Following up on our last blog – Ways to de-risk Climate Finance – one of the common discussion themes that takes centre stage is ‘Leveraging Public Finance,’ and almost always leveraging public finance invokes the use of ‘Blended Finance.’ These approaches get discussed so frequently in almost all climate forums that it sometimes seems as if they should work by magic to mobilize private finance. While these discussions are necessary, it is not magic and requires the appropriate internal capacity and financial expertise.

This note is an attempt to demystify these magic wands—starting with Guarantees and Insurance—as useful mechanisms to de-risk finance and demonstrate how similar approaches can be used to leverage public finance.

Instruments for Risk Mitigation

1. Guarantees
   
   A guarantee, usually a financial guarantee, provides assurance that in case of credit default, the guarantor will fulfil the obligation of debt repayment. Guarantees can be of different types – partial or full, specific or continuous, and can be given by a company, a country, or a financial institution. A guarantee essentially reduces the cost of money[1] for the business or project.

2. Insurance
   
   Insurance provides compensation if a specified risk materialises. It is usually event based. Insurance comes into play once the event/damage has taken place, depending on the type of insurance taken. Insurance can compensate for the actual loss, subject to assessment, or parametric, which has a predetermined pay-out based on a qualifying event occurring.

While insurance and guarantee are both risk mitigation mechanisms, they are often loosely used interchangeably and incorrectly. It is important to remember that they both work very differently and need to be used appropriately.

How do they work?

Typically, a guarantee will reduce the risk associated with the borrower. It can also act as a risk transfer mechanism. For example, in terms of credit ratings, a guarantee may raise the rating of a borrower from a BBB to an AA. This provides the lender comfort in terms of pricing of the instrument (e.g., loan) and capital allocation against the instrument.

Insurance, on the other hand, does not reduce the evaluated risk but provides comfort to the lender. For example, credit-linked insurance, is a life insurance policy linked to the credit given to the borrower, secures the borrowers debt in case of death of the borrower(s). This provides comfort to the lender since repayment is secured.  

Examples of Guarantees and Insurance to mobilize investment

Guarantco was established in 2005 to help close the infrastructure funding gap in lower income countries across Africa and Asia. Guarantco so far has been able to guarantee bonds and loans enabling USD 6 billion in total investments. They do this by providing guarantees. Since GuarantCo has good (high) credit rating, which is usually equivalent or better than sovereign risk in lower income countries across Asia and Africa. This helps in reducing cost of capital to the project by providing guarantees to the lenders. For example, Guarantco provided a USD 50 million guarantee for the Kacific Broadband Satellites International project. The transaction included the following stakeholders:

1. Borrower – Kacific Broadband Satellites International Limited (Kacific)
2. Lender – European Institutional Investor
3. Co-financiers – Asian Development Bank and GuarantCo

GuarantoCo supported this by providing a partial guarantee of USD 50 million to the European institutional investors for the project. Products are structured so that, in the case the borrower is unable to pay the lender, the risk is transferred to Guarantco from the lender to the extent decided in the agreement.

The credit-linked insurance policies used by the microfinance sector in India is a good example of insurance used to expand credit. Credit-linked Life Insurance (CLI) secures a borrower’s debt in case of death of the customer. Another such example is the Pradhan Mantri Fasal Bima Yojana (PMFBY). PMFBY insurance taken out by farmers supports sustainable agriculture production by: a) providing financial support to farmers suffering from crop loss/damage arising out of unforeseen events; b) stabilizing the income of farmers to ensure their continuance in sustainable farming; c) encouraging farmers to adopt innovative and modern agricultural practices; and d) ensuring flow of credit to the agriculture sector.

The above two examples illustrate how guarantee and insurance works differently. In the first example, the guarantee reduces risk perception, making it easier and cheaper to price the loan. In the second example, the safety net provided encourages new investment and sustainable practices, but the total cost and capital requirements remain the same. 

Potential solutions for climate and green finance

There is clearly a potential to design guarantee schemes and insurance offerings which can leverage public finance to create investment flows towards climate and green activities. Potential ways to use insurance and guarantees to increase finance flows include:

1. Use of guarantee to increase blended finance offerings
2. Use of insurance to increase credit uptake in small and marginalized communities. This may be achieved in multiple ways, including lowering insurance premium, and using public fund to pay premiums for specific communities/sectors to reduce their riskiness, among other things.
3. Use of guarantees to improve creditworthiness of new businesses who may not have a credit track record.
   
   We will go into details for each of the above in our next articles.

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[1] Cost of money reduces since there is a reduction in perceived risk by investor. This happens since a Guarantee provides comfort to the investor of assured return of capital.