By Carlos Felipe Jaramillo
How the Catastrophe Bond Market is Supporting Financial Resilience in Jamaica
On September 10, 2004, hurricane Ivan devastated Jamaica with its Category 4 winds and rain causing more than US$350 million in damages and taking the lives of 14 people. The scene is far too common, not only in Jamaica but more broadly in the Caribbean, a region notorious for its vulnerability to natural disasters. While governments are getting better at preparing for the economic and human impact of these storms, the ever more serious effects of climate change are making these threats increasingly frequent and intense.
It’s an unfortunate reality that these storms will happen again. For Caribbean countries like Jamaica, it’s important to be financially prepared before they strike. Pre-arranged financing cannot stop hurricanes from wreaking havoc, but it can help a country provide immediate support to the poor and vulnerable, as well as rebuild critical infrastructure. Emergency funds and pre-arranged loans are often the cheapest way to finance disaster relief and recovery. However, it’s neither cost-effective nor feasible for small islands to set aside hundreds of millions of dollars. Instead, countries can build resilience by insuring themselves to lessen the impact of disasters. This is one of the innovative approaches that Jamaica has forged ahead with. Here’s how they did it.
First, Jamaica created a national public policy on disaster risk financing. With support from the World Bank and financing from the UK, the policy aims to improve the financial resilience of Jamaica through pre-arranged financing instruments and includes a contingency fund, contingent credit, and catastrophe insurance from the Caribbean Catastrophe Risk Insurance Facility (CCRIF). While this protected Jamaica from smaller, less severe disasters, the country would still experience large financing gaps if severe hurricanes like Ivan occurred. Through a World Bank issued catastrophe (cat) bond, Jamaica–together with development partners in the US, the UK and Germany – addressed this financing gap by securing US$185 million worth of insurance coverage for three hurricane seasons.
By entering into an insurance-like risk transfer agreement with the World Bank, the government of Jamaica can quickly receive much-needed funds if future storms exceed pre-defined intensity thresholds. The World Bank issued a cat bond to investors with terms that mirror those of the risk transfer agreement. If payouts are triggered, the cat bond principal is reduced by this amount. This win-win approach is good for Jamaica since the cat bond transaction generates much-needed financing without raising already high debt levels, and good for investors since they earn a coupon to compensate them for taking on the catastrophe risk. At maturity any remaining bond principal is returned to investors by the World Bank.
The payout triggering mechanism was developed by a specialized risk modeling firm, in collaboration with lead managers of the transaction, the World Bank, and the government of Jamaica, and includes a grid structure with 19 areas on and around the island of Jamaica (see image). A payout is triggered if a storm passes through one or more of these areas and the central pressure of the storm is at or below specified intensity thresholds. With this approach, payouts can be made quickly – within weeks of a storm – which will facilitate and greatly enhance Jamaica’s emergency response.
So why go through organizations like the World Bank for this approach? The World Bank is an effective issuer of cat bonds for the benefit of its sovereign members thanks to its experience and reputation in the capital markets, its AAA credit rating, and its uniquely flexible capital-at-risk notes program that facilitates risk transfer solutions using capital markets. Credit rating agencies recognize that a comprehensive disaster risk financing strategy improves fiscal resilience. This cat bond transaction adds a significant protective layer against potential negative impacts on Jamaica’s sovereign credit risk following a catastrophe event. Overall, improved credit-risk assessments can translate into lower and more stable funding costs for countries.
Despite being in one of the most disaster-prone regions of the world, Jamaica is building resilience by preparing for these threats in advance. Innovative approaches like this cat bond will help the country rebuild quicker and stronger. If Jamaica had this coverage in place when hurricane Ivan struck, they would have received a $185 million payout offsetting a substantial portion of the damage.
While financial solutions like these cannot save lives or buildings, they can provide quick relief when it is most needed in order to rebuild critical infrastructure in the aftermath of a disaster. Moving forward, the World Bank will look to support even more Caribbean countries by offering the same type of financial protection and enhanced risk diversification that Jamaica has through the design of a regional CAT bond.
This document has been prepared by the World Bank (International Bank for Reconstruction and Development, IBRD) for information purposes only. The World Bank makes no representation, warranty, or assurance of any kind, express or implied, as to the accuracy or completeness of any of the information contained herein. This document is not an offer for sale of securities of the World Bank. Any offering of World Bank bonds will take place solely on the basis of the relevant offering documentation including, but not limited to, the prospectus, term sheet and/or final terms, as applicable, prepared by the World Bank or on behalf of the World Bank, and is subject to restrictions under the laws of several countries. World Bank bonds may not be offered or sold except in compliance with all such laws.