With weather-related disasters on the rise as the earth warms, catastrophe bonds are gaining attention in Latin America and the Caribbean. Chile recently gained $630 million in financial protection from earthquakes and tsunamis through a catastrophe bond and swap deal. More want to follow suit.
Weather-related disasters are on the rise globally as the climate changes, and few regions are as susceptible as Latin America and the Caribbean. The region already suffers frequent droughts, earthquakes, floods, hurricanes and wildfires. With each catastrophe, the lack of unpreparedness is exposed. The economic and human losses can be severe.
Capital markets can play a role in improving this readiness. Sophisticated investors have shown a growing appetite for fixed-income vehicles that help governments to transfer catastrophic risk exposures to investment portfolios. These so-called catastrophe bonds, or cat bonds, offer a healthy coupon and low risk on the understanding that, if they are triggered, investors will suffer tremendous losses.
Cat bonds are common in heavily exposed markets such as Florida and Japan, where public and private actors are frequent issuers.
In March, Chile showed how this system can work in Latin America too.
A $350 million bond was issued by the World Bank to provide cover against earthquakes and tsunamis in the Andean country. Combined with a $280 million deal with two dozen reinsurance companies mediated by the World Bank via an instrument called a reinsurance swap, Chile will be able to raise up a total of $630 million in the capital markets in the event of a large quake.
It may not sound like a lot of money, considering the potential damage that a catastrophic event can cause. The last time Chile was hit by a strong quake, in 2010, the economic losses were estimated at more than $30 billion. But the features of the deal enable the government to have access to an immediate source of recovery funds to provide aid to the affected populations and kick-start the reconstruction of infrastructure.
“This deal is part of a more comprehensive strategy to transfer catastrophic risks,” says Carola Moreno, head of international financial affairs at the Chilean Finance Ministry.
In practice, Chile bought an earthquake insurance policy from the World Bank, which, as if it were an insurance company, transferred the risk to the reinsurance and capital markets via the cat bond and swap deals. It was the largest such transaction ever made by the World Bank for a single country, a feat that was even more impressive because it was placed at a time when tight global financial conditions have made investors more averse to risk.
Photo: Carola Moreno
It also came at a time when cat bond investors were still anxious about the impact of Hurricane Ian, which hit the Caribbean and Florida in September 2022, on their holdings of the instrument.
“The dual placement element was the innovative part of the latest Chilean issuance,” says Rubem Hofliger, head of public sector solutions in Latin America at Zürich-based Swiss Reinsurance Company, which helped structure the deal. “This decision was driven by a lack of capacity for nat cat risks in capital markets after Ian.”
Chile will pay 4.75% a year for the three-year insurance policy. That is the same rate that investors agreed to pay the World Bank for the cat bonds and swap contracts, which have the same maturity.
Michael Bennett, head of market solutions and structured finance in the World Bank’s Treasury Department, says that the rate illustrates the interest that investors have for catastrophic risks outside the United States, where most cat bond issuances are made.
“We went out on that transaction with a range of 4.75% to 5.5%, based on our preliminary market soundings,” he says. “We were happy that it came in at the very low end of that range.”
A Few Precedents
Chile’s deal was impressive for its size, but it was not the first such transaction performed by the World Bank in Latin America. Mexico has issued cat bonds for over a decade and a half, and it has a two-year cat bond now in place. Chile itself previously participated in an initiative along with Colombia, Mexico and Peru where the World Bank placed a total of $1.36 billion in combined earthquake covers in the market. Jamaica purchased a $185 earthquake cover in 2021 via a similar structure, and the Caribbean Catastrophe Risk Insurance Facility, a consortium of Caribbean and Central American countries, has been active in offering cat risks to capital markets since the mid-2000s.
Even so, the Chilean deal came at a time when the search for market-based solutions for catastrophic risks has gained a new urgency because of accelerating climate change. The frequency of weather-related events has increased dramatically worldwide, and Latin America is no exception. Even countries traditionally seen as catastrophe-free, such as Argentina and Brazil, have suffered severe losses from harsh weather conditions.
So, if the need is there and investors have an appetite for the risk, why haven’t Latin American issuers made more use of insurance-linked securities, or ILS, as those solutions are known in the market?
Experts list off several reasons to explain the lag. The first is purely technical. The structuring of ILS deals can be fiendishly complicated, especially in countries that have little history of collecting reliable data on the catastrophes in their territories. Reinsurers and investors base their decisions on models built from historical data, which can be hard to find for rainfall, droughts and other perils that are not earthquakes or hurricanes. Programs such as Chile’s use a methodology known as parametric insurance. The payments are triggered not after the actual losses are evaluated, but if certain levels of rain, soil moisture or wind, for example, are met, independently of the damage caused.
“The reinsurance market also has an appetite for parametric covers like that one,” Hofliger says. “But it is a tailor-made product. It is designed according to the capabilities and the needs of each client.”
In the case of Chile, the national territory was divided into a grid, and each part of the grid was evaluated in terms of its urban concentration and the potential of property losses. If an earthquake happens, the compensation to be paid to each part of the grid will depend on its magnitude, the depth of its epicenter, and the distance between the area and the epicenter, among other factors. Depending on the parameters reached, the government will be paid 25%, 50% or 100% of the agreed limit.
This is hard stuff even for reinsurance buffs, and governments are notoriously bereft of experts in the insurance market. This is why the World Bank has been the intermediary of choice for Latin American deals so far for its expertise in these matters. Also, the investors who buy these very high but low probability bonds are extremely specialized. Many are institutional investors who rely on ISL-focused funds to do the heavy lifting for them.
“Issuing this kind of bond requires having access to a market that is different from traditional sovereign bond investors,” Chile’s Moreno says.
And then there is the political side of it. Cat bonds and other ISL issuances are not cheap because of the high risks involved, and the most likely outcome is that the covers will not be triggered. Governments working on tight fiscal budgets may have little incentive to fork out the money to place the deals. Some municipal governments in Colombia and Mexico have tried to go their own way and implement their own risk transfer programs.
Franziska Arnold-Dwyer, an insurance expert at Queen Mary University of London, has devised a vehicle that she calls climate resilient development bonds to help bring together municipal issuers, insurers, and philanthropic funds, as well as environmental, social and governance funds, to place catastrophic risks in the ILS market. But this is still a fledgling movement, and some countries place restrictions on the ability of lower-level government bodies to take on debt.
Even then, there seems to be an awakening about the need to bring capital markets into the catastrophic mitigation effort as the climate warms. In 2021, Brazil approved a new ILS law that facilitates the placement of local insurance risks in the capital markets. However, no deal has been structured with the new framework so far.
“Brazil aims to be an ILS hub in Latin America,” Cassio Gama Amaral, a partner at Brazilian law firm Machado Meyer Advogados, said during a webinar in June. “The main hurdle is not regulatory, but a lack of political willingness from someone who can orchestrate between the government, the private sector and investors to set up such a sophisticated structure.” LF