World Bank’s Pandemic Bonds: A short overview
A majestic football ground without the roars of the cheering crowd resonating down the stands sounds like an unimaginable sight, but that is how the fate of sports championships appears to be going forward, thanks to the ‘new normal’ under Covid-19. Insurers all over the world are already on the hook for billions of dollars as pay-out to organizers of iconic sporting events such as the Wimbledon or Tokyo Olympics.
Three years ago, based on learnings from the Ebola outbreak in West Africa during 2014–16, the World Bank through its lending arm the International Bank for Reconstruction and Development (“IBRD”), set up the Pandemic Emergency Financing Facility (“PEF”) with the twin objectives of (i) rapid mobilization of funds to low-income countries (also known as “International Development Association” or IDA eligible countries) facing pandemic outbreaks and (ii) transferring some of the pandemic financing risks to the capital markets instead of having them entirely on its own books.
At this point, let me introduce a class of bonds called the Catastrophe bonds (“Cat Bonds”). Cat Bonds have been around since the ’90s and have had a tried and tested history of bringing in private capital to countries facing natural disasters and at the same time, providing issuers with financial protection in case of any major catastrophes. Based on the principles of a Cat Bond, the PEF bonds are structured primarily as an insurance facility. Under normal circumstances, they function as typical bonds wherein the investors provide capital to the World Bank through PEF, earn a certain pre-determined amount in interest each year, and on maturity, the investors receive their principal back. In the event of any unforeseen calamity which meets with certain pre-defined criteria, instead of repaying the full principal to investors on maturity, some or all the funds are disbursed to the affected countries dealing with the outbreak. The funds with the World Bank come from the donor countries who support the cause in form of grants.
On the face of it, it looks like a bad deal for the investors, right? One gets high returns throughout the life of the bonds but at any point of time when the “event trigger” strikes, one loses the hefty principal amount. Seems, not really. The first bond sale in 2017 was subscribed up to 200% closing $320 million of capital. Regular Cat Bond buyers, asset managers, pension companies and other institutional investors were the main subscribers.
The reasons for this oversubscription were pretty market opportunities driven. Fixed income rates have been abysmally low as central banks around the world have cut rates and investors chasing yields have had only limited avenues for earning meaningful returns. The pandemic bonds with a maturity of three years and a total face value of $320 million had two tranches with different thresholds for similar parameters triggering pay-outs. However, Class B investors were compensated by higher coupons owing to no principle-protection. Taking on pandemic risks for “black swan events”, uncorrelated to the rest of the market movements seemed to be meaningful to some investors and surprisingly, the investor base was skewed towards pension fund managers for the riskier Class B tranche.
The catch here is, of course, the parametric “triggers” which list certain requirements, all of which must be met at once for funds payout, that is, these are “and” and not “or” conditions. To name a few, outbreak size (the number of cases of infections and fatalities), outbreak growth (over a defined time period), and outbreak spread (with two or more IBRD/IDA countries affected by the outbreak) were on that list. For example, Congo had fresh Ebola outbreaks as recently as June 2020, however as most of the recent outbreaks were regional, it did not meet the ‘additional country’ criteria trigger and the insurance window could not be utilized for any pay-outs for Ebola. Under the current coronavirus outbreak, all the criteria were met only by the third week of April 2020, though Covid-19 was declared as a public health emergency of international concern on January 30, 2020.
The complexity of the triggers and the inherent difficulty in fetching the data meant that the entire process of trigger analysis and subsequent funds pay-out could not be done as quickly as desired. An outbreak makes on-the-ground data availability very challenging, hence, calculation of mortality rate and the international spread of the virus is based on data which is dated. In countries that have weaker medical infrastructure, large-scale testing is itself a major pain point, and therefore pay-outs based on those very factors seem counterintuitive. Also, the sum calculated as pay-outs amounts to a drop in the ocean compared to the huge funds cumulatively required in such countries. Meanwhile, the investors have continued to reap cash benefits through the high coupon rates to the tune of $110 million that has been paid to bondholders and reinsurers.
A total of ~$196 million is still in the process of disbursement among 64 of the world’s lowest income-eligible countries affected by Covid-19 while an erosion of 16.67% of the $225 million from the Class A tranche and 100% of the Class B (risky) tranche or $95 million according to the bond terms has taken place. The Cat Bond investors who upheld the theory of risk overpricing, through the recent experience and in general due to the climate changes are now wary of risk being rather underpriced, and hence investor appetite is gradually getting weaker. Hence, a more effective way to innovate lies in the process rather than the financial instrument. A systematic escalation of the donor funds directly to the IDA countries, rather than a cumbersome disbursement subject to a long-list criterion which kicks in only when the event gets worse, would justify the intent of the process. Such events as also described by Taleb as “white swan” are bound to happen and hence a funding method, rather than a financial innovation, that directly help those affected and in a timely manner stands a better chance of success and is the need of the hour.
By Amrita Sarker