS, this kind of information helps to investors in order to analyze if and ILS in renewal is competing with other instruments: insurance, reinsurance, etc.
“For example, a good case of best practices is, for example, the risk pools for Florida, California, Louisiana, and the Caribbean States CAT, as well as the Taiwanese and Turkish CAT funds, among many others.
“On the other side of the coin are new entrants and potential new entrants to the risk markets. For many of them, in particular those from developing economies, there are loopholes in regulation: for instance, on renewal of an issuance or in definitions of waiting times before the renewal.
“This kind of regulation is irrelevant for some risk market players such as reinsurers because they are trading risk all the time. But the renewal of an issuance bond program from public entities could be a major issue if there isn’t strong regulation base.
“In my view, for global risk markets the use of risk management strategies never stops; at least one should always be in use. A strategy can mitigate, transfer, or assume risk. The difference between picking one strategy rather than another is that one strategy could be more costly than others. For example in corporations, for the same kind of risk, the only way to stop a issuance of bonds for renewal (implicitly retaining it) without mitigation or transference in place is when retention is the less costly strategy, or the only affordable one given the market.
“For the public sector, this rationality is incomplete given loopholes in regulation (for example, a public entity could reconsider renewal for more favorable political timing). From the point of view of a risk taker, investor, or reinsurer, it is complicated to consider a long-term investment program in a public entity without its having explicit regulations providing guidance for its operations except when these are explicitly agreed to in the issuance of the bonds. But even in this case, from the timeframe of one issuance program to another issuance program, this explicit agreement is not enough to consider for a long- term investment if there is a lack of detailed internal regulation for its operations.
“Government officials´ statements during a roadshow should be insufficient for investors without enforceability in regulations that support those statements. Enforceability could take many forms, but a regular comprehensive strategy in risk management needs to include it.
“On the other hand, for public entities, enhancing and developing transparent regulations, explicitly providing empowerment and enforceability to decision makers, would give public entities strong benefits in risk markets. These kinds of norms should be mandatory for day-to-day operations, minimizing uncertainty for risk takers. But in CAT risk in Latin America, except for the Caribbean pool, there is not another example of this level of transparency in internal operation, Mexico included.”
The second important factor that needs consideration concerns trustworthiness, and Cardenas stressed how key this is for new entrants to risk markets, and in particular, for small economies with multi-year insurance / reinsurance programs.
“Two factors should be considered: first, a legal review needs to be made of the procedures to execute the periodic payments. In some extreme cases, the forthcoming premiums (coupons) should be deposited upfront, in others, with a financial guarantor, with others, an extra-premium should be charged for credit risk. Secondly, regular PR should be carried out with clients; in other words, relationships should be maintained with their customers beyond a healthy costumer service policy. For public entities, this is particularly relevant, especially for small and less developed economies where there are high rotation rates for government officials,” explained Cardenas.
The final element to consider relates to transparency, and Cardenas was eager to discuss with Artemis the impact this can have on a deal.
“Perhaps, given the large number of scandals in the world related to public entities, it is repetitive to mention, but making all the process transparent is strongly recommended. Many risk-takers worldwide currently follow best practices in this regard.
“However, this never was an issue in the past for investors in ILS. The reason for this was because of the role played by the investment bank in reviewing material before the roadshow as a first line of defense in the process of transferring risk. But, it certainly should be emphasized that transparency should always remain a major issue, and should be carefully reviewed by legal representatives before participating,” he said.
Our thanks to Victor Cardenas for his time.
For additional info or to contact Victor, please email: [email protected]