AMID ongoing concerns caused by the eruption of the Taal Volcano, we should take a moment to appreciate how the Department of Finance (DoF) has probably guaranteed that no matter what the volcano has damaged or might still yet ruin, the economy will not be among the casualties.
Unbeknown to most people until Finance Secretary Carlos Dominguez 3rd announced it last Monday, barely two months ago, in November of last year, the DoF organized the issuance of a so-called CAT bond — the CAT stands for “catastrophe” — worth $225 million through the World Bank. If the damage from the Taal eruption reaches a specified limit, the government will be able to collect that amount to fund relief and rehabilitation efforts, sparing the national budget from an enormous expense.
In concept, a CAT bond functions as a kind of insurance. In buying the bond, which is attractive because it usually has a short tenor (about three years) and a better-than-average interest rate, investors are betting that a catastrophe defined by the terms of the bond will not occur before the bond matures. According to the Finance chief, in the case of the Philippines’ World Bank-underwritten CAT bond, the threshold is P11 billion in total damage or about the loss incurred as a result of the 1990 Luzon earthquake.
In other words, if a disaster that causes P11 billion or more in damage does not occur by the time the bond matures, the Philippines must pay the investors the $225-million principal plus interest. Technically, the government must repay the World Bank, which will pay the investors directly, as it is holding the funds collected in the sale of the bond. If such a disaster does occur, however, the principal is paid to the government, and the investors lose their investments.
CAT bonds were first developed by insurance companies in the United States in the mid-1990s after 1992’s Hurricane “Andrew,” which caused massive damage in Florida, and the 1994 Northridge earthquake near Los Angeles. At the time, these were the costliest natural disasters in US history and drove many insurers to near-bankruptcy. Issuing CAT bonds was a way for these insurers to spread some of their risks, and ensure that they would be able to cover their policyholders’ losses in the event of a major catastrophe.
From the Philippines’ point of view, there are far more advantages than disadvantages to issuing a CAT bond. The funds serve as a large-scale cash infusion in time of disaster, allowing the government to spend as needed for relief and recovery efforts without compromising other programs and expenditures. Likewise, the government can avoid issuing additional bonds to raise funds or producing a supplemental budget, both of which take time.
If a qualifying disaster does not occur before the bond matures, the government will, of course, have to pay for it, plus interest, but it can manage and even reduce these debt costs to some degree by issuing other bonds in the regular market to cover the CAT bond. Likewise, paying out on a matured CAT bond is credit-positive; subsequent CAT bond issuances can be made with slightly lower interest rates.
If a disaster of the magnitude required to trigger the CAT bond does occur, that is bad news in the sense that it technically amounts to a bond default. But due to their somewhat unique nature, CAT bonds do not negatively impact the country’s credit profile to the extent that a regular bond default would; it is understood that a CAT bond is a gamble, and gamblers sometimes lose. The most significant result of a CAT bond being defaulted, that is, being paid to the government rather than investors, is that any subsequent CAT bond issuance would probably have to be done with a higher interest rate.
Everyone certainly hopes that the Taal eruption does not become worse or continue to inflict damage on people and property. It is comforting to know, however, that the government’s foresight will ensure that its fiscal position will remain sound even in a major catastrophe, and that it can easily afford to provide aid for everyone who needs it.