Chile is reportedly looking to issue a catastrophe (cat) bond in order to be more prepared for natural disasters and severe weather. A cat bond is like insurance, transferring monetary risk from Chile, in case of disaster, to investors in the bond.
Cat bonds were first used in the 1990s in the aftermath of Florida’s Hurricane Andrew and the Los Angeles area Northridge earthquake. The catastrophe bond is a way to obtain cheaper insurance against low probability, expensive events, offering multiple year coverage.
They work in a fairly straightforward fashion. A government, state or investor, looking to insure itself against financial risks from natural disasters, would issue a bond with coverage for specific disasters. An insurance company issues the cat bond through an investment bank, which sells the bond to interested investors.
Should the specified natural disaster occur, the government stops paying the insurance premium and keeps the principal of the bond, which is held in a trust fund, to pay for the expenses caused by the disaster. If the event does not occur, investors are repaid with interest.
Cat bonds also depend on certain parameters before the payout kicks in. Predefined triggers, like an earthquake of a certain magnitude, would determine the amount of the insurance payout.
Cat bonds are risky. If a catastrophe occurs, the principal would be forgiven and the insurance company would use the investor’s money to pay their claim-holders, meaning the investors would lose their investment. But If no catastrophe occurs, the insurance company pays a coupon to the investors, who make a healthy return on their principal. The low probability of disaster and high return is worth the risk for many investors.
Asset managers and hedge funds are the typical investors in cat bonds. To date, the only country that has issued cat bonds is Mexico. So why is Chile looking into issuing a cat bond?
Speaking at the IMF and World Bank annual meetings held in Lima, Peru earlier this month, Rodrigo Valdes, Chile’s Finance Minister, said that his nation is actively looking into catastrophe bonds as a source of financing for weather and nature-related disasters.
The South American nation has faced eight major disasters in the last two years. The most recent was the Chile earthquake a month ago, but the nation is vulnerable to other disasters such as volcanic eruptions, mudslides and flooding.
Chile has a comprehensive disaster alert and response operations framework in place to save and protect as many lives as possible, but the cost of the disaster and the response operations is a burden too big for Chile to bear.
“The country has learned to handle these situations well in terms of operation,” Valdes explained, but he noted that Chile lacked the financial means required for major disaster response.
Chile is not the only country currently looking to issue catastrophe bonds. The Philippines finance minister has said that the island nation is seeking a cat bond issuance by the end of 2015, with support from the World Bank.