Mexico: Developing a Framework for the Issuance of Catastrophe Bonds
Mexico is exposed to significant risk from earthquake, primarily from faults lying along its Pacific coast. The resulting risk to the infrastructure led to the establishment of Natural Disaster Relief Fund (FONDEN) which provides funding after a natural disaster. However budgetary constraints led to insufficient funding for FONDEN. The Mexican Ministry of Finance and Public Credit requested FIRST support in August 2004 to:
- review the legal and regulatory framework, and amend if need be, to permit issuance of catastrophe bonds (CAT bonds) and ensure the process comes under the finance sector supervisory net;
- validate the financial analysis and determine legal implications for the basic CAT bond structuring for a catastrophe management model;
- assist in the evaluation of proposals for CAT bond issuance.
Two groups of consultants were engaged by FIRST: one for financial advice to the Ministry of Finance on CAT bond structure, and an expert on legal issues.
The final outcome was the issuance of a catastrophe bond (CAT bond) of US$ 450 million under-written by Swiss Re (the largest global reinsurer) which was purchased by investors through a private capital market placement. Deutsche Bank, the partner in the transaction, helped in distribution and investor relations. The coverage was arranged through Swiss Re Group and Deutsche Bank. Swiss Re provided the reinsurance coverage, as well as creating the CAT bond fund. That mix of coverage from the reinsurance and capital markets served the government well as the client, since a key component of coverage was obtained at a reasonable price. Mexico became the first developing country to issue a CAT bond.
The CAT bond identified three zones in Mexico where a triggering earthquake could occur. The bond would be triggered if an earthquake is of certain intensity at certain depths from the surface in one of those zones. Regardless of the location of the earthquake, the bond covers resulting losses to government-owned property throughout the country. The Mexican government will be reimbursed even if the financial losses occur outside the specific zones where the earthquake occurs.
The mechanism is such that the investors who buy the bonds are essentially ‘betting’ that an earthquake will not hit Mexico in the next three years. If there is no disaster in three years, the investors keep the premium and the interest and get back the bond. In the event of a quake, the government gets up to the full value of the bonds, and investors lose some or all of their money, depending on the severity of the quake at different Richter scale trigger points.
Catastrophe bonds were started in the 1990's, and have largely been issued by private companies to cover losses from natural disasters. Taiwan is the only other government that has issued such a bond against a quake, albeit with a different payout structure.
Overall, therefore, the FIRST project achieved a tangible result serving as a demonstration effect for other developing countries and markets, while at the same time bridging innovation in the financial sector with mechanisms for future disaster funding, which help to stabilize government budgets while obviating the need for building up excessive idle budget reserves.
The Ministry of Finance, World Bank and FIRST worked closely and effectively throughout the project and achieved a remarkable and well-publicized outcome (global press, including Wall Street Journal).
- Funds used were allocated to engage reputable leading experts who were crucial for proper bond design and credibility and receptivity by the market. Because the use of less recognized contractors (i.e., by the market) would have hampered the quality and ‘executability’ of the final issue.
- The local coordinator contributed significantly in terms of ensuring quality checks and organization among the parties involved. The active involvement of a representative of the MOF was one of the keys to successful outcomes in this project.
- Robust data on earthquake incidence and collateral damage was essential for risk assessment, structuring and pricing of a CAT bond issue.
- This initiative demonstrated that financial sector instruments can be used to address specific developmental needs besides those strictly residing in the financial sector. In this case it was about post-disaster expenditures where a financial instrument was developed to manage the budgetary impact.
- One aspect to be mentioned was the final structure of the CAT bond which was issued/supplied by an international reinsurance company along with two separate regions of coverage using traditional, albeit, parametric insurance coverage. While the CAT bond component succeeded in meeting the goals of the project, its underwriting by the reinsurance company (vs. an outright capital market issuance) gave it a very favorable interest rate which attracted the needed market investors. However, as a demonstration effect, this was perhaps less replicable since the low rate was absorbed by the reinsurance company when standard market terms might have been a bit higher. Thus, the pricing was not fully demonstrative of typical possibilities in the emerging country markets.
- The initiative demonstrated that the avoidance of fiscal volatility is quite an important concern in countries subject to natural disasters because undue volatility can have both economic and political effects. That the project demonstrated that such volatility can be managed and transferred to the private sector markets is commendable, and shows how financial innovations in emerging countries can be exploited to share risks globally while maintaining local economic stability despite exogenous (in this case disaster) shocks.
- This type of project will be of great value to Mexico in gaining protection from the risk of loss from other catastrophic events and the results of the project may apply to other developing countries interested in gaining similar protection. There is currently a study underway by a group of Caribbean states to determine if they can join together to obtain similar protection from earthquake and hurricane loss. Other examples are certain Latin American states obtaining earthquake protection or Asian countries obtaining protection from tsunami.
- The project is replicable in Mexico for other catastrophic risks and in other countries. In terms of future products, this project has provided incentives for the government to develop CAT bonds for other perils such as hurricanes which impact Mexican territory frequently and for other countries to develop such instruments. It has also generated government interest in multi-instrument mechanisms (as had been proposed under the earlier disaster loan) combining CAT bonds for risk transfer with long term contingent credit support so as to maximize coverage while minimizing the cost. A group of Caribbean countries is also looking to club together to obtain similar protection from earthquake and hurricane loss, while Asian countries might seek to insure against tsunamis.
The Consultants’ Final Report is disseminated. This is a clear description of the entire process involved in the structure and pricing of the CAT bonds.