A solution must be found at the European level to deal with the costs of extreme health risks such as a pandemic. This can be done by launching bond-like products that can be sold to institutional investors.
This is the conclusion of a paper written by David Veredas (photo), professor at the Vlerick School, together with his colleague Simon Ashby and PhD student Dimitrios Kolokas. The paper is called “An Emergency Health Financing Facility for the European Union. A proposal”. ‘The set-up is very similar to the securitisation of natural disasters, which is already happening through the concept of catastrophe bonds,’ says Veredas. ‘In our proposal, health risks are sold to institutional investors. This type of products are in strong demand, because they are uncorrelated with financial markets and do not carry any default or investment risk.’
Risks
‘The situation around Covid-19 showed that there systems in place at the European level to deal with this type of situations, but in practice the European Commission had to hastily innovate as the institutions, protocols and processes in place were not sufficient.’
Many international institutions such as the World Bank and global insurance companies actively look for ways to finance the risks inherent to their activties. Insurance companies were the first ones. They have issued cat bonds since the early 90s to insure against the risk of hurricanes, floods and the like.
‘At one point, we started thinking about a mechanism we could implement to deal with extreme health risks. So we developed a proposal after talking to several European Commission officials. Under our proposal, no additional debt is being accumulated: a bond is issued, and a coupon is paid. It is a good mechanism to avoid higher debt levels.’
Demand from institutional investors, as mentioned, is there because of the perfect diversification characteristics of these bonds. ‘The average spread for catastrophe bonds is considerable, 5% per annum with a maturity of three to five years. They are placed off-balance sheet in a special purpose vehicle (SPV). The only risk is therefore the pure health risk.’
Risk structuring
According to Veredas, the seriousness and frequency of risks can be divided into three categories (see above). ‘These bonds are clearly in the upper tranche, especially those of the very serious risks which are extremely rare, but can have enormous consequences. The Covid-19 pandemic is, of course, a good example of this.’
The risks in the lower tranche (medium frequency/medium severity) are already covered by the existing EUCPM and rescEU mechanisms. The middle tranche is covered by the emergency support instrument (ESI), with funding depending on the activation of the ESI by the European Council. We expect a lot from these products because we believe that they respond to a real market need and have clear risk characteristics.’