Subscribe to our Newsletter to receive the latest updates on our content. By tapping the “Subscribe” button you will be redirected to subscription page. Subscription is free.
In recent years, Nigeria has been increasingly exposed to various natural disasters, including flooding, droughts, and disease outbreaks, which have taken a toll on its economy and population. According to the United States Government’s Nigeria Complex Emergency Fact Sheet,[1] seasonal heavy rains and subsequent flooding had adversely affected more than 157,000 people and displaced an estimated 68,000 people across Nigeria as of October 2023, exacerbating already high levels of humanitarian need and requiring urgent food and shelter assistance.
In addition to the devastating human toll, natural disasters can have dire economic consequences for disaster prone countries, especially for emerging countries which typically have extremely low rates of insurance penetration. For example, in 1998, Hurricane Mitch generated uninsured losses in Honduras equal to 34% of the country’s gross domestic product (GDP) and 158% of government revenues. Such events have a negative impact on public finances as governments are often required to cover the costs of emergency and relief efforts, as well as reconstruction work. Consequently, resources are often diverted from other important development programs to fund disaster relief and recovery operations, which has a significant adverse impact on economic development.
The growing frequency and severity of natural disasters in recent years has intensified the negative economic impact on affected countries; and, yet most governments do not have access to insurance against these events due to high costs or the insurance industry’s inability or unwillingness to absorb the risks of catastrophic events, particularly in high-risk areas.[2] Accordingly, as Nigeria strives to strengthen its resilience against these disasters, exploring innovative financial instruments that mitigate the impacts of these incidents is an important element. Catastrophe bonds have emerged as one of such critical financial instruments for disaster risk management. This article examines these instruments, their utilisation by global entities such as the World Bank, and why countries like Nigeria should consider their adoption.
What is a Catastrophe Bond?
Catastrophe bonds are debt instruments that transfer risk for specifically named catastrophic events (earthquakes, cyclones, etc.) from one party (typically the government or an insurance company) to the investors who buy the bonds. Payment of the bonds is only triggered if the particular event(s) designated in the instrument occur.[3] Traditionally, catastrophe bonds have been primarily issued by companies, especially insurers and reinsurers, to transfer the risk of large-scale disasters to the capital markets. However, more recently, there has been a noticeable rise in the issuance of catastrophe bonds by sovereign governments and regional risk pools. Sovereign governments and regional risk pools[4] have turned to catastrophe bonds as a way to manage the financial risks associated with natural disasters and other large-scale catastrophic events. By issuing these bonds, they can access a broader pool of capital and transfer some of the financial risks associated with catastrophes away from their own balance sheets.
Catastrophe bonds typically offer financial protection against specific perils such as earthquakes, hurricanes, or floods, with predetermined payout mechanisms triggered by catastrophic events. Investors benefit from catastrophe bonds due to their minimal correlation with equity and bond markets, as well as economic instability thereby allowing investors to diversify their portfolios and enhance their risk-return profiles. Furthermore, catastrophe bonds typically pay higher interest rates to investors when compared to alternative investments to compensate for the risk of the issuer’s likelihood of not repaying the principal in the event of a qualifying catastrophe.
Catastrophe bonds can be broadly classified into 2 categories: indemnity-based and parametric-based bonds. Indemnity-based bonds provide coverage based on actual losses incurred, while parametric-based bonds use predefined triggers, such as wind speeds or earthquake magnitudes, to determine payouts.
The World Bank has played a pivotal role in facilitating catastrophe bond issuances to provide financial assistance to disaster-prone regions. For example, the World Bank’s MultiCat Program, a multi-issuer platform designed for sovereign entities to transfer a portion of their natural catastrophe risk to investors through the capital markets, provides ready-made infrastructure that permits the World Bank’s member governments to access catastrophe bonds in a fast and efficient manner.[5] Collaborations between the World Bank and countries like Mexico, Chile, and Peru have resulted in catastrophe bonds that offer rapid access to funds for disaster response and recovery efforts.
Illustration of a Typical Catastrophe Bond Structure:
In a simple structure under a typical catastrophe bond, the sponsor enters an insurance contract with a special purpose vehicle (SPV) that issues notes to capital markets investors through financial institutions. The SPV thus acts as special purpose insurer as well as a special purpose issuer. It invests the proceeds of the notes in highly rated assets (AAA-rated assets such as US Government securities) and transfers the return on this investment, along with the insurance premiums paid by the sponsor under the insurance contract, to the buyers of the notes as the periodic coupons. The assets are held in a collateral trust. Catastrophe bonds specify the type of natural disaster that they cover (e.g., earthquake, hurricanes). A typical component of the catastrophe bond is the trigger mechanism used to determine the insurance payment under the bond. There are several types of triggers which differ in complexity as well as in terms of the residual (or basis) risk that the sponsor is left with. Some commonly used triggers, of increasing complexity but decreasing
Should you require more information please do not hesitate to contact Ajibola Asolo.
_______________
Contributors
Kareemat Ijaiya – Senior Associate
[1] USAID, ‘Nigeria-Complex Emergency Fact Sheet #1 Fiscal Year (FY) 2024’ (Situation Report) (2023)
[2] Alejandro Garcia, Nirmaljit S. Paul and Ivan Zelenko, ‘The Euromoney International Debt Capital Markets Handbook’ (2011) https://documents1.worldbank.org/curated/en/393111507025134952/pdf/120186-BRI-PUBLIC-euromoney-handbook-2011-world-bank-multicat-program.pdf accessed 9 September 2024.
[3]‘Climate Policy Initiative’ https://www.climatepolicyinitiative.org/gca-africa-adaptation-finance/instruments/catastrophe-bonds/ accessed 16 September 2024.
[4] Meaning collaborative initiatives among countries that offer parametric insurance products to help them access quick financial resources in the event of disasters.
[5] Alejandro Garcia, Nirmaljit S. Paul and Ivan Zelenko, ‘The Euromoney International Debt Capital Markets Handbook’ (2011) https://documents1.worldbank.org/curated/en/393111507025134952/pdf/120186-BRI-PUBLIC-euromoney-handbook-2011-world-bank-multicat-program.pdf accessed 9 September 2024.