Municipal Catastrophe Bonds Would Incentivize Natural Disaster Mitigation

Capital Markets Fall 2011: Presidio Graduate School
This post is part of the capital markets open letter project by MBA students at Presidio Graduate School.

Lateral spread in the 2001 Nisqually Earthquake

Open Letter to Amy L. Brown, City Administrator
Office of the City Administrator, San Francisco

Re: Municipal Catastrophe Bonds

Dear Ms. Brown:

At least one catastrophic earthquake is likely to affect the San Francisco Bay Area in the coming decades. Earthquakes are unpredictable and can be economically, environmentally, and socially devastating. As regions like the Bay Area continue to become more densely populated, the magnitude of the impact and recovery will amplify. It is important that disaster prone regions proactively seek mitigation mechanisms to protect citizens and strengthen their communities.

Today’s catastrophe bonds use capital markets to spread the risk incurred by insurers. The bonds have proven to benefit investors, municipalities, and insurance companies, but continue to lack incentive to improve the community’s overall resilience to natural disasters.

We would like to introduce a new form of municipal catastrophe bond that would incentivize natural disaster mitigation funding while also providing financial protection in the event of a major earthquake. The bond would be issued through a partnership between the City of San Francisco and the municipality’s infrastructure insurance provider. It would attract local investors who seek a safe, modest return and want to invest in the disaster mitigation of their local community. A special purpose vehicle (SPV) would manage the fund. If an event triggers the payout of a bond there would be immediate funding available to rebuild the cities infrastructure in a sustainable manner.

This is how it works. Seventy-five percent of the fund would be invested in safe securities, such as risk-free treasury bonds, which would comprise a portion of the overall financial return to the investors. Twenty-five percent of the fund would be issued to the city for immediate mitigation work with a 1-3 percent interest loan expected to be paid back before the planned expiration of the bond term. The insurance provider would utilize a percentage of their premiums to subsidize the coupon on the bond, providing investors an acceptable return. As a result of the bond, the insurance company hedges their exposure to disaster claims.

Similar to any catastrophe bond, if an earthquake were to occur that met the trigger criteria, the full payout of the bond would be paid to the insurance company to cover claims. Investors would therefore forfeit their entire principal and any additional future payouts. The city of San Francisco would be the benefactor to 100 percent of the bond’s value, absolving the city of repaying their previous 25 percent loan, plus interest note. To reduce risk to investors, these bonds could incorporate multiple municipalities throughout the region, creating a tranche design that would spread the exposure across numerous geographic areas.

Any capital issued from the municipal catastrophe bonds, either by way of a full payout or the initial 25 percent loan, will be subject to specific use terms. The funds may only be directed towards strengthening infrastructure to mitigate earthquake risk and impact. If a qualifying disaster does not occur within the five-year term, the investors will benefit from the receipt of the annual coupons plus the return of their initial principal investment.

We are kindly requesting that your office join us in an effort to create this new bond. We would like to ask for your time to discuss the city’s disaster mitigation needs and ongoing role. With your approval, we would like to work with the primary insurer for city infrastructure to determine the feasibility of this proposal. By adopting this new bond, we believe there is an opportunity to put capital to work for the benefit of the local community while at the same time providing protection against earthquake disasters.

Best Regards,

Krystal Kavney
David Pope
Peter Rose
Joseph Wilzbacher

[Image Credit: WAstateDNR – Department of Natural Resources, Flickr]

One response

  1. Interesting idea. However could you just clarify a couple of things:

    So the cat bond triggers; you say the insurer gets 100% of the bond value but only 75% is held in collateral. At the same time you say that the municipal loan doesn’t have to be paid back. If this is the case how does the insurer recoup their losses?

    Also, you say ‘the city of SF would be 100% benefactor to the bonds value’. How? If the insurer is receiving a payout how does the city of SF benefit?

    It’s a really nice idea though, allowing a portion of the collateral to be used to actually put into risk mitigation projects. Cat bond investors would be fine with this as long as the loan is paid back (you may need some way to cover the loan payments).

    If you can clarify the above for me I may write about your idea on Artemis as it would no doubt interest our audience.

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