Setting the record straight: A stocktake of pre-arranged financing instruments
Pre-arranging more disaster financing can help ensure the right amount of funding is in the right place at the right time, reducing the negative impacts of disasters on lives and livelihoods. Several governments now have access to an expanding toolbox of pre-arranged financing instruments. Yet, they are often insufficiently equipped to make informed decisions in this provider-driven, highly technical and rapidly evolving space. Our report Demystifying Pre-Arranged Financing for Governments: A Stocktake of Financial Instruments from International Financial Institutions seeks to set the record straight.
Pre-arranging more disaster financing can help ensure the right amount of funding is in the right place at the right time, reducing the negative impacts of disasters on lives and livelihoods. But despite being able to model and anticipate a large proportion of disaster risk relating to extreme weather, geophysical hazards and public health emergencies, governments and the international crisis financing system continue to treat disasters as surprises and rely on ad-hoc financing that is often too little and too late: only 1.1% of total crisis finance in 2022 was pre-arranged (USD852 million out of USD76 billion). This is due to various financial, technical and structural constraints.
Several governments have access to an expanding toolbox of instruments by partners in the international system to pre-arrange financing before disasters occur: contingent grants and loans, climate resilient debt clauses (or debt pause clauses), catastrophe (cat) bonds and insurance. Yet, they are often insufficiently equipped to make informed decisions in this provider-driven, highly technical and rapidly evolving space. They usually have incomplete information and lack the expertise to determine which combination of instruments is most appropriate for them, given their specific context. This can lead to over-reliance on the advice of the providers and intermediaries, introducing a potential conflict of interest. Some governments have been disappointed in the outcomes - sometimes due to misplaced expectations - leading to a loss of trust and confidence in the instruments and in pre-arranged financing more broadly.
Our report is the first comprehensive high-level assessment of the main sovereign-level pre-arranged financing instruments from two of the biggest international players in this space: multilateral development banks and regional risk pools. It reveals what we know (and don't know) about each instrument in terms of seven critical criteria: their attractiveness; affordability; financial efficiency; timeliness; predictability; and evidence of their contribution to specific development outcomes and wider resilience-building.
There is no single 'best' instrument
As with most things in life, the devil is in the details. But sometimes, those details are obscured by the rose-tinted glasses through which some instruments are viewed. Others are heavily criticised for failing to meet expectations, with little attention paid to the underlying evidence (or lack of) or whether the expectations were realistic in the first place.
There is no single 'best' instrument. Conventional wisdom among disaster risk financing practitioners is that governments should develop strategies that combine different instruments for different layers of risks. Our report puts the main pre-arranged financing instruments available to governments from international financial institutions under the microscope - particularly those available from three multilateral development banks* and four regional risk pools**. It uses the seven critical criteria to ask an important but often neglected question: "What do we know about these instruments regarding their performance, successes and limitations to date?"
What is working and what needs to be improved?
Based on publicly available information as well as key informant interviews with experts from the multilateral development banks and regional risk pools, Demystifying Pre-Arranged Financing for Governments highlights that while pre-arranged financing instruments can enhance fiscal resilience, there is insufficient evidence that they benefit the most vulnerable populations within countries. The findings emphasise that different instruments vary significantly in their value for money, and the opaque nature of trigger designs poses a barrier to effective implementation:
Most pre-arranged financing instruments help governments strengthen their fiscal resilience, but there is insufficient evidence of their impact on serving the poor and vulnerable.
Most of the instruments reviewed in the report have a proven track record in reducing the fiscal vulnerability of governments to disasters, providing timely liquidity following the occurrence of eligible events. However, there is limited robust evidence that sovereign-level pre-arranged financing instruments benefit the poorest and most vulnerable communities. Except for the Inter-American Development Bank's contingent loan and African Risk Capacity's (ARC's) insurance product, the majority of instruments studied in this report are explicitly designed to provide governments with quick general budget support. While governments, particularly ministries of finance, typically value this flexible, unearmarked support highly, it means the use of funds cannot be tracked or explicitly tied to specific expenditures or a pre-agreed plan.
In the case of the World Bank's and Asian Development Bank's contingent loans and grants, the measured development impact is assessed solely on the policy actions tied to instruments, usually to strengthen a government's disaster risk management capacities. These policy actions can indirectly benefit poor and vulnerable groups through improved disaster readiness. For example, strengthening shock-responsive social protection systems or incorporating disaster risks into the government's budgeting process. Yet, for the most part, the information to meaningfully assess these impacts is insufficient. This also applies to evidence of instruments reducing vulnerability and exposure to natural hazards through risk reduction, preparedness, building back better and risk understanding, with some exceptions among the World Bank's recent contingent loans and grants.
Governments and development partners seeking to design pre-arranged financing solutions to reach poor and vulnerable people must ensure appropriate instrument and modality selection and design. This will be key, for example, in developing loss and damage solutions. It may require considering alternative modalities to budget support or redesigning budget support programmes to ensure better targeting of policy actions to specific vulnerable groups. Instruments are a means to an end, and it is critical that the 'end' is clearly defined.
Different instruments offer different value for money.
Governments and development partners must use the instruments that provide the best value for money to make the best use of scarce public finance. Given the probabilistic nature of pre-arranged financing, one key metric that governments and international partners need to understand is the average cost to a government for one unit of payout from an instrument on average. This can vary substantially between instruments and depending on what the instrument is meant to finance. In particular, this average cost tends to increase as the instrument is used for less frequent events. The rate at which the cost increases differs for different instruments, meaning that some instruments are more cost-effective for more frequent shocks, while others are more cost-effective for less frequent shocks.
However, most international discussion focuses on whether financing is a grant or loan. Little to no attention is given to the full economic cost to be borne by governments. For example, when an International Bank for Reconstruction and Development (IBRD) member country allocates part of its World Bank country allocation to a contingent loan, it has to forgo drawing down that amount immediately for other purposes. This is expensive for countries with limited headroom and where the IBRD loan is cheaper than alternative sources of finance for the foregone use. This cost contributes to the full economic cost of the instrument to countries but has been missing from the international discourse.
Financial efficiency also matters for development partners. For example, a World Bank International Development Association (IDA) Cat Deferred Drawdown Option grant is 100% subsidised. In contrast, ARC insurance is 60% subsidised***, yet despite this, our research finds that ARC has a lower cost to countries for risks at return periods above 1-in-6 years**** (in terms of the average cost to a country for one unit of payout). For these lower-frequency events, ARC insurance may be cheaper to countries and cheaper to donors. Governments and development partners must choose instruments that maximise the impact of every dollar spent, and this can only happen when development partners fully account for the cost to governments of the instruments they support.
Detailed trigger design information tends not to be available publicly
There is a risk that a pre-arranged financing instrument does not pay out after a disaster occurs, particularly in the case of parametric triggers. In contrast to instruments that pay out based on actual losses incurred from a disaster (traditional indemnity insurance), parametric instruments pre-specify the amount of payout based on concrete trigger events relating to observed or modelled event data. While this can make the decision-making process quicker and less costly for both parties, it gives rise to basis risk (i.e. the difference between the index measurement and the loss experience). Consequently, an instrument may not be triggered due to a mismatch between the modelled and actual loss. Basis risk events can also occur if the client misunderstood the trigger and therefore had payout expectations not aligned with the trigger structure. Several instruments, particularly the cat bonds and risk pool insurance products, have experienced basis risk events which have led some countries to drop these instruments because they are not seen as a predictable source of financing.
While basis risk can never be eliminated, several good practices help manage this risk and ultimately increase confidence in the instrument's reliability. Various providers are taking steps to manage basis risk and improve governments' understanding of triggers. But there is an urgent need for a common set of standards and guidelines concerning trigger design that all pre-arranged financing providers adhere to. For example, before any trigger is used, its accuracy over time should be rigorously tested using historical data, and this information should be publicly available. Currently, no provider provides publicly available information on its basis risk analysis or trigger validation process.
Making pre-arranged financing fit-for-purpose
This new report taking stock of pre-arranged financing instruments shows that while good practices are emerging, there's still significant room for improvement to ensure the potential benefits of pre-arranged financing. This includes improvements in the following three areas:
- Multilateral development banks and regional risk pools need to support governments in identifying and addressing the bottlenecks that prevent the implementation of pre-agreed plans, and the timely and effective utilisation of public finance for disaster responses more broadly.
- Multilateral development banks and regional risk pools should make more trigger design information publicly available.
- More independent evaluations of the development impact of most PAF instruments are necessary to facilitate accountability and learning.
Instruments are a means to an end - rather than an end in and of itself. This requires greater focus on the contribution of the instruments - individually and collectively - to the development objectives of both governments and their international partners and, where applicable, to the poorest and most crisis-vulnerable communities they are designed to serve. We stand at a critical juncture where the decisions made today can potentially transform the lives of poor and vulnerable people and communities in countries hardest hit by disasters.