Catastrophe finance innovators turn attention to pandemics
Could capital market instruments help the world prepare for or react to another pandemic? Those who have spent the last few years designing these types of tools for natural disasters have some ideas.
The World Bank’s pandemic bond has had a bad crisis. It was designed as part of a scheme to transfer cash quickly to poor countries when an epidemic was spreading, but before it reached epic proportions. But its complicated structure meant the release of funds was only triggered on April 17, when Covid-19 was already rampant around the world. Cue much attention and criticism across the financial press.
This bond represented a rare use of the capital markets to finance a response to disease. As a catastrophe bond, it essentially provided insurance coverage. Investors received coupon payments as premiums, but lost principal when the bond was triggered.
With the coronavirus crisis far from over, and other pandemic threats potentially lying in wait for the world in the years ahead, now is the time to look at how instruments could be used in a more effective way.
As well as drawing on the experience of the pandemic bond, we can use existing ideas for funding and insurance, as it relates to natural disasters. Specialists see a connection between these catastrophes and pandemics.
Shalini Vajjhala is founder and chief executive of re:focus, based in San Diego, California. Re:focus works with the public sector, engineers and investors to design and finance resilient infrastructure. Vajjhala links the challenge of dealing with a pandemic to one she is familiar with: encouraging people to finance projects when the benefit is hard to perceive, because it occurs as a lack of loss, rather than a visible gain.
“The first year you’re applauded. Everyone remembers the crisis, and they recognise that something didn’t happen this year. The second year, you obviously don’t need your budget or your staff, and so they’re cut. And the third year, your job goes away.”
Vajjhala continues: “The fundamental commonality between natural disasters and this pandemic is that you are trying to make something not happen. And that’s a very difficult type of investment to mobilise capital to work.”
Aid and finance
The humanitarian aid sector has also started looking at novel financing tools, as it seeks to shore up a gap between resources and needs.
According to Simon Meldrum, from the innovative finance team at the International Federation of Red Cross and Red Crescent Societies (IFRC) in London, the current crisis underscores the funding challenge. “When you have a once-in-a-lifetime — we hope — issue like Covid-19, the humanitarian sector isn’t of a scale to be able to address that now.”
The attraction of some of these tools is not just about volume of funding. They are also meant to improve return on investment — a phrase that may be unfamiliar to the sector.
One way to improve return on investment is to change when that investment is injected. Aid that is predictable can be of more help.
“Traditionally the humanitarian sector has come in post-disaster and provided support, and obviously that is much needed,” says Lauren Sidner, a research associate at the World Resources Institute (WRI), a research organisation based in Washington, DC.
“I think there’s a recognition that that aid is slow to arrive, it’s unpredictable, it’s fairly ad hoc, and that it may not be used to greatest effect.”
Timing is particularly relevant for pandemics, as early funding can have a greater impact.
“Injection of resources is crucial in the very early stages of a pandemic even before it becomes called a pandemic,” says Leonardo Martinez-Diaz, global director at the WRI’s sustainable finance centre.
We should also look beyond purely reactive solutions: prevention is the best cure. The World Bank’s pandemic bond was designed to trigger after a certain level of contagion was reached, rather than before any harm was caused. Could a future instrument tackle it the other way round?
“Imagine that you have a life insurance policy and a health insurance policy. You would never trade your health insurance for life insurance,” says Vajjhala. “You have to have a terrible outcome to get a payout for a life insurance policy.”
She continues: “In the case of a pandemic bond, the same is true. You have to have a pandemic in order to get the money.”
Treating the humanitarian aid sector as one that is ripe for financialised solutions, and where perhaps private investors stand to profit, incites controversy. This is particularly true when, as with the pandemic bond, investors receive a high coupon (11.1% plus six-month dollar Libor on one of the tranches).
“The first instruments of these types are always going to be less efficient,” says Vajjhala. “You are running global experiments to be able to mobilise capital to things that have been underserved or underfinanced. And so we’re not going to do that with perfect efficiency in the first bond or the second bond, or even the third one. It’s really refining them over time.”
Range of approaches
Beyond the pandemic bond, there are other models that can be examined to work out how to finance the prevention and response to an event like a pandemic.
Firstly, one is already road-tested. The International Finance Facility for Immunisation (IFFIm) issues bonds to provide quick funding for Gavi, an organisation that vaccinates almost half of the world’s children. IFFIm issues bonds and sukuks backed by long-term donor pledges from developed countries, and so can frontload these pledges.
Secondly, the IFRC is seeking to build on what IFFIm has done, through issuing a sukuk to tackle cholera. The idea is that a fund will be donated cash, and promised additional funding based on outcomes achieved. This gives it an equity base and a revenue stream, and from this it can raise debt. Plans have been delayed due to coronavirus.
This type of approach involves some work: coming up with models and targets, and evaluating performance.
But Meldrum takes confidence from various other organisations endorsing the structure. “That as an approach could be used in lots of different financing tools to finance other programmes, whether they’re WASH [water, sanitation and hygiene] or other issues where you can articulate outcomes and outputs.”
Both IFFIm and the IFRC are using the capital markets for debt-based funding. There are other models that offer insurance, too.
Re:focus’s concept — the resilience bond — is one of these. This starts with the idea of a standard cat bond. But the bond issuance is aligned with the development of a project that boosts resilience.
The coupon on a standard cat bond is linked to the expected loss from the disaster it covers. With the resilience bond, once the project is completed, the expected loss falls, and as a result the coupon on the bond is reduced. In this way, the issuer gains what re:focus calls a “rebate” from the coupon savings. Savings can be matched against the cost of resilience projects.
By combining project development and insurance, this is quite complicated, and it might be simpler to refine existing tools first. But it is an intriguing idea in that it confronts short-termist policymakers with the savings from resilience projects.
Vajjhala says her resilience bonds have not yet been issued because of the time taken to design and develop infrastructure, but she is “quite optimistic” about issuance in the next year or so.
Transferring this idea to pandemics presents difficulties. Resilience bonds are designed for discrete events like hurricanes, rather than something like a pandemic, which has a different timescale. In addition, measuring and modelling the expected reduction in loss thanks to infrastructure to protect against a natural disaster would be easier than doing it for a policy related to pandemics.
However, over the longer term, there is the potential for progressing the concept to more complicated projects.
“Start where there is data, start where there is investment, and figure out if we can create that value capture mechanism,” says Vajjmara. “And then push into areas where there’s less data or more uncertainty.”
Pick and mix
A fourth model for using finance to manage disaster comes from Martinez-Diaz and Sidner. They focus on the national level, and think developing countries can benefit from using a range of instruments for different levels of risk.
These instruments include insurance products like cat bonds, national reserve funds and catastrophe contingent credit lines, which are pre-approved development loans that can be drawn when required.
In the case of pandemics, Martinez-Diaz says: “There are moments when governments will need the money more quickly than the markets may be comfortable providing, and so in those cases what you need is contingent credits or you need national reserve funds.”
The World Bank has supported the coronavirus response through a credit line called the Catastrophe Deferred Drawdown Option (Cat-DDO).
“That tool showed how it can quickly disperse money to governments without the need for the market to agree to the model,” says Martinez-Diaz.
Cat bonds need more experimentation around triggers and models, and at present may not be so cost-effective for insuring against more frequent events. Martinez-Diaz says that the cost and complexity of issuing cat bonds puts off developing countries.
Those in the capital markets interested in finding a solution for future epidemics have a range of ideas to explore, from conventional debt issuance to cat bonds and more complicated mechanisms.
It will be difficult to ensure funds can be released at the right time while at an acceptable price. Focusing on prevention rather than purely reaction is also essential.
But it is time for the best minds to get their heads together.