In 2009, the Cinchona earthquake caused damages greater than ¢280,000 million in Costa Rica. Almost eight years later, Hurricane Nate caused damage to three quarters of the country, for amounts that exceeded ¢329,000 million, and it was considered the worst natural disaster that had occurred in decades. How would we have dealt with these economic losses if the two events had happened in a shorter period?
The answer to that question can be found in the United States, where two severe natural disasters occurred just over two years apart.
Hurricane Andrew struck Florida in August 1992 and the Northridge earthquake in California in October 1994, causing insurance companies to be unable to cover the damage and going bankrupt. Consequently, Catastrophe Bonds were created.
¿What are Catastrophe Bonds?
Suppose that the Costa Rican Government wants to insure all public infrastructure against the damage a hurricane could cause in the country and an insurer wants to offer this service, but does not have the financial resources to do so. What the insurer will do is sign a reinsurance contract with an entity called Special Purpose Vehicle (SVP). The insurer will agree to a premium in exchange for the SVP providing coverage in the event of a hurricane and the SVP will issue a bond, typically for a period of three years, which will sell on the capital market to investors.
The amount paid by investors will go into a trust fund. If the hurricane occurs the fund will be transferred to the insurer to cover hurricane damages to Costa Rica’s Government. If the hurricane does not happen, the investors will receive the corresponding amount of the fund or the principal of the bond, as specified in the contract.
What is the main advantage for the insurer? It keeps your business and transfers the risk. What is the main advantage for investors? An attractive Rate of Return. What is the advantage for the Government of Costa Rica? To insure possible losses if a catastrophic event takes place.
Every day we notice a greater number of natural disasters affecting us. The rainy season in Costa Rica that we are leaving behind is described as “remarkable and out of the ordinary.” Not surprisingly, the transfer of insurance risk for catastrophic weather events is expanding. According to an article from the World Economic Forum, the catastrophe bond market is growing at a compound annual rate of almost 10%.
Catastrophe bonds can be a bet for better resilience. If the hurricane in the previous example occurs, it is possible that it will not only impact Costa Rica, but also other countries in the region, forcing them to seek international help. These aids usually fall short, as the funds are often less than the amounts promised and arrive late. On the other hand, if more catastrophe bonds are issued, the countries will improve their economic resistance capacity and will have the money that allows them to provide assistance to their citizens in less time. Especially for emerging markets, catastrophe bonds can become a major economic lifeline.
Earthquakes and cyclones
Catastrophe bonds have some drawbacks. If Costa Rica’s Government decides to insure the public infrastructure against the damage that a hurricane may cause in the country, it will have to assume costs to initiate and operate the bond alongside the insurer. There will probably be a discussion among decision makers about whether it is worth investing these resources, given the situation might not materialize.
Additionally, as a Milliman article indicates, the catastrophe bond’s structure accommodates a wide variety of potential risks in different geographical regions, but requires reliable models for proper pricing. To build these models, there must be data that provides confidence to the entities that wish to structure the bonds.
It is also important to consider that these bonds cannot be used for all types of catastrophes. Some disasters are simply too likely to occur, making bond structuring very expensive. As a CFA Institute article indicates, this is already happening in the insurance market. For example, many houses located on the slopes of Mount Vesuvius, near Naples, Italy, are deserted because a large eruption of the volcano could take place.
In the Latin American region, the World Bank has structured several catastrophe bonds. The most renowned was issued for $1.360 million to collectively grant earthquake protection to Chile, Colombia, Mexico and Peru between February 7th, 2018 and February 15th, 2021. At the time, that was the largest sovereign risk hedging operation and the second largest issuance in the history of the catastrophe bond market.
The most recent bond is reviewed in an article by the Milliman company and was issued for Jamaica, with the purpose of covering the impact in case of tropical cyclones between July 24th, 2021 and December 21st, 2023, with a coverage of $185 million. The bond uses barometric pressure as the weather parameter, rather than actual or insured economic losses. The bond structure divides Jamaica and the surrounding area into a grid with nineteen sections. Each section has a different payment to compensate if a storm passes through it, based on the central barometric pressure of the storm. This allows it to be much easier to calculate and the payment to proceed faster and more efficiently.
In Costa Rica
On June 30th, 2022, Costa Rica’s National Strategy for Financial Management of Disaster Risks became official, in which four guidelines are defined to reduce fiscal risk in the event of disasters. Among these guidelines, it stands out “to have adequate instruments to face the fiscal risks associated with disasters” and it is indicated as a key action to evaluate the feasibility of structuring catastrophe bonds.
Disaster management must focus on mitigation, but countries like Costa Rica, located in multi-hazard scenarios, must be prepared for an adequate response and recovery. As Jorge Familiar, Vice President of the World Bank for Latin America and the Caribbean, indicated:
“When people are just one disaster away from poverty, risk management is a development priority”.
Catastrophe bonds can be an ideal tool for risk management, in precarious situations such as those that Costa Ricans go through frequently.