Bonds to the rescue

When a devastating 8.1-magnitude earthquake struck off the southern coast of Mexico in early September last year, toppling buildings in the region and leaving at least 90 people dead, the country was able to turn to the catastrophe bond market to help finance its emergency relief effort.

Mexico, which has been the most active sovereign cat bond issuer since its first deal in 2006, had issued a bond in August just weeks before the temblor hit, buying it US$150m of earthquake cover that it was able to claim in full (the deal also included another US$210m of tropical cyclone coverage).

While around a quarter of the US$26bn of cat bonds that were outstanding at the end of last year were sponsored by sovereigns or public entities, according to AON Securities, Mexico remains one of just a small number of sovereign nations including Turkey and Taiwan that have previously tapped the cat bond market to insure themselves against disaster risk.

However, a landmark deal in February from the World Bank’s International Bank for Reconstruction and Development, which raised US$1.36bn of debut earthquake cover for Colombia, Chile and Peru, as well as further coverage for Mexico – making it the largest sovereign cat bond on record – could begin to change that.

“That transaction was very important because it shows that countries can place sizeable limits in the market and it is generating a lot of conversation that we hope will bear out,” said Cory Anger, global head of insurance-linked securities origination and structuring at GC Securities, the investment banking unit of reinsurance broker Guy Carpenter.

“These deals have a very long gestation period and the World Bank had been working on that transaction for a number of years, but we think now that the market is showing robust capacity that will feed into more issuance.”

Cat bonds allow sponsors to transfer insurance risk for natural disasters such as earthquakes and hurricanes to investors, with sovereign cat bonds typically paying out if an event occurs that meets certain parametric criteria, such as the location and severity of an earthquake. That is different from traditional insurance cover, which usually pays out based on actual losses.

“The fact that you don’t have to prove any loss, just that an event has happened, obviously cuts a lot of red tape and gets the money to the government much faster,” said Luca Albertini, CEO at Leadenhall Capital Partners, which invests in insurance-linked products.

“That speed of recovery is important because to get the money three years down the road for something where you need to fund disaster relief immediately is obviously no use, so the fact that parametric transactions allow you to get the cash within a matter of two or three months is a massive benefit for sovereigns.”

The IBRD’s Pacific Alliance deal followed a record year for cat bond issuance, with sponsors raising US$10.7bn of cover in 2017, according to AON Securities, which helped structure the Pacific Alliance bond.

That deal raised US$500m of three-year cover for Chile, US$400m of three-year cover for Colombia, US$260m of two-year cover for Mexico (split over two tranches with different risk thresholds) and US$200m of three-year cover for Peru. In total, the deal raised almost US$400m more than originally intended as rampant demand from investors allowed IBRD to tighten pricing for each country between 25bp and 100bp inside the low end of guidance, increasing the amount of cover the countries could afford.

The bonds pay three-month dollar Libor (less the IBRD’s 20bp funding margin) and an annual risk premium of 2.5% for Chile and Mexico’s less risky tranche, 3% for Colombia, 6% for Peru and 8.25% for Mexico’s riskier tranche.

More than 45 investors participated in the deal, underscoring the potential enthusiasm for further sovereign cat bond issuance.

“[The Pacific Alliance deal] was very well received, these bonds were oversubscribed, so there is a lot of appetite coming from ILS managers like AXA IM because for us it brings some extra diversification,” said Francois Divet, head of ILS at AXA Investment Managers. “Most cat bonds are exposed to developed countries like the US and Europe, so for us it’s very useful to have access to perils in developing countries.”

Tightening spreads

Anger said cat bond spreads in general have compressed over the past five years in part because of the greater inflows of capital into the asset class, but also because cat bonds have low correlation with more traditional securities that usually move in tandem with broader economic sentiment.

“It’s a recognition that that low correlation in itself has value, so the risk margin investors need doesn’t need to be as great,” she said.

In the past, insurers and reinsurers have also tended to rely on equity financing, which has a much higher return hurdle than fixed income investors require, allowing cat bond pricing to be more attractive for issuers, Anger said.

The World Bank’s involvement in the Pacific Alliance deal also helped the countries achieve better pricing, given the bank has a ready-made cat bond programme that investors are familiar with.

That programme is attractive for sovereign sponsors because cat bonds otherwise require them to set up a special purpose vehicle to actually issue the bonds, which can be uncomfortable for some governments given the SPV typically needs to be structured in a no-tax jurisdiction such as Bermuda or the Cayman Islands. Issuing through the World Bank swerves that potential political banana skin.

Other obstacles have also hindered the pace of the sovereign cat bond market’s development.

“When you’re sponsoring or buying insurance through a cat bond, you obviously have to have all the regulatory approvals and internal authorisations and budget to buy insurance, and that’s something that not every government has ready,” said a person familiar with the World Bank’s cat bond programme.

That means for debut sovereign issuers, it can often be an arduous task to secure budgetary approval for something that might never be used.

“Political decision-making takes a while and if you’re a decision maker, suggesting something new has a certain amount of risk,” said Matthew Feig, a special counsel at law firm Cadwalader, Wickersham and Taft, who has worked on a number of Mexico’s cat bond deals. “You might get the credit but you’ll definitely get the blame if the product doesn’t work out.”

But the market has come along way since Mexico issued its first cat bond in 2006. The earthquake off the coast of Chiapas last September that triggered a full payout on Mexico’s 2017 deal further reassured potential issuers that the bonds work as advertised.

“It’s a lot more palatable in any political process to suggest something that is well proven, so cat bonds are an easier sell now, and all of these other governments can point to Mexico’s success,” said Feig. “The risk of bringing it up is lower, the unknowns are lower, the possibility to execute is much firmer and the cat bond market is much bigger, so the proof of concept is very well settled.”

Developing market

While the sovereign deals so far have tended to come from emerging market countries, the US also has a fairly active local cat bond market where privately funded but publicly managed entities such as the California Earthquake Authority have sponsored deals. Other developed nations are also looking at the cat bond market, said Anger.

And while the cat bond market mostly covers earthquake and storm risk, another landmark deal from the World Bank last year which is designed to provide emergency funding to help contain virus pandemics in some of the world’s poorest countries may also spur an expansion of the types of events sovereigns could look to insure themselves against in the future.

“There is interest from individual countries, and that’s probably the next stage of the pandemic insurance market; either individual countries insuring themselves against whole different diseases that they are particularly exposed to or it could be regional groupings that may include developed and less-developed members,” said the person familiar with the World Bank’s cat bond programme.

“Depending where you are in the world, you might be exposed to pandemic outbreaks in your neighbouring countries, so there may actually be reasonably developed countries that are not heavily exposed to pandemics but want to insure because of the risk of economic contagion from disease contagion in one of their neighbours.”

The World Bank is also looking at the potential for cat bonds to insure against famine risk and cyber attacks, while investors and ILS bankers say governments, including the UK, are exploring the possibility of using cat bonds to insure against terrorism risk.

In spite of a number of cat bond payouts in 2017 that left investors nursing sizeable losses, Andras Bohm, an ILS structuring specialist at AON Securities, reckons the momentum from last year’s record level of issuance will continue into this year, anticipating at least US$9bn of bonds.

Yet, even though more countries are eyeing the market, there is unlikely to be a wave of new sovereign deals in the near term, according to the person familiar with the World Bank’s cat bond programme.

“It’s not like there is trillions going through the market and the sovereigns aren’t there; it’s a fairly small market and there’s been a pretty good pick-up – but it’s going to take a while to build up,” the person said.