4.2.3. Catastrophe Bond (CAT Bond)
A catastrophe (CAT) bond is a high-yield debt instrument that is usually linked to insurance intended to raise money in case of a catastrophe. CAT bonds will provide a payout to the insurance company if a defined event occurs, such as total loss greater than a specific amount or an earthquake of a certain magnitude or greater (Source: Mobilizing Private Finance for Development: A Comprehensive Introduction). CAT bonds are a means by which insurers and reinsurers can transfer risk to investors, thereby lowering the risk premium.
- Ability to resolve bankruptcies in a timely manner
- Appropriate capital to meet borrower needs
- Ease / cost of collecting payments
- Exchange rate risk
- Interest rate risk
- Potential for higher inflation
- Unpredictable fiscal policy
- Off-take risks associated with target sector/region
- Production costs associated with target sector/region
- Rate of return on lending in target sector/region
MUST HAVE’S, CRITICAL POINTS, OR QUESTIONS TO CONSIDER
VIGNETTE: BUILDING DISASTER RESILIENCE IN THE FINANCIAL SECTOR IN INDONESIA (SOURCE: MF4D TRAINING)
Indonesia often faces severe, natural calamities. In the event of disaster, clients of financial institutions (FIs) often need financing to rebuild businesses and ensure their income is protected. FIs may also need additional financing to physically rebuild, respond to client claims, and cope with sharply higher defaults. If FIs can’t access enough financing and respond to their clients’ needs, the entire economy’s rebound is affected.
To mitigate these challenges, Mercy Corps pioneered the Indonesia Liquidity Facility After Disaster (ILFAD) as proof-of-concept initiative in partnership with the USAID Office of Foreign Disaster Assistance. ILFAD was structured to take a systems approach to build resilience to disasters up and down the financial sector spectrum with activities that included: strengthening the capacity of Indonesian FIs to prepare for emergencies through training, working with FIs to develop new short-term financial products for clients immediately that payout immediately after disasters and facilitating partnerships to bundle savings products with disaster insurance; and by engaging global reinsurer Swiss Re and the World Bank’s Global Index Insurance Facility to design portfolio-level insurance products which enable FIs to purchase protection for their portfolios and infrastructure. USAID’s role was to provide funding and coordinate a series of private sector actors to allocate, finance, and distribute risks from smallholder farmers to global reinsurance firms.
Among other impacts as a result of these activities, new insurance products were developed which pay out in response to specific triggers, such as the strength of an earthquake, so policyholders receive their payouts much sooner than they would under a traditional insurance product. Through this activity, USAID partnered with 164 FIs with potential to provide immediate access to 72,500 clients, benefiting up to 362,610 Indonesians immediately after the next disaster hits.