International humanitarian movement the Red Cross is looking to the capital markets and the potential issuance of a parametric catastrophe bond to protect against volcanic risks, according to Adam Bornstein.
Adam Bornstein is an innovation finance specialist working in the Global Innovative Finance Team, a new unit of the International Federation of Red Cross and Red Crescent Societies and the Danish Red Cross.
A former private equity manager in Hong Kong with a pan-Asia private equity fund and set to be a speaker at our next conference in New York, Bornstein recently spoke with Artemis about the desire of the Red Cross to control its downside exposure while maximising its humanitarian impact, something that could ultimately improve the chance of saving lives and alleviating human suffering while optimising the use of donor funding.
He explained that in the humanitarian space, the Red Cross deals in extreme risks, and in fact is an arbiter of risk.
As a result of its position in the risk landscape, owing to the nature of its existence, Bornstein said that it makes sense to manage downside while maximising humanitarian impact.
“If we can minimalize the prospect of failure by de-risking the performance of our operations, then we improve the chances of alleviating human suffering and optimizing the use of donor funding.
“When we look to optimize cost of our capital deployed, it makes sense to look for pools of capital that offer tight spreads. As this is grant funding, we do not need to return this capital however there are measurable expectations around performance and outcomes. This metric can be measured very simply, for example $1 of donor funding equates to x lives saved. A tight spread for us would allow for maximum quantity and flexibility around how this capital is allocated (which is a bit counter intuitive). However, the donor world is now demanding more accountability, offering less unrestricted capital, and requiring higher performance, which widens our spread.
“Capital markets offer maximum liquidity and the more liquid a market is the tighter the spreads; therefore, it makes all the sense in the world that the Red Cross turn towards global capital markets to off-set risk,” he explained.
Interestingly, Bornstein explained that, in some cases, it’s perhaps cheaper to purchase an option (i.e. swap out donor funding for private capital) then pay the total price for the underlying where they are fully-exposed and hold the maximum risk.
“One way to buy an option is to structure something like an insurance-linked security (ILS),” said Bornstein.
Currently, the Red Cross is looking at catastrophe bonds, and more specifically the issuance of a private cat bond deal, which are typically smaller in size, as shown by the Artemis Deal Directory, to protect against volcanic risks.
“Inspired by the work our Climate Centre is doing around Forecast based Financing, a mechanism that uses climate and weather forecasts to trigger timely funding for humanitarian action, we started looking at variations of index insurance with risk pooling components. This journey led us down the path of the dynamic world of cat bonds.
“There has never been a pure volcano cat bond placed in the market, and so we’re making history; however, we couldn’t do it without honest and constructive feedback from the investors. My colleagues Simon Meldrum and Kaspar Bro Larsen, and I are looking at this first cat bond as a pilot, but the ambition is to go global in a big way,” said Bornstein.
He continued to explain that the cat bond would potentially operate at a regional or global scale, and that it would be privately placed with a size of around $15 million.
Currently, the trigger is shaping up to be based on column (the plume or ejection from a volcano) height for its ease and speed of measurement that could result in a quicker payout.
Varying amounts of payout will be based on individually named volcanoes and associated plume height. While the timeline to issue this first volcanic risk catastrophe bond is targeting May 2019, Bornstein explained to Artemis.
In future issues, if the first volcano cat bond is successful, Bornstein said that the trigger could become more complex, “On the volcano front, we are working with Pablo Suarez on the prospects of structuring a cat bond around a “climate-changing explosive eruption” which sends >5tg of SO2 into stratosphere.
“Some scientists believe, within our lifetime, that there is a decent chance of a very large explosive eruption, large enough that massive amounts of very fine SO2 particles are sent upwards of 37K feet. As happened with Pinatubo 1991 and Tambora 200 years ago, the sulfuric matter is so light that it stays in the upper atmosphere for a couple of years, blocking just enough sunlight to noticeable cool down the planet and creates all sorts of dangerous climate anomalies in regions across the globe.
“There is always appetite for risk, it is just a matter of the pricing of this risk as a function of probability of the event taking place. We have been given guidance on where the investors would like to come in at, and we’re all coming together to see how that can happen. We have a global pool of volcanoes to pick from, the trick is to maximize benefits at a specific price point.
“On the back of this, ensuring we price this on a commercial basis so that we can have proof of concept going forward. If we ply this cat bond with guarantees and subsidies, for example as has been the case with some other impact mechanism, then there is no chance we’ll replicate and reach the scale we need, purely from a humanitarian assistance perspective.
“Our team’s starting point is to structure and develop investible products to support long-term humanitarian financing – that is the goal.
“From the start, this has been a collaborative effort. Although early days, much gratitude and appreciation goes out to our partners who have enthusiastically supported this endeavour. In close partnership with the Red Cross Climate Centre and Red Cross national societies in Latin America and the Caribbean, the team is jointly working with volcanologists from Mitiga Solutions, Barcelona Super Computer Centre, and the University of Bristol, various private investors and asset managers, and Mayer Brown for legal support.”
Currently, the team is in the process of conducting the technical analysis of global volcano rankings which will make up its cat bond universe.
“Once we have our universe locked-in, we will develop long-term (probabilistic) hazard assessment to support structuring and pricing of the targeted cat bond. We’ll also need to develop a short-term (deterministic) impact and structure cat bond payout formula,” said Bornstein.
The series of Residential Reinsurance Ltd. catastrophe bond transactions from USAA, an annual feature of any cat bond issuance year, has since 2014, included volcanic eruption risks as well as a host of other natural perils.
However, and as noted by Bornstein, should the Red Cross catastrophe bond efforts come to fruition, it would be the first pure volcano risk cat bond the market has seen since its inception more than 20 years ago.