Pacific Alliance explores cat bonds for climate related risks

The four Pacific Alliance countries, Chile, Colombia, Mexico and Peru, are beginning the work alongside the World Bank to identify potential solutions to help them transfer climate related natural disaster risks, including identifying whether further catastrophe bonds would be suitable.

The Pacific Alliance trade bloc nations in Latin America currently benefit from a combined $1.36 billion of catastrophe bond backed earthquake insurance protection, in a landmark multi-country issuance from the beginning of 2018.

The transaction was the largest single issuance of catastrophe bonds ever facilitated by the World Bank, in fact the largest sovereign risk insurance transaction ever seen.

It was issued by the World Bank’s International Bank for Reconstruction and Development in five series of catastrophe bond notes, as a way to establish protection for each of the covered countries.

The experience of tapping the capital markets for the reinsurance capacity to back the earthquake cat bonds has clearly been one the Pacific Alliance countries are ready to repeat.

We understand they are beginning the work now to identify what other climate or weather related, perils they could secure disaster insurance against and transfer to insurance-linked securities (ILS) investors in the capital market.

It’s early days in this process, we’re told, as the first stage is to engage with risk modelling firms to identify which climate, weather and so-called hydrometeorological perils, could feature in another catastrophe bond for the Pacific Alliance.

We understand this work could include looking at tropical cyclone risk and other severe storms, as well as drought, rainfall and precipitation and other exposures linked to extreme weather or climate conditions.

Precisely what financial instruments could be used to hedge these risks for the Pacific Alliance countries is open as well, we understand.

But catastrophe bonds are seen as one possible solution and we’re told there is a strong desire in the finance ministries of some of the countries involved to align any new risk transfer instruments with the successful earthquake cat bonds.

Some weather and climate related risks may be better suited to other solutions, such as derivatives. But that’s not to say that large enough transactions spanning the four member nations couldn’t be securitised into cat bond form anyway, no matter what structure underpins the transfer of risk or hedge.

The Pacific Alliance has driven this next phase of work as it seeks to enhance the protection each country receives against natural peril risks, electing to focus on the climate and weather linked exposures that are much more frequent drivers of economic loss to these nations.

Identifying the risks that could be transferred, measuring the potential impacts and exposures, then fitting them to the best structures for risk transfer is the likely outcome of the project, with cat bonds definitely an agenda item throughout.

Some of these perils could be more suited to an annual aggregate type approach, given they tend to be more frequency than severity based in a lot of cases. So could a parametric index that is calculated on an annual aggregate basis be explored perhaps? We’re told this is something that could come up for discussion.

Whether the risks can be fit into a catastrophe bond remains to be seen. But it’s encouraging to learn that the Pacific Alliance wants to continue to explore cat bonds as a potential risk transfer tool for a wider set of climate related disaster risks.

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