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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
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Introduction
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Contingent Liability• A contingent liability is a potential liability that may occur, depending
on the outcome of an uncertain future event.
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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.
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Measuring and Pricing
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Measuring Contingent Liability
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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.
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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
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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
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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
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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
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• 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
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Impacts of Market Pricing
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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
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Pricing: Changing Limits
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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
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Catastrophe Insurance
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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
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Examples of Catastrophe Insurance
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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
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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)
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Other Considerations
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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
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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
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Thank YouFor additional information, please contact
• Nikhil Bhandari
• www.RockCreekAnalytics.com
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