Executive summary
Faced with increasing exposure to natural catastrophes such as tropical storms, earthquakes, floods and droughts, the countries of Asia and the Pacific are in growing need of risk management strategies. One of the important challenges is financing disaster-related expenses. Traditional methods are not necessarily sufficient, so governments need to broaden their financial options by exploring innovative approaches. This study focuses on the adoption of catastrophe (CAT) bonds as a potentially useful disaster risk financing tool by the countries of the region. CAT bonds allow the transfer of disaster risks to investors in capital markets, lightening the load on governments in the event of a natural catastrophe, among other advantages. However, developing a CAT bond market presents challenges, especially for emerging economies.
This report discusses policy guidelines for countries of the region to consider when developing a CAT bond market. It also explores examples of the use of CAT bonds as a risk transfer mechanism around the world, as well as regional initiatives.
The global market for catastrophe bonds has grown steadily since it began developing in the 1990s. However, CAT bonds have mainly been issued in Europe, Japan and the United States, and the market in Asia and the Pacific remains underdeveloped. The Philippines is the only country of the Association of Southeast Asian Nations (ASEAN) to have issued a sovereign CAT bond covering property risks to date. Nonetheless, CAT bonds sponsored by the governments of Jamaica, Mexico and the Philippines show that there is market appetite for these instruments when they are deployed by countries that are highly exposed to disasters.
At the same time, protection gaps are a major issue in the region as insurance coverage for disasters is limited. From 2012 to 2018, only a negligible share of losses due to natural disasters was insured in many Asia and Pacific countries. In the absence of sufficiently developed private insurance markets, disaster losses either remain with households and firms or must be absorbed by the public sector.
Catastrophe bonds are financial instruments that utilise a process called securitisation to wrap natural disaster risk into a tradable format. In most cases, they provide a fast means of absorbing the impact of natural catastrophes in the short run since bond protection can be put in place immediately. They can be issued anytime and have a typical term of three years, offering flexibility and price stability. CAT bonds are designed to immunise the sponsor against counterparty default risk through full collateralisation with high-quality securities. Furthermore, in the event of a disaster, parametric triggers allow for a quick source of funding, while price signals from the CAT bond market and modern pricing models allow for informed decision making.
However, the development of CAT bond markets presents certain challenges. The use of parametric triggers may lead to basis risk – the gap between the sponsor’s actual loss and the composite index of losses that prevents the sponsor from receiving full risk hedging. The use of CAT bonds requires advanced and reliable infrastructure, trustworthy data providers and suitable catastrophe risk models. Moreover, the sovereign sponsor needs to design efficient and fair distribution schemes. The lack of a track record in CAT bond issuance can stifle investor interest. Investors may have concerns about standardisation and illiquidity. Lastly, as CAT bonds are a relatively new financial product in many developing countries, legal and regulatory frameworks remain underdeveloped.
To develop bond markets successfully, policy makers should:
Formulate a grand design for disaster risk financing, while recognising the importance of an integrated approach to disaster risk management and the contribution of risk assessment, risk awareness and risk prevention to the financial management of disaster risks.
While the individual issuance of CAT bonds has its merits and allows sponsors to address their unique risk profiles and tailor the instruments to their specific needs, governments can also explore regional initiatives. In addition to reducing transaction costs, joint issuance of CAT bonds allows sponsors to access a broader investor base. A regional approach may represent an alternative for developing countries in Asia and the Pacific, with cost-sharing benefits.