Latam Briefing: Regional Nat Cat
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Latam Briefing: Regional Nat Cat

Earthquake Damage, mexico City

Latin America’s insurance market is exposed to an impressive range of natural catastrophes. To the traditional perils of earthquakes in the Andes and Mexico and hurricanes in Central America and the Caribbean, new(ish) threats have gained weight of late such of floods across the region and droughts in the Southern Cone.

What is mostly lacking, though, are risk transfer tools that could help countries in the region to mitigate the financial impact of catastrophic events and accelerate humanitarian aid and rebuilding efforts.

The absence of such structures is one of the reasons why catastrophic insurance penetration in the region remains very low. According to Swiss Re, Latin American countries endured in 2022 $17.4bn in economic losses linked to catastrophic events. Of that number, only $1.9bn, or about 11%, were covered by insurance. In the United States and Europe, the level of protection reached more than 58%.

Risk mutualization schemes such as Spain’s Consórcio de Compensación de Seguros or the nat cat pools managed by CCR in France or Flood Re in the UK have helped to develop protection against catastrophic perils in their respective markets. In the US, public and private partnerships like The National Flood Insurance Program have had a similar impact, and a powerful cat bond market has also contributed to the mitigation of losses borne by home and business owners.

In Latin America, however, the insurance sector and private officials have broadly failed to come up with satisfactory financial mitigation tools, and governments have to tab virtually all the cost of reconstruction when a catastrophe hits. However, there are a number of experiences under way that could help boost protection levels with the participation of the insurance, reinsurance and capital markets.

The most recent one was the issuance in March of $350mn in cat bonds and the placement of $280mn in catastrophe swaps by the government of Chile, with the support of the World Bank, totalling $630mn of earthquake insurance cover for the Andean country. Michael Bennett, the head of Derivatives and Structured Finance, Capital Markets and Treasury at the World Bank, says that the deal showed the interest of investors for this kind of deal.

“We placed the bonds and the swaps with a rate of 4.75% a year, which was in the very low end of the range we had anticipated,” he says. “The cat bond market is highly concentrated in the US. When we bring deals from other regions, they are diversification opportunities for investors.”

The cat bonds were placed in the Hong Kong Exchange and were sold to 25 investors who were almost evenly distributed between Europe and North America. The catastrophe swap contracts, for their part, were placed with a number of undisclosed reinsurers, 60% of which are located in Europe, 36% in North America and 4% in Bermuda. The transaction will cover a period of three years after the transaction was finalized.

The deal was not the first one performed by Chile, which had already gone to the ILS market a few other times in the past two decades, including a four-country, $1.36bn earthquake deal in 2019 that also included Mexico, Colombia and Peru. Mexico is another experienced issuer of cat bonds, having renewed last year its $250mn share of the 2019 Pacific Alliance and tapping the market other times for earthquake and hurricane covers, including a $485mn deal placed in 2020. In 2021 Jamaica also acquired $185mn of protection against storms. A longer running experience is the Caribbean Catastrophe Risk Insurance Facility, CCRIF, a multi-government scheme that was structured in 2007, has recently expanded itself to Central America and included a couple of utility companies into the mix.

What all those initiatives have in common is the participation of the World Bank, which has structured nat cat risk financing tools for member countries since 2007. Over $3bn worth of cat bonds have been issued with support of the bank so far, and including other tools such as cat swaps, the total volume of risk transferred to capital and reinsurance markets reaches more than $5bn, Bennett says. Latin American governments are the most loyal customers of the programme.

“We use cat bonds as a reinsurance vehicle that allows us to offer insurance to member governments,” he stresses. “A catastrophe swap is basically a reinsurance agreement, but documented under a swap contract.”

By using those instruments, the World Bank offers parametric insurance covers to member countries, charging a premium that will be paid to ILS investors. Some, like Chile and Mexico, can fund their own parts of their deals, but others, like Jamaica and the CCRIF members, have relied on external grants from foreign governments or development agencies to kickstart their nat cat programmes.

“We are never allowed to hold any insurance risk. We can only write an insurance policy to a member if we can simultaneously and completely hedge it in one of these two ways,” Bennett points out. “The actual market execution is rather simple because it is just a reinsurance contract with the World Bank. We simplify the execution as much as possible, but that still leaves governments with the task of making decisions about the parametric coverages.”

That is where the process gets really complex for many governments in the region. Financial ministries are bereft of people with expertise in the insurance and reinsurance market, and the definition of the parameters that will trigger the policies can be a complex process.

For the latest Chilean bond, for example, it involved the development of a nat cat grid structure that encompasses the whole territory of the country and which defines whether the cover will be triggered in the case of an event. This is based on how deep is the epicentre of the quake, what is its magnitude, and the physical exposures of each part of the grid.

As with all parametric covers, there may be cases where the cover will not be triggered even though losses are significant, which is a hard sell with voters and something that officials may be unwilling to accept.

“There is an inherent mistrust by governments of the insurance and reinsurance industry. They will pay fortunes to investment bankers without blinking an eyelid, but when someone comes up with an insurance or reinsurance solution, they just say no,” says Aidan Pope, the executive chairman for LatAm & Caribbean at the BMS Group. “That is why they don't look into ILS solutions as much as they should. There is still a lot more we could do as an industry to educate governments about it.”

Another challenge refers to data. Earthquake and Mexican Gulf hurricanes are perils with plenty of historical information, and the data is collected by well-established bodies such as the US Geological Survey. Perils whose frequency is on the rise in Latin America, such as droughts and floodings, tend to be more reliant on local data providers that could be less immune to conflicts of interests from the governments that benefit from the policies.

“The reinsurance market and the modelling agencies feel comfortable about earthquake. So doing something that's related to earthquake is a much more straightforward process than a potential deal on flood,” Pope says. “Once you start combining perils, it becomes much more complicated and much more expensive.”

In his view, a potential solution to expand the use of ILS vehicles to transfer nat cat risks can rest on local, rather than national administrations.

“We are working on a number of projects with individual municipalities. There is less political wrangling, and they are very much more focused on the individual needs of towns and their inhabitants,” Pope points out.

The existing structures, at current values, are unlikely to cover a large share of economic losses caused by a huge earthquake or hurricane, but they can help governments to provide immediate assistance to the regions affected. More comprehensive nat cat schemes, including mandatory insurance systems, would be required to take protection levels to anything close to US or European standards.

But the fact is that the transfer of nat cat risks remains a topic that few people still want to discuss in the region, especially in times of economic hardship. In Brazil, CNSeg, an association of insurance companies, has recently floated the idea of setting up nat cat funds for crop insurance and flooding risks in poor areas, but the discussion still needs to gain steam. In other countries, similar initiatives hardly overcome the initial stages of discussion.

“We have insisted with the government that, at the very least for critical assets, there should be an insurance structure, which is not the case today,” says Eduardo Moron, the chairman of Apeseg, Peru’s insurance association.

He regrets that talks have not made much progress not even after the latest powerful quake that hit the country, which caused 514 deaths in 2007. The 7.8 earthquake that hit Turkey and Syria in February served as another reminder of how costly can this failure one day be for the country. The European country is facing a difficult reconstruction period despite the fact that, since the end of the 1990s, it has implemented a mandatory earthquake property insurance programme. In Peru, however, only 3% of all homes and about 15% of infrastructure assets are covered against the peril.

“Regretfully, in Peru, the catastrophic exposure is similar to Turkey’s,” Moron says. “But we have not progressed as much in this area as Turkey had done before the latest earthquake.”