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Last September, two powerful earthquakes shook Mexico. Combined, they killed nearly 500 people as buildings crumbled across the capital and at least five other states. The quakes were both among the deadliest to hit the country, with the second of the two coming 32 years to the day after the worst tragedy in the nation’s history, the 1985 Mexico City earthquake that killed an estimated 10,000 people.
Events like these have prompted the country and others in the region to seek out alternative risk financing methods to help recover from future disasters. Perhaps most notably, Mexico recently teamed up with three other Latin American nations in the Pacific Alliance trade block—Colombia, Chile and Peru—to procure a $1.36 billion catastrophe bond to cover earthquake risk. Issued by the World Bank in February, this was the second-largest cat bond ever issued and the largest sovereign risk insurance transaction in history, according to the organization. Based on specific parametric triggers and U.S. Geological Survey data, the bond will allocate varying amounts of insurance to the covered nations in the event of an earthquake—$500 million to Chile, $400 million to Colombia, $260 million to Mexico and $200 million to Peru.
The bond reflects a relatively new effort by the World Bank to embrace more creative disaster risk financing. In 2007, for example, it launched the Caribbean Catastrophe Risk Insurance Facility (CCRIF), an ongoing insurance pool for 16 hurricane-exposed nations including Haiti, Jamaica, and Trinidad and Tobago. A similar concept was also used to address drought risks in the African nation of Malawi.
In 2009, the World Bank also debuted its MultiCat Program, which helps countries issue catastrophe bonds to insure themselves against the risk of natural disasters. As part of the program, the World Bank acts as arranger for the transaction, assists in formulating a disaster risk management policy, offers off-the-shelf documentation, supports preparation of a legal and operational framework, and selects service providers. Mexico quickly took advantage by issuing bonds for $290 million worth of earthquake and hurricane coverage. The country followed up with deals of $315 million in 2012 and $360 million in 2017, $150 million of which was ultimately paid out after the September earthquakes.
The new four-nation cat bond builds on this strategy for Mexico and brings three other nations into the fold in a transaction that involved the participation of insurers Swiss Re and Aon, financial services giant Citi, and catastrophe modeling firm AIR Worldwide. By simplifying the process and establishing the World Bank as the bond issuer, the institution believes more developing nations can use this type of arrangement to safeguard budgets in the event of disaster.
“From the point of view of the member government, it is very, very simple,” said Michael Bennett, head of derivatives and structured finance in the World Bank’s treasury department. “All they’re doing is buying insurance from us. They face us, and we hedge in the market. So we think we’ve streamlined this process now for them to make it about as simple as possible.”
The Rise of Catastrophe Bonds
Catastrophe bonds have grown in popularity in recent years. Although they were developed in the 1990s in the wake of Hurricane Andrew, they have taken a while to catch on. The annual value of bond issuance climbed steadily each year, culminating in a record $7.6 billion in 2007, according to Aon. Then the financial crisis interrupted progress. Pre-crisis levels were not reached again until 2013, and last year saw a new all-time high issuance value of $10.6 billion.
In terms of all outstanding bonds, the market rose by 60% between 2012 and 2017, from roughly $16.5 billion to $27 billion, Aon reports. And this only appears to be increasing after last year’s historic catastrophe losses. “The industry could again be in the early stages of more aggressive expansion,” said Andras Bohm, vice president of securities at Aon Benfield. “The first quarter of 2018 has set new records for catastrophe bond issuance, and we expect this momentum to continue throughout 2018.”
It is easy to understand the interest. A cat bond is a relatively straight-forward way to transfer disaster risk to investors. If a catastrophe strikes during an allotted timeframe and meets certain objective parameters, the insured is paid. If it does not, then it is a win/win: there is no tragedy and investors see a good return.
At times, the rate of return can beat the S&P 500. Indeed, when the stock market was at its worst, cat bonds helped some investors stay afloat. “The catastrophe bond market outperformed its benchmarks during the financial crisis, returning 2.6% in 2008,” Bohm said.
Investors also enjoy benefits beyond financial gains. Given the global nature of today’s economy, most investments are correlated to at least some degree. Speculating on the housing market is different from betting on oil futures, for example, and both are detached from early-round seed funding in a Silicon Valley startup. But not entirely. If the U.S. economy falls into recession, those investments all get riskier overnight.
Fault lines and storm fronts have no ties to Wall Street, however. So investors see cat bonds as a way to add truly independent risks to their portfolio, and they particularly enjoy betting on faraway exposures in, say, Peru that do not usually overlap with other things on their books. “Cat bond investors are generally faced with a lot of risk heavily concentrated in hurricanes hitting Florida or earthquakes hitting California,” Bennett said. “Adding to their portfolio with a totally uncorrelated risk, like an earthquake hitting Lima, is a good source of diversification for them.”
In fact, because of the such strong demand, Bennett said the World Bank was actually able to include more coverage in the Pacific Alliance bond than it expected. The four countries involved had a fixed budget for premiums, and the experts placing the bond expected that to equate to around $1 billion in coverage, but investor demand was enough to ultimately extend that to $1.36 billion at the same premium cost.
For the countries involved in the cat bond, a key benefit is simplicity. As with all cat bonds, the payment trigger is parametric, so as long as the seismic magnitude is higher than a predetermined threshold and the epicenter is at a certain depth in a covered location, there will be no claims-wrangling or on-the-ground evaluation necessary. Within just a few weeks of a major earthquake (the time it takes for scientific bodies to confirm final seismic measurements), the government of Colombia, for example, would have its $400 million.
Disaster Risk Financing
For the countries in the Pacific Alliance cat bond, finding creative ways to finance natural disaster risk is an important consideration. Chile, for example, is far too familiar with disaster. In 2010, a colossal 8.8-magnitude earthquake—the sixth-strongest ever recorded by the U.S. Geographical Survey (USGS)—struck off the nation’s Pacific coast, killing more than 500 people. As tragic as that was, the death toll could have been much worse—hundreds of thousands of people were killed by weaker earthquakes in Haiti and China in 2008 and in the aftermath of the Indian Ocean earthquake and tsunami in 2004.
Improved local building standards, a stronger culture of preparedness and sheer luck may have minimized the loss of life in the 2010 quake, but Chilean officials know that more quakes are on the way. According to the USGS, at least a dozen earthquakes of magnitude 7.0 or higher have hit the country since 1990, including an 8.3-magnitude quake in 2015 that forced the evacuation of more than one million people. “Many of these people lost everything,” then-President Michelle Bachelet said in a statement.
The government quickly paid out disaster assistance of around $2,200 to a pool of 1,800 severely affected households and pledged to do more. “We know that relief given cannot make up for all the losses stemming from this latest natural disaster, but we would like the people to know that the government will not abandon them,” Bachelet said.
Nikhil da Victoria Lobo, regional leader for the Americas and global partnerships at Swiss Re, sees such disasters as a call to action. “A political consciousness builds that the status quo—basically, going uninsured—is not acceptable,” he said. This realization prompts governments to look for solutions, like cat bonds.
The collective interest from the governments involved in the Pacific Alliance bond shows not only that the region is prioritizing disaster risk management, but that these countries could be attractive partners for foreign investment. “It sends a very compelling signal to sovereign bond investors that the government is taking risk seriously,” da Victoria Lobo explained. “When you look at the Pacific Alliance group of countries, these countries have put in place very strong fiscal policies, and this is just the natural growth of prudent fiscal risk management.”
Pushing for More Progress
The Pacific Alliance cat bond represents just one of many disaster risk management strategies being used by these four countries. “There has been a dramatic improvement in everything from catastrophe models to academic research,” da Victoria Lobo said. He sees Mexico’s enthusiastic leap into the cat bond market as an “outgrowth of a very comprehensive and integrated risk management framework that the government has adopted for public assets and public institutions.”
This is key, he said, because a one-time cat bond is not enough to protect lives. More must be done at all levels to make these developing economies more resilient in the decades to come. “Risk mitigation, prevention and management are not an annual activity—they are a generational activity,” he said.
For example, since the 1985 Mexico City earthquake, Mexico has been diligently working to reduce its disaster risk by improving building codes, promoting incentives to rebuild after disasters and funding other disaster preparedness initiatives as part of its National Civil Protection System. The country developed a Seismic Warning System in 1991, which provides up to 60 seconds of warning of an impending earthquake, and introduced the SARMEX early-warning radio network in 2012 to issue important weather-related updates. A number of startups in the country have also been working in recent years to develop a portable warning gadget that can be used by everyday citizens.
Colombia is also seeing increasing sophistication of its overall insurance market and its disaster risk management practices. In 2012, the country established a national system for disaster risk management that focuses on disaster preparedness as well as response. Its National Unit for Disaster Risk Management has implemented emergency policies, installed warning systems and conducted disaster resistance drills to help strengthen the communities that are most vulnerable to natural disasters.
In addition, Lloyd’s of London established its first formal office in Bogota in 2016 and has multiple syndicates operating in the country, while the structural engineering firm Miyamoto set up shop there last year to bring more seismic expertise to the construction sector. AIR Worldwide has also continued to improve its catastrophe model for the nation, receiving local regulatory approval for its latest update in 2017.
Whether it is through massive risk financing deals like the Pacific Alliance cat bond or small mitigation tactics, the result is that more people are becoming better protected against disaster across the region. While no government can stop the earth from shaking, many countries are showing that something can always be done to prepare. “It is a very positive trend we see in Latin America,” Bennett said. “Countries are really looking at risk management as opposed to just waiting for events to occur and then trying to react to them.”