Contingent Liability in PPP Projects - Rock Creek Analytics...AGROASEMEX S.A. Mexico earthquake...

Rock Creek Analytics, LLC

Contingent Liability in PPP Projects

Nikhil Bhandari

February 9, 2018

Rock Creek Analytics, LLC

Agenda• Introduction

• Measure and Pricing

• Catastrophe Insurance

• Other Considerations

2

Rock Creek Analytics, LLC

Introduction

3

Rock Creek Analytics, LLC

Contingent Liability• A contingent liability is a potential liability that may occur, depending

on the outcome of an uncertain future event.

4

Rock Creek Analytics, LLC

Implicit vs Explicit Liabilities• Implicit: political or moral obligations

that arise from expectations that government would intervene in the event of a crisis or a disaster

• Examples:− Bailouts

− Natural disaster relief

− Environmental cleanup

− Assumption of debt

− Nationalization

• Explicit: Obligations based on contracts, laws, or clear policy commitments.

• Examples:− Revenue guarantees

− Loan guarantees

− Export guarantees

− Other financial guarantees (exchange rates, etc.)

− Government insurance

− Natural disaster spending

− Legal claims against government

− Indemnities

− Etc.

5

Rock Creek Analytics, LLC

Measuring and Pricing

6

Rock Creek Analytics, LLC

Measuring Contingent Liability

7

Implicit Contingent Liabilities Explicit Contingent Liabilities

Both magnitude and timing not known

Magnitude can be estimated while the

timing not known

In either case, governments rarely undertake a comprehensive analysis of these liabilities

We will focus on explicit contingent

liabilities in the rest of the discussion.

Rock Creek Analytics, LLC

One Methodology• Estimate the expected value of the loss each year

• Price the liability at [4-5] times the expected loss

• Appropriate multiplier is more of “art” than “science” and will depend on a variety of factors such as the nature of the liability, the likelihood of occurrence, etc.

• Looks straight-forward

• But in practice not that simple

8

Rock Creek Analytics, LLC

Measuring and Pricing Example• Toll highway concession

• Government gives a minimum revenue guarantee of $10 million per year (i.e., if the toll highway does not generate $10 million in revenues in any year, the government will pay the difference between the actual revenue and $10 million)

• In any year, the probability of payouts are as shown in the table

• Expected payout: $0.40 M

• Price the cost of minimum revenue guarantee in the $1.6 - $2.0 M per year

9

Actual Revenue Government Payout Probability

$0 M $10 M 0.05%

$1 M $9 M 0.15%

$2 M $8 M 0.50%

$3 M $7 M 1.00%

$4 M $6 M 1.10%

$5 M $5 M 1.20%

$6 M $4 M 1.30%

$7 M $3 M 1.40%

$8 M $2 M 1.50%

$9 M $1 M 1.80%

$10 M or more $0 90%

Expected value of payout $0.40 M

Rock Creek Analytics, LLC

Actual Revenue Government Payout Probability

$0 M $10 M 0.05%

$1 M $9 M 0.15%

$2 M $8 M 0.50%

$3 M $7 M 1.00%

$4 M $6 M 1.10%

$5 M $5 M 1.20%

$6 M $4 M 1.30%

$7 M $3 M 1.40%

$8 M $2 M 1.50%

$9 M $1 M 1.80%

$10 M or more $0 90%

Expected value of payout $0.40 M

Measuring: Event Probabilities

10

• Tail probabilities• Probabilities at the end of the curve• Typically low probability but high impact events

• Lot of literature suggests that humans have a hard time assigning appropriate values to such events• We typically underestimate these probabilities

• Who should do this estimate:− Concessionaire – they have an incentive to

under-estimate the “tail” probabilities − Government – they have an incentive to over-

estimate the “tail” probabilities− 3rd parties – depends on who pays them− Multilaterals or specialized non-profits

Estimating the probability is critical to overall pricing calculation

Rock Creek Analytics, LLC

Impacts of Market Pricing

11

Actual Revenue Government Payout Probability

$0 M $10 M 0.05%

$1 M $9 M 0.15%

$2 M $8 M 0.50%

$3 M $7 M 1.00%

$4 M $6 M 1.10%

$5 M $5 M 1.20%

$6 M $4 M 1.30%

$7 M $3 M 1.40%

$8 M $2 M 1.50%

$9 M $1 M 1.80%

$10 M or more $0 90%

Expected value of payout $0.40 M

• An appropriate price for the minimum revenue guarantee:

− Forces the concessionaire to re-evaluate the need for minimum revenue guarantee

− Forces the concessionaire to be realistic in their projections

• At times, it also makes the project financially unfeasible which may force the government to re-evaluate the terms of the concession

Rock Creek Analytics, LLC

Pricing: Changing Limits

12

Actual Revenue Government Payout Probability

$0 M $5 M 0.05%

$1 M $4 M 0.15%

$2 M $3 M 0.50%

$3 M $2 M 1.00%

$4 M $1 M 1.10%

$5 M or more $0 97.20%

Expected value of payout $0.05 M

• Reduce minimum guarantee requirement to $5M

− Price range would be $0.20 – 0.25 M.

• Increasing the guarantee limits have a large impact on the price

Rock Creek Analytics, LLC

Catastrophe Insurance

13

Rock Creek Analytics, LLC

Catastrophe Insurance• Catastrophe (Cat) bonds have become

quite common to address natural catastrophes

• Country governments along with World Bank (IBRD) and insurance companies are major issuers of cat bonds

• Common events covered: earthquakes, hurricanes, natural disasters, etc.

• How does it work?− Government or private entity issues the

bonds

− They pay a “coupon” payment (i.e., interest) while the bond is outstanding

− If the pre-specified event occurs, then the bond holders lose their principal

− If the event does not occur, then bond holders get paid their principal + interest

14

Rock Creek Analytics, LLC

Examples of Catastrophe Insurance

15

Issuer CedentRisks / Perils covered

Size Date

IBRD CAR 120 Republic of Peru Peru earthquake $200m Feb 2018

IBRD CAR 118-119FONDEN / AGROASEMEX S.A.

Mexico earthquake $260-290m Feb 2018

IBRD CAR 117Republic of Colombia

Colombia earthquake

$375-400m Feb 2018

IBRD CAR 116 Republic of Chile Chile earthquake $460-500m Feb 2018

Rock Creek Analytics, LLC

Cat Bonds for PPP Projects• Can the cat bond approach work for

PPP projects?

• Sure− If the event can be specified in a clear

way (ideally, with a yes/no response)• “The annual revenue of the toll road is

less than [xx] million”

• Not clear− Typical PPP project’s annual liability on a

specific item may be small to compared to fees to issue the bond

• Governments can use the cat bond approach to buy insurance against the contingent liability

• May need to merge projects to create a large enough bond issue to justify bankers/lawyers fees

• Merging projects can also help distribute risks across multiple projects (though the risks may be amplified if all projects are affected by similar factors)

16

Rock Creek Analytics, LLC

Other Considerations

17

Rock Creek Analytics, LLC

Disclosing PPP liabilities• Accounting issues

‒ Different accounting systems treat contingent liability differently

• Legal issues ‒ Some countries have a legal requirement to disclose fiscal risks

• Nature, scope and amount of contingent liability ‒ These can be difficult to explain in a clear manner

18

Rock Creek Analytics, LLC

Sources of Further Study• World Bank and IMF have a lot of material on their web sites

• Some countries (Chile, Australia, UK, South Africa, etc.) have very practical information on what they are doing

‒ Government of India has a handbook for estimating contingent liability for PPP projects in the highway sector

19

Rock Creek Analytics, LLC

Thank YouFor additional information, please contact

• Nikhil Bhandari

• Nikhil@RockCreekAnalytics.com

• www.RockCreekAnalytics.com

20